Microfinance: How to manage borrowers of non-income generating loans

In India’s rapidly rising economy, microfinance has emerged as a pivotal force in fostering inclusive economic growth. Over the past six years, the industry has demonstrated robust expansion with a compound annual growth rate (CAGR) of approximately 9% (considering the drop in COVID time, however, it will be more if the years of COVID are not counted), serving a clientele that soared to 532 lakh (53 million) by March 2023. As of Sept 30, 2023, the combined microcredit portfolio of all lenders is at ₹3,95, 889 Cr, a growth of 10.37% over June’23 and a growth of 30.03% over Sept’22 of FY 22-23. Additional 134.03 lakh Self Help Groups are catering to the unreached population of India, underscoring the sector's significant impact on the country's financial inclusion agenda.

Traditionally, microfinance loans in India have been earmarked for income-generating activities, officially accounting for about 95% of all loans disbursed. However, recent insights reveal that between 15% to 25% of total loan funds are utilised towards non-income generating purposes, including healthcare, housing, and education. This trend suggests that borrowers often repurpose part of their microfinance loans to meet urgent personal needs, circumventing the prohibitive costs of informal moneylenders.

This pattern is particularly evident among the poorest borrowers, who are disproportionately affected by economic shocks, health issues, and various other adversities. Several reasons underpin this shift in loan utilisation.

Limited Accessibility to Savings: One might assume that as microfinance helps increase borrowers' income, it consequently boosts their savings, providing a buffer for non-income-generating needs. However, this assumption does not hold in practice for several reasons. First, while savings may accrue, accessing these funds remains a significant hurdle. In a predominantly cash-based economy like India, the physical distance from banking facilities such as ATMs or Business Correspondent outlets, which are not open around the clock, poses a considerable challenge.

Insufficient Family Support: Another potential assumption is that impoverished borrowers might turn to their familial networks for financial support during crises. Yet, this too is frequently implausible, as their families are often equally strained by financial hardships and are unable to provide the necessary support. This lack of a reliable safety net compels borrowers to seek alternative sources of funds.

Strategic over-borrowing: Finally, a common strategy among borrowers, particularly those facing constant financial insecurity, involves requesting larger loans than what is necessary for their intended income-generating activities. This approach allows them to allocate a portion of the loan for emergencies or to manage initial loan repayments. This tactic is a direct consequence of the limited access to other forms of credit and the immediate cash needs they face, which compels them to maximise the utility of the loans received.

These dynamics highlight a complex landscape where microfinance loans, while pivotal in facilitating economic activities, also play a crucial role in addressing the immediate and pressing needs of the borrowers. This underlines the importance of MFIs recognising and adapting to the multifaceted uses of microfinance funds, ensuring that their services truly resonate with the real-life conditions and challenges faced by their clients.

The misalignment between the intended use of loans and actual expenditure patterns stems from the limited access to other credit sources for non-income-related needs. Despite this shift in usage, the microfinance sector has maintained impressive repayment discipline, evidenced by a Portfolio at Risk (PAR 90+) of merely 0.86% as of September 2023. This resilience in repayments indicates a strong underlying commitment among borrowers to honour their financial obligations, regardless of the nature of their expenditures.

Challenges and Opportunities

The evidence suggests a significant opportunity for Microfinance Institutions (MFIs) to innovate and realign their product offerings. By introducing loan products specifically designed for non-income generating purposes, MFIs can enhance transparency and more effectively address the genuine needs of their clients. This shift would not only foster greater honesty in borrowing practices but also potentially expand the market base of the MFIs.

Risks and Mitigation Strategies for Non-Income Generation Loans

Non-income generation loans, while addressing a vital need, introduce specific risks that must be carefully managed. First, these loans typically have a less direct path to repayment than loans used for income-generating purposes because they do not directly increase the borrower's earning capacity. Consequently, there is a heightened risk of default, especially if borrowers face ongoing financial difficulties that impede their ability to generate sufficient income.

One way to mitigate these risks is through the establishment of a credit guarantee facility specifically for non-income-generating loans. This would provide a safety net for Microfinance Institutions (MFIs), reducing the perceived risk and encouraging them to offer these types of loans more freely. In addition, MFIs can implement rigorous assessment procedures to better understand the borrower's overall financial situation and needs, thus tailoring loan products that align more closely with the borrower's ability to repay.

Another mitigation strategy involves the integration of financial education programs that help borrowers understand the implications of their borrowing decisions and manage their finances more effectively. By educating borrowers on financial planning and management, MFIs can help ensure that loans are used responsibly and that borrowers have a clearer path to repayment, regardless of the loan’s purpose.

Transparency and Regulation

There is also a significant need for enhanced transparency regarding the use of microfinance funds. MFIs should require borrowers to disclose their intended use of borrowed funds at the outset and offer a follow-up mechanism to track actual usage. Such transparency would not only foster trust between borrowers and lenders but also enhance the effectiveness of financial aid by ensuring funds are used as intended or help identify when adaptations are needed.

The main challenge in promoting non-income generation loan products lies in persuading lenders about the viability and necessity of these loans. In addition, establishing a credit guarantee facility could mitigate the perceived risks associated with these loans, encouraging more MFIs to broaden their product portfolios. This approach aligns with the concept of "life cycle credit," which recognises the diverse financial needs throughout a borrower's life, extending beyond mere income generation.

While non-income generation loans serve critical needs and can significantly improve the quality of life for borrowers, they require careful management and regulation to ensure they benefit both the borrower and the lender. By addressing these risks through targeted strategies and clear regulatory frameworks, the microfinance industry can better serve the diverse financial needs of low-income borrowers, ultimately contributing to a more inclusive financial system. Fortunately, predominant regulation for microfinance rests more responsibilities on the MFIs and extends the opportunities in different spheres including product development.

The microfinance sector in India stands at a crossroads, where the need for a broader, more inclusive approach to lending is increasingly evident. By acknowledging and addressing the multifaceted financial needs of low-income borrowers, MFIs can play a crucial role in enhancing financial inclusion and also in improving the quality of life for millions. As the industry continues to evolve, the introduction of non-income-generating loan products could mark a new era of microfinance.

(Dr. Saibal Paul is Deputy Director of Sa-Dhan, the National Association of Impact Finance Institutions; the views are personal)