It was hailed as the salvation for India’s poor. The growth of microfinance institutions (MFIs) originated from a desire to make small loans available to people in rural communities, giving women in particular access to funding to set up businesses. As we have reported on Biz/ed before, microfinance was developed by the Grameen Bank, under the direction of Prof. Mohammed Yunus, as a solution to inadequate access to capital for poor women in Bangladesh. How the system worked is covered in a ‘Wanna Argument’  in greater detail.

Impressed by the success of the Grameen Bank, which boasted high rates of repayment and relatively low delinquency levels, India jumped onto the MFI bandwagon. In trying to promote access to capital in this vast country, with a total population far in excess of that in neighbouring Bangladesh, the Grameen model of non-profit, self-help lenders collecting deposits and making loans to poor communities, ceased to be the norm. An MFI boom followed, with the southern state of Andhra Pradesh at the centre of the bubble. Lenders in the sector experienced growth at breakneck speed. News reports put the number of borrowers at 70 million, including government-backed MFI schemes, with a total market worth $7.5bn.

The problem is that, as with those experienced elsewhere, this boom has proved to be unsustainable. It appears that lending standards were relaxed, with capital provided for activities other than setting up small local businesses. Multiple loans were made to finance consumer spending in a country where economic development has led to growing awareness of the attractions of a ‘western’ lifestyle. Then, when the credit crunch dried up microfinance firms’ access to bank funding, they sought ever-higher rates of interest on their loans. For-profit MFIs faced pressure from shareholders for increased financial returns. Many argue that by letting the industry abandon its pro-poor roots, these lenders’ clients – the very people that microfinance is supposed to help - were cut adrift.

What followed in late 2010 was a spate of suicides among the poor in Andhra Pradesh. Over 60 borrowers there took their own lives. Several big MFIs in the state were charging interest rates around the same as those of traditional moneylenders. As the markets for microfinance grew so institutions such as private equity funds, hedge funds and so-called angel investors queued up to provide capital to MFIs. In addition to poor lending standards which saw the debt liability of many poor borrowers grow ever-larger, some MFIs resorted to intimidation as defaults became more common.

The government set up a committee to investigate the problem and its Malegam report found that MFIs should have their interest rate charges capped, a limit should be placed on total loans to one individual, and three-quarters of MFI lending should be ringfenced for productive purposes. Some commentators argue that these are actions designed to calm political nerves in Andhra Pradesh and elsewhere, rather than working with the best elements of microfinance and adapting the system to the needs of different groups.

Whatever the outcome, the MFI scandal has rocked faith in a system that offered hope to many impoverished people in India. The microfinance industry continues to be a success in some parts of the world, but some analysts claim that in India it needs to embrace the principles of Self-Help Groups for the very poor. Otherwise, they say, the original development goals of microfinance will fail to materialise in India.