Micro-Finance: An alternate financial system for rural India

Divya Ganesan


Indian Institute of Management Bangalore

Venkatesh Sankararaman


Indian Institute of Management Bangalore


Micro-finance is increasingly playing an important role in meeting the financial needs of the poor in developing nations. This form of financing has received a lot of attention over the last few years around the world. India , being a predominantly agricultural society, could benefit tremendously in terms of poverty alleviation, improvement in standards of living of the poor etc.

Rural Credit

Need for Credit for Rural Households

The rural population in India suffers from a great deal of indebtedness and is subject to exploitation in the credit market through high interest rates and lack of convenient access to credit. Rural households need credit to fund their working capital needs on a day-to-day basis, investment in agriculture, insurance against minor spikes and troughs with respect to income and expenditure. Since cash flows in rural areas for the majority of households are small and savings are small as well, rural households typically tend to rely on credit for other consumption needs like education, food, housing, household functions etc. To meet these credit needs rural households need access to financial institutions that can provide them with credit at lower rates and at reasonable terms than the traditional money lender thereby helping the rural populace avoid debt-traps that are common in rural India .

Features of Micro Credit

The main features of Micro-credit include the following.

•  No collateral

•  Group lending thereby lowering transaction costs and improving repayment through the concept of social collateral

•  Way of promoting market-led growth/privatizing the economy

•  Targeting the poor below the line of poverty

•  Limited size of loans that varies from region to region

•  Delivery of the loans through NGO and Micro Finance Institutions (MFI)

Self Help Groups and NGOs

•  Self-Help Group (SHG) is a small voluntary association of poor people, preferably from the same socio-economic background. This group concept is leveraged using NGOs for provision of micro-finance in India . SHGs typically involve women, about 10-20 in number and the group members pool in their savings every week, fortnight or month in a bank. This pool of money can then be used as collateral to provide loans for income-generating activities. NGOs play an important role in promotion of Microfinance through SHGs. For provision of these services, NGOs get some financial support in the form of grant from Apex Financial Institutions like NABARD and RMK (Rashtriya Mahila Kosh).

Review of Government Policies

The RBI has been issuing directives for a long time now regarding ‘social and development banking'. Some of these are:

•  Imposing a cap on the interest rates

•  Sectoral allocation of credit and expansion of rural branches.

In line with this it was made mandatory for commercial banks to lend around 40% of their advances to the ‘priority sector'. Also now there has been a change in the definition of ‘priority sector'. Advances to newly created infrastructure funds, to non banking finance companies for on-lending to small units, to the food processing industry and even to multinationals like Kelloggs, Pepsi, Hindustan lever etc. fall under priority sector.

Also all of the formal sector institutions involved in microfinance have depended on refinancing and recapitalization by apex institutions like NABARD and SIDBI on a regular basis. s

Impact of other Government policies:

•  High Fiscal deficit: This results in the government appropriating all the financial savings to repay its own debt instead of helping the rural sector.

•  The government also further aggravates the banks problems by capping the PLR especially to small sector industries and by flooring the deposit rates thus increasing the banks borrowing costs.

Impediments to growth of Micro-Finance

The following are some of the limitations that can be seen in the micro-finance lending scenario in the country.

•  In spite of the rapid growth of micro-credit, the outreach is still modest in terms of proportion of poor households served, covering less than 5% if India's rural poor.

•  The quality and sustainability of independent micro-financing institutions and SHGs is a concern as these suffer from weak governance and internal management structures.

•  The current MFI movement is highly biased towards women, when men form a bulk of the clientele in the unorganized money-lending sector (approx Rs. 250 billion).

•  The current regulatory environment needs to be upgraded in the form of clear policies that will promote and sustain MFIs in India .

•  There is always a danger that as MFIs grow, they could fall into the trap of catering to the richer clientele among the rural masses thereby defeating the basic purpose of micro-credit.

•  MFIs are largely concentrated in the southern regions and a concerted effort is required to disperse these institutions across the nation.


Suggestions to Improve Micro-Credit Lending

The following suggestions are in order for the development and scaling up of micro-finance in the country.

•  Credit Scoring Models: Scoring develops a scorecard that loan officers use by inputting client data to create "scores" that predict several types of client behavior . It helps evaluate credit risk and thus automates loan application approval process. This can be implemented for MFIs that are typically large and for individual clients as opposed to group lending since group characteristics are difficult to evaluate using these models.

•  Quality of SHGs : Evaluation of the management and internal control structures of SHGs should be promoted using formal credit ratings processes. Such models are evolving in the industry and needs to be carefully evaluated and promoted across the country. This will help in improving loan recoveries and speeding up the process for loan disbursals. An example of such a model is the GIRAFE methodology, a comprehensive rating and evaluation tool designed to address the unique characteristics of MFIs . Promotion of transparency and effective supervision will also ensure the maintenance of the quality of the SHGs.

•  Deregulation of Interest Rates: This will help MFIs to adjust its interest rates in line with its costs thereby enabling their sustainability in the long run.

•  Development of Standardized Loan Appraisal Forms will help in speedy disbursal of loans thereby reducing transaction costs.

•  Improving repayment rates : MFIs need to develop mechanisms that take advantage of the group lending process and reduce default rates. This can be done by focusing on target groups and emphasizing on the self-selection of its members that will ensure mutual responsibility for loan repayment. The restriction of the group size and enforcement of group liability by excluding groups that do not repay from future loans can help increase repayment rates.

•  The government can initiate policies, which promote c ompetition in this sector thus generating high payoffs. This will also help in eliminating geographic concentration.


  • Ramachandran V.K and Madhura Swaminathan, Rural Banking and Landless Labour Households: Institutional Reform and Rural Credit Markets in India, Journal of Agrarian Change, Vol. 2, No 4, October 2002, pp. 502-544
  • Ibid
  • Srivatsava Pradeep, Basu Priya ‘Scaling-up Access to Finance for India 's Rural Poor'
  • http://www.cgap.org/docs/IT_credit_scoring.pdf
  • http://www.planetfinance.org