The microfinance sector is in the throes of a crisis, with defaults surging and cracks emerging in its group-based lending model. As state interventions threaten to hurt collections, lenders are being forced to recalibrate their strategy, explains Narayanan V
How deep is the crisis?
The microfinance sector is facing a severe crisis, with delinquency rates nearly doubling in just one year. The gross non-performing asset (NPA) ratio for the sector has surged to 16% at the end of FY25, up from 8.8% a year earlier, per early estimates from credit bureaus. In absolute terms, NPAs jumped to Rs 61,000 crore in March from Rs 38,000 crore a year ago. Small finance banks (SFB) have been hit hardest, with 22% of their Rs 59,817 crore gross loan portfolio turning bad. Universal banks saw 17.5% of their Rs 1.24-lakh crore microfinance exposure slip into delinquency, even as non-banking financial companies-microfinance institutions (NBFC-MFIs) reported over 12% of their Rs 1.48-lakh crore exposure as stressed. The surge in defaults has prompted lenders across the board to sharply cut back on fresh disbursements. As a result, the sector’s total gross loan portfolio contracted nearly 7% to Rs 3.81 lakh crore as of March 2025. A report by Mavenark Advisors says the worsening asset quality could drive up credit costs to 6% in FY25, impacting the MFI’s profitability. The outlook appears cautious, it said, with overall growth expected to fall to 4% in FY25.
What led to the mounting bad loans?
Weak underwriting and widespread borrower overleverages are the main reasons. Per industry estimates, 8-10% of the assets under management (AUM) as of September 2024 were linked to borrowers with four lenders, while 9% is tied to those with five or more lenders. Again, 7% of AUM is exposed to those with outstanding debts above Rs 2 lakh. Post-pandemic stress in rural incomes has affected repayment capacity, while poor credit information sharing has allowed over-indebtedness to go unchecked. Another key factor is the weakening of the joint liability group (JLG) model, where groups of women borrowers acted as social collateral. This model is central to microfinance lending. As Spandana Sphoorty Financial noted in its Q3 investor presentation, “Dilution of the JLG model post-Covid is taking longer to turn around.”
Latest flashpoint in Tamil Nadu
Tamil Nadu has introduced a Bill to regulate lending practices—sparking fresh concerns among formal micro-finance players. Though it targets unregulated and digital lenders known for using coercive recovery methods, NBFC-MFIs and SFBs fear it could erode credit discipline and disrupt collections in the state, the second-largest market in the Rs 3.85-lakh-crore industry. It reportedly includes strict provisions such as a three-year jail term for coercive recovery and penalties against agents who harass borrowers. Lenders worry that state-level intervention could embolden defaults by creating a perception of protection for borrowers. The development follows Karnataka’s enactment of a similar but stricter law in February 2025, which allows for up to 10 years’ imprisonment and a Rs 5-lakh fine in such cases. Since then, Karnataka has seen a sharp rise in delinquencies. CreditAccess Grameen, India’s largest MFI, reported its PAR 90+ (loans overdue by more than 90 days) in the state doubling to 2.4% in March 2025 from 1.2% in the December quarter.
How are lenders responding?
Lenders are tightening credit norms. The Microfinance Institutions Network (MFIN), the sector’s self-regulatory body (SRO), rolled out Guardrails 2.0 from April 1, 2025. The guidelines cap the number of lenders per borrower at three (down from four) and limit total loan exposure, including unsecured retail loan, to Rs 2 lakh per borrower (from Rs 3 lakh earlier). New loans are barred for those with over 60 days of overdue loans exceeding Rs 3,000. Sa-Dhan, the other SRO for the industry, has limited the combined exposure to microfinance and retail loans to Rs 2 lakh per household, while ensuring that loan repayment obligations do not exceed 50% of the household’s monthly income, in line with RBI norms. While these steps aim to prevent over-leveraging, they are likely to weigh on profitability. Per Mavenark Advisors, the net interest margins of MFIs are likely to shrink in FY25 due to rising asset quality concerns and softening yields. The industry had seen improved profitability over the last two years, but those gains now appear under pressure.
Is the worst over?
While lenders have begun pulling back, most believe the worst may not be over. “We remain cautious on the unsecured segment… As for the MFI portfolio, we have consciously reduced the exposure, shrinking the book by 23% over FY24,” RBL Bank MD & CEO R Subramaniakumar said during a recent earnings call. In a media interaction, Kotak Mahindra Bank chief Ashok Vaswani said that stress in the segment could persist for another one to two quarters more. Whether the current distress is cyclical or structural also needs to be understood, he added. The collapse of the JLG model has exposed the limits of group-based underwriting, especially in the absence of reliable individual credit histories, and may even need a rethink on the business model. While recent rules may contain fresh slippages, fixing underlying vulnerabilities—like poor borrower assessment or overleveraging —will take longer.
