Microfinance institutions (MFIs) were created with the socio-commercial objective to provide access to credit low-income people and thereby aid in poverty alleviation. Tthese loans were meant to rescue the borrower from the high lending rates imposed by traditional moneylenders. However, the industry has recently come under scrutiny in India for reasons varying from alleged suicide cases induced by high interest rates to coercive collection methods and corrupt and unethical practices amongst the head honchos of some of the largest MFIs. In response, the Andhra state government has published an ordinance attempting to exercise greater control over the activities of MFIs.
There seems to be an uncanny resemblance between some of the business models that have developed in microfinance lending and that of sub prime lending. The main differentiator between the two though is that a sub prime loan charges a high rate of interest assuming a high probability of default by the borrower. In the case of MFIs, higher rates of interest have been justified by high operational costs due to smaller sized loans.
Apart from lending, MFIs have broader responsibilities of limiting credit dependence. Moreover, microcredit is meaningful only if it is a part of a range of offerings including microinsurance, financial literacy, and entrepreneurship skills training. Over the last five years, as MFIs chased growth, the nature of microfinance delivery changed. The job of income generation and social capital building was left for others to tackle. As competition intensified and markets reached saturation, MFIs took on the additional risk of lending to households with uncertain cash flows. If this trend persists, there is a huge likelihood that the industry will follow some of the flawed practices of the sub prime lending models, resulting in huge collective losses over a period of time.
This does not necessarily mean the death of the micro finance industry as we know it. But it will have certain implications on the workings of these institutions including the shelving of IPO plans by some MFIs and more state level regulations similar to that of Andhra.