How is Microbanking Industry in India faring?

Micro-banking is an organized and regulated lending industry. It arose from the Indian banking sector’s failure to reach the underserved people. Micro-banking, sometimes known as shadow banking, is a long-standing practice that includes Self-Help Groups (SHG), Bank-Based Lending, and Microfinance Institutions (MFI). Individual lending is also included in microfinance credit in India, but its market is too small. Furthermore, in the Indian MFI market, certain larger companies are entering into this segment, although at a nascent stage of implementation.

The success of the joint liability group (JLG)-based MFI business in India is founded on the door-to-door lending model. Players have shown discipline due to robust credit rules and tight regulations, including a cap on lending norms. The banking industry, on the other hand, may have stayed away from the potential due to the unsecured nature of the product, high operational expenses, and required collection methods.

Even though the business is inherently risky, investors have been drawn towards microfinance because of its fast development, high return ratios, and social effect.

Roller Coaster Ride of the Industry

Within a few years of existence, the microfinance industry in India has experienced a rollercoaster ride:

• The FY06 to FY10 periods were characterized by robust growth and profitability
• In the subsequent period, that is, from FY11 to 13, when NPAs increased, portfolios of microlenders declined, and many of them went bankrupt as a result of the AP crisis
• The period post FY13 was characterized by high growth rates due to increased reach. It grew at a CAGR of 48% from FY14 to FY19

The industry has room for more expansion because it only accounts for 25% of the addressable market. Geographic expansion has been the primary driver of microfinance growth. To minimize portfolio risk and optimize costs, several participants in this market are integrating technology and collaborating with fintech firms across the value chain. This necessitates changes in the players’ operational structures, product portfolios, collaboration arrangements, and delivery capacities.

What Currently Ails the Business?

Micro-Finance is a high-risk-high reward business and profitability depends on managing the risk well. In the past, the asset quality of microcredit has been driven by highly localized credit events. Until Q1FY21, asset quality trends in the microfinance business were favorable. The pandemic has had a big impact on Microfinance companies. Their collection efficiency plummeted as a result of it. However, after the easing of restrictions, the efficiency has improved significantly. The pandemic has struck the lower-income population harder than the higher-income one, putting a strain on the loans taken by them. Currently, Microfinance Institutions have the highest proportion of loans under the moratorium. The industry’s Portfolio at Risk has begun to rise.

Percentage of GNPAs in BFSI Sector

Factors Contributing to their Risk

• Determining Borrower’s Profile: Assessment of borrowers’ incomes is challenging due to a lack of suitable documentation. The nature of the economic activity that borrowers engage in is the cause of lack of documentation. The issue is exacerbated by the fact that these borrowers come from society’s most economically challenged groups.
• Cash Collection Efficiency: Despite the incentive provided by demonetisation, the majority of micro loan repayments (nearly 66%) are made in cash. As observed during the lockdown, this poses operational issues. Therefore, several microfinance institutions continue to push borrowers to make electronic payments.
• Lack of Collateral: Unsecured nature of loans results in high write-offs. As seen in various situations, microlenders had to write off a significant proportion of their portfolio.
• Geographical Concentration: Microcredit is concentrated in India, with 82.4% of outstanding credit clustered in the top ten states. The mix has remained fairly constant. Within this, eastern and southern states dominate. WB has the largest market share, with 14.5 %, followed by TN, with 13.7 %. The number of NBFC-MFIs is largest in the southern and eastern states.

How Microfinance Institutions Manage Risk?

• High-Interest Rate Spreads: Interest rates charged by most lenders are more than 20%. The RBI has currently capped the rates charged by NBFC-MFIs, limiting their spreads to 10% in the case of large NBFC-MFIs and 12% in the case of other NBFC-MFIs. Further, Interest rates will be restricted at 2.75 times the five largest commercial banks’ average base rate. As a result, high spreads safeguard Micro-Finance Institutions by absorbing defaults.
• High RoE business: Due to wide spreads, microlenders frequently make higher returns than most other types of lenders. Given the event-based asset quality risks, one could argue that during cycles, returns eventually line up with those of other lending enterprises (AP microfinance crisis, demonetization, etc.). However, many lenders have been able to resist industry-wide asset quality trends and earn better returns as a result.

Conclusion

They say leverage is a double-edged sword – so is Microbanking! During a boom, Microbanking seems to be a very lucrative business to entrepreneurs and investors, but during unprecedented times, it becomes one of the most badly affected businesses. The high NPAs of the Microbanking industry will most likely cause additional domino-like effects to various other sectors that are dependant primarily on microfinance. As an investor, it is worthwhile to wait for a few more quarters before investing in the microbanking sector. On the flip side, there exist some real gems in the microbanking industry that has impressively outpaced the pandemic.