Opinion
Microfinance risk: Small loans can spell big trouble for Indian banks
Summary
- Watch out for signs of asset stress in India’s micro-finance sector after a phase of irrational exuberance. Bad loans, even if small, extract a cost by way of reduced profits as well as higher interest charges on credit across the board.
Once bitten twice shy" goes the old adage. But it clearly does not apply to banks. Or so it would seem. After having pursued aggressive lending to non-banking financial companies only to see the chicken come home to roost in the form of rising bad loans and recovery problems, banks are now seeing a replay of the same irrational exuberance.
This time in the context of loans to India’s micro-finance sector. Remember, banks and non-bank lenders compete fiercely in this field.
Driven perhaps by the lack of credit demand from corporates, a boom in retail credit, an eagerness to bridge the last- mile gap in credit delivery and pressure to achieve priority-sector lending targets, banks seem to have lowered their guard and gone overboard in extending such loans.
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Especially since regulations were harmonized to remove interest-rate caps. The net result? Rapid growth in micro-finance loans—essentially small-sized but collateral-free credit to those with annual incomes of up to ₹3 lakh.
According to data from the Microfinance Industry Network (MFIN), as of June-end, the total outstanding of such loans had jumped by 18.3% year-on-year. Inevitably, default rates have also risen.
According to a recent India Ratings report, despite new regulatory guard-rails set by MFIN, there are growing signs of overheating in the sector.
Part of the problem is the very nature of micro-finance lending, characterized as it is by informality and lack of collateral. While this is only to be expected, or even desirable for credit to reach borrowers at the bottom of the pyramid, successful lending to this sector also calls for more ears to the ground—of the kind that commercial banks do not have.
In this respect, micro-finance institutions (MFIs), small finance banks and even regional rural banks are better placed. Today, it is not banks alone that face the heat of rising defaults.
According to India Ratings, MFI collections fell in the June quarter, leading to higher delinquencies and a slowdown in the growth of assets under management during those three months. This followed a 30% decline in new loan sales in the March quarter.
The last time MFIs came under a cloud, more than decade ago (recall the Andhra Pradesh crisis of 2009-10), the reverberations were felt countrywide and it took a long time for them to recover and gain steam afresh.
To its credit, the Reserve Bank of India (RBI) had alerted banks earlier of the risk of rising defaults in the sector, while flagging unfair practices, including “usurious" interest rates and “unreasonably high" processing fees.
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In an informal advisory, RBI had asked lenders to stop issuing new micro-finance loans to borrowers unless the latter had cleared previous loans.
Unfortunately, as is often the case when such advisories are issued, the result is likely to be a temporary spike in defaults, since many banks have been ‘ever-greening’ loans or ‘netting off’ old dues against new credit.
For now, it is unlikely that bad loans to India’s micro-finance sector could pose a systemic risk to the overall banking sector—and thence to the larger economy. But that is no reason to be complacent and let these danger signals go unheeded.
Bad loans extract a cost in terms of reduced profits (due to higher provisioning) as well as higher interest charges levied across the board as banks try to protect their net interest margins. And then, there is also the risk of banks turning averse to micro-finance—which is something we must guard against.
