Microfinance sector faces funding crunch, default fears amid scrutiny

The microfinance industry is in a bind as funding declines and fears of defaults swirl amid stricter regulatory scrutiny

Sometime towards the end of this month, microfinance institutions (MFIs) hope to get a funding lifeline: The number being bandied about is around ₹6,000 crore, though the demand is much higher. The business is not doing well, to put it mildly. Funding fell to ₹58,109 crore in FY25, a decline of 55.40 per cent year-on-year (Y-o-Y). Confidence levels of lenders (to MFIs) headed south on fears about asset quality, over-leverage and relatively poor collections. The industry’s gross loan book shrank to ₹3.59 trillion in June 2025, down 5.8 per cent quarter-on-quarter and 17 per cent on an annual basis, even as the Reserve Bank of India (RBI) pushed for responsible lending, and guardrails to curb overleveraging kicked in. 

The worst may not be over. With state election season around the corner — when political parties typically throw fiscal caution to the winds while promising freebies — MFIs that fear its impact on credit discipline have raised the issue of loan waivers with the RBI and North Block. Bihar, Assam, Kerala, Tamil Nadu and West Bengal — they go to polls between the second half of 2025 and early 2026 — account for 42 per cent of the microfinance portfolio with 3.2 million unique borrowers, discounting those with multiple loan accounts. Crisil has said the Bihar portfolio, which accounts for 15 per cent of MFIs assets, “remains under watch as well given the state goes to polls in the third quarter of the current fiscal. In the past, sociopolitical issues have impacted collections during polls in some states.” 

In this context, it is pointed out that even the well-meaning Karnataka Micro Loan and Small Loan (Prevention of Coercive Actions) Ordinance (2025) in February affected collections. The ordinance excluded RBI-regulated entities in the microfinance business — be they MFIs or banks — but confusion continued within the state administration and customers regarding its scope. The Tamil Nadu Money Lending Entities (Prevention of Coercive Actions) Bill (2025) passed in April to protect vulnerable groups from aggressive tactics used by money-lending firms has also affected MFIs’ field collections. 

In June, the RBI gave a breather. MFIs are now required to maintain qualifying assets of minimum 60 per cent of their assets over the earlier requirement of 75 per cent. This helped them improve loan diversity, thereby augmenting their credit risk profile and enabling them to meet other credit requirements of end borrowers. But “managing concerns around borrower-level leverage, however, shall remain a key monitorable,” feels A M Karthik, senior vice-president and co-group head, Icra. 

What’s at stake 

“Given the focus on financial inclusion, this (funding) has to be addressed as over 6 million borrowers are without access to formal credit,” says Manoj Nambiar, managing director of Arohan and chairperson of Microfinance Institutions Network (MFIN). 

Over the past year, there’s been a noticeable shift to safe harbours, with around 60 per cent of loans being extended to existing customers with proven repayment histories, noted CRIF High Mark’s ‘MicroLend Report’ released in June. It reveals a deliberate shift from rapid expansion to prudent, quality-focused lending, with lenders prioritising established customers, larger ticket sizes, and reduced borrower leverage. The share of loans above ₹1 lakh in the industry’s portfolio rose to 8.3 per cent Y-o-Y in June, with 80 per cent of these being extended to borrowers with a vintage of more than two years. Implicit in all this is that customers may again knock on the doors of moneylenders. 

Is this an exaggeration? Sumita Kale, chief executive officer (CEO) and senior fellow at Indicus Foundation, points to National Bank for Agriculture and Rural Development’s latest survey on Rural Economic Conditions and Sentiments. The share of rural households reporting credit from formal sources increased to 54.5 per cent last month from 48.7 per cent in September 2024. Borrowing from informal sources was around 20-21 per cent. Of the 21.8 per cent households that borrowed from informal sources in September 2025, around half tapped family and friends and just 4 per cent took money from moneylenders. “This is across the period of time that MFIs have been under stress. Two things stand out. One, formal finance is on the rise in rural areas, and those with low-income have always resorted to family and friends as their mainstay in times of need,” says Kale. But she concedes “the sector has to be reimagined; and break out of the cycles of overleveraging and stress” 

The RBI is considering whether to give Section 8 companies, or not-for-profit entities, involved in microfinance access to credit information companies (CICs). Under the CIC (Regulation) Act (2005), only RBI-regulated entities (REs) are allowed to hook into credit bureaus — that is sharing data with and accessing it from them. This cuts data flow to Section 8 MFIs as only non-banking financial companies dedicated to microfinance are eligible. 

 

As matters stand, loans provided by MFIs are not visible to the wider MFI ecosystem. This leads to defaults and customer indebtedness as lenders end up giving more loans to an unworthy clientele. It also affects banks which have funded Section 8 MFIs. An aspect which had featured in meetings between the RBI and MFIs is of customers taking advantage of the arbitrage available between Section 8 and mainline MFIs; it also affects priority sector loans given by banks to Section 8 entities. Incidentally, Sa-Dhan — one of the sectoral self-regulatory organisations (SRO), the other being MFIN — has partnered with TransUnion Cibil to launch a dedicated credit awareness initiative. Designed to strengthen credit literacy and prudent lending practices within the MFI ecosystem, it will support lenders and microfinance borrowers. But this aspect only takes care of MFIs being blindsided when they lend. What of institutional support? 

 

Grading over rating 

MFIs are typically small and find it difficult to get a better credit rating. “If lenders can adopt grading instead of rating, it will help many MFIs get funding support,” says Jiji Mammen, managing director and CEO, Sa-Dhan. Incidentally, the Small Industries Development Bank of India and sectoral experts developed a grading system, which has been adopted by all rating agencies. Despite this, it could be that rating agencies and lenders have reasons for doing things their way. Another is dedicated funding for MFIs or a government guarantee mechanism for borrowing. During Covid-19, there was a dispensation of this kind. “There was hardly any case of recourse to this guarantee fund. But it helped MFIs borrow from banks which felt comfortable to lend with sovereign backing,” says Mammen. 

“I think in order to facilitate capacity building and offer a slew of fund-based and non-fund-based services to member MFIs, the SROs in the sector (MFIN and Sa-Dhan) could consider the feasibility and utility of a national umbrella body for the MFI sector,” says V S Das, former executive director, RBI. That would be akin to the National Urban Finance and Development Corporation promoted by the National Federation of Urban Cooperative Banks and Cooperative Societies. 

The RBI’s Financial Stability Report (FSR) of June 2025 observed that the ratio of stressed assets in microfinance increased in the first half of 2024-25, with 31-180 days-past-due (DPD) rising to 6.2 per cent in March 2025 from 4.3 per cent in September 2024. Banks also saw an increase in stress in their microfinance book with 31-180 DPD rising to 6.5 per cent from 4.7 per cent. Another edition of the FSR will be out in three months. And it is unlikely the commentary on MFIs will be much different. 

 

 

     

Setting standards: A timeline

• Regulatory change l Impact
• Andhra Pradesh microfinance ordinance (2010)
• Restricted MFI activities in state; led to massive decline in collections and investor confidence
• Malegam Committee recommendations (2011)
• Recommended setting up a regulatory framework, interest caps, and client protection measures
• RBI definition of NBFC-MFI (2012)
• Defined NBFC-MFIs with specific criteria; formalised the sector and its supervision
• Creation of MUDRA Bank (2015)
• Launched to refinance MFIs and promote inclusive micro-lending across small enterprises
• Bandhan licensed as universal bank (2015)
• First MFI (Bandhan) transformed into a full-service commercial bank under RBI licence
• Digital onboarding via e-KYC (2016)
• Allowed Aadhaar-based client verification; facilitated scale-up of digital lending
• RBI microfinance regulations (2022)
• Borrower-centric regulation applicable to all lenders offering microfinance loans
• Removal of interest rate cap (2022)
• Lenders are allowed to set rates transparently via board policies instead of RBI caps
• Household income-based loan limit (2022)
• Loan size tied to household income; mandatory income assessment for all clients
• Digital lending oversight guidelines (2023)
• Targeted digital MFIs: mandatory disclosure norms and privacy-compliant loan practices
• Borrower education & literacy mandates (2024)
• Literacy modules mandated before onboarding borrowers in vulnerable districts.
• Risk weight revision for NBFCs & banks (2023-25)
• Risk weights increased for banks/NBFCs on unsecured loans to MFIs in high-risk areas.

Source: Infomerics Valuation and Rating report 'Reimagining MFI: Financially Inclusive Trends & Outreach'