India’s microfinance bubble grew 2,100%. Now a bust looms

medium119976190Subprime loans in India are teetering on the edge of a fresh crisis, with surveys showing signs of distress among 68% of borrowers. Those who have provided the capital for a multiyear 2,100% expansion will have to stomach losses. The $45bn industry will probably muddle through its latest difficulties, though analysts want the central bank to come up with more robust supervision.It’s hard to disagree with that assessment. True financial inclusion has to mean more than a bubble — followed by a bust. The share of loans overdue for between 91 and 180 days has jumped to 3.3%, from a post-pandemic low of 0.8% in June 2023. There’s more pain ahead. With 27% of borrowers taking out new loans to service old ones, and some families driven to more extreme coping strategies, such as pulling children out of school, the industry is bracing itself for higher defaults.We are talking about very different subprime loans to the ones that crippled the US mortgage industry and contributed to the Global Financial Crisis in 2007-08. These are small, collateral-free advances known as microfinance that serve millions of self-employed people or those working irregular jobs. There’s a huge appetite for such debt in an economy where nine out of 10 workers have no formal occupation. Yet, it’s a segment that would otherwise not qualify for bank loans.The industry ensured discipline in the past by advancing money to groups of four to six women and making it their joint responsibility to ensure all members stayed current with repayments. But the social-distancing norms that came with the pandemic put a halt to cohesive rituals like weekly collection meetings.“It has since then become difficult for microfinance institutions to engender the same level of group solidarity,” Dvara Research, a Chennai-based policy research institution, said in a paper last month. “Customers now know that it is, in fact, possible to evade the social pressure implicit in a group setting that was the mainstay of joint liability.”This erosion of what Dwijaraj Bhattacharya, the report’s lead author, calls “social collateral” has profound implications for regulation. That’s because when group liability becomes ineffectual, the risk in borrowing becomes personal — and the data gaps begin to bite. The poor in urban areas are increasingly taking their incomes and expenditures online, making it somewhat easier for lenders to evaluate their creditworthiness. But high cash usage in rural settings makes it near impossible to assess household incomes or committed expenses.Yes, there are credit bureaus, but they may not have data on loans taken from fintech firms or against gold ornaments. Maybe the borrower’s husband is a gambler. Her neighbour would know. But once their financial fates aren’t intertwined by group liability, neither woman has an incentive to resist over-leverage. Each borrower is on her own, and the carefully constructed economics of microfinance — for which Muhammad Yunus, currently the chief adviser to the interim Bangladeshi government, won the Nobel Peace Prize in 2006 — is in disarray. Which is why lenders need a fresh approach to supervision. medium nocaptionhttps://youtu.be/wLi1xddfQ20?si=BoJx8CGJcaWQvFv9Even the present regulations aren’t that old. In 2022, the Reserve Bank of India (RBI) relaxed the definition of a microfinance borrower to a household earning a maximum of ₹3 lakh annually. For urban areas, it meant a 50% lift in the eligibility ceiling. In villages, the increase was more substantial. The RBI capped total monthly repayment on all loans at 50% of income, changing its previous policy of a hard numerical limit on indebtedness. It also freed the industry from a decade-long control on interest rates it could charge the borrowers. The mandate that no family should be served by more than two lenders was scrapped.A more liberal approach may not necessarily have been bad policy, but it was mistimed. At a time of stagnant wage growth, it sent the wrong signal to so-called impact investors — including specialist European funds — that poured capital into Indian microfinance thinking they would earn returns that were both high and safe. Banks, too, chimed in with more funds for the industry.On the demand side, since the regulatory changes occurred right after the pandemic, borrowers weren’t necessarily taking out new loans to put into small businesses or smooth their daily consumption. They were also competing to organise flashier weddings or purchase consumer durables.“Status signalling happens in every society,” says Indradeep Ghosh, Dvara’s executive director. But in an environment where access to microfinance is too easy and lenders aren’t performing adequate checks, “status signalling can ratchet up very, very quickly”.Now that overborrowing has occurred, let some institutions fail. Switching back to harsher controls on lending might only make the current crisis worse. Where the government needs to get involved is in allowing borrowers to shed unsustainable debt in an orderly fashion. The mechanism for that exists in India’s bankruptcy code; it’s yet to be implemented for individuals other than guarantors for corporate loans.The RBI needs to put in place an adequate market monitoring system. That means exploiting information that already exists with credit bureaus, and supplementing it with high-frequency surveys on where users are spending their borrowed funds.Finally, in a continent-sized economy like India’s, there are vast regional differences in output and income. The credit absorption capacity of households also varies tremendously. Global impact investors may not know any of this. They need to be shown the data so they can take more informed calls on where they can earn safe returns, or high profits — or both.