Hi everyone,

Welcome to the 131st edition of The Pattern, a weekly where we dive into the latest from the world of economy, technology and finance. Let’s get started.

Small loans, large asks

The microfinance sector in India is something of an ephemera. While those at the grassroots level need credit support to finance their businesses and consumption, the microfinance sector serving them often finds itself caught up in troubles emanating from the very financial stress it seeks to relieve.

The key to understanding the problem of microfinance in India is first understanding the borrower profile – microfinance loans are usually short-tenured, unsecured small-ticket loans given to individuals with annual incomes less than Rs 3,00,000. These borrowers are often credit unserved or underserved and while the promise of formal credit is tempting, the problems start to mount when one starts digging deep into the ways in which this credit is disbursed.

Because the borrowers are largely underbanked, they have very little by way of formal credit histories or income proofs. Hence, it becomes a tough ask for the on-field correspondents and executives to figure out whether an applicant will be able to afford the loan EMI or not.

This, broadly speaking, is at the heart of the stress that’s building up in the microfinance sector – two years after the regulator Reserve Bank of India tried to resolve these issues through an overarching uniform regulation for the sector. The RBI prescribed that a borrower shouldn’t be paying more than 50% of their monthly household income in repayment of loans.

However, this is a rule that’s often broken – not least because the microfinance lenders have few reliable ways of accurately assessing the actual household income. In fact, it’s not just the income that’s not being assessed properly, even on the liabilities side, most microfinance lenders seem to rely on the word of the borrowers at face value.

"So far, there is no foolproof way of measuring household income for borrowers in the microfinance sector. This is very subjective as of now, and largely depends on the feedback from the borrowers. As the field officers are under pressure to expand business, there is a possibility of over reporting of income which can result in over-lending," said Jiji Mammen in August, executive director at Sa-Dhan, the older of two microfinance associations.

This is important because inaccurate assessments lead to over-leveraging i.e. one borrower availing loans from multiple lenders which turns into an unsustainable repayment burden eventually turning into a debt trap.

“Additionally, overleveraging in some areas remains a concern, prompting MFIs to take corrective actions that may take one or two quarters to yield full results. Despite this, new loan generation has already fallen by 24 percent in Q1. Seasonal trends may provide some relief in the second half of the year, contributing a higher share of annual business,” a report by India Ratings stated earlier this year.

In the March quarter, new loan sales declined by as much as 30%, according to the research firm. Meanwhile, six months down – things are not getting any better.

A new report by The Economic Times states that the microfinance sector faces another round of stress build-up. Default rates have already started climbing. In the September quarter-end, many big lenders including Kotak Mahindra Bank, Bandhan Bank, IndusInd Bank and RBL Bank reported higher defaults in their microfinance portfolios.

As a result, last month, RBI reportedly asked bankers to stop issuing fresh loans to existing borrowers until they clear off their existing loans. This seems to be an unofficial directive but one which lenders will have to follow and the worry in the sector is that many borrowers might find themselves hapless if they can’t generate new loans to rotate existing loans.

Many lenders have already started bracing for impact and have tightened their underwriting standards while many others claim that they’re improving their Expected Credit Loss models to increase provisioning for loans.

Some suggest the way forward is to improve credit reporting from institutions to the credit bureaus so that over-leveraging can be nipped in the bud. Once a loan hits a borrower’s credit report, other lenders can assess whether the borrower is eligible for additional credit without hurting their propensity to repay.

In August, the RBI mandated fortnightly reporting of data to credit bureaus but industry experts say this isn’t enough.

"Microfinance clients being vulnerable, the reporting has to be daily as 15 days also will lead to a lender not able to factor loans given in the last 15-20 days," said Alok Misra, chief executive of MFIN, a microfinance association.

Even as the microfinance sector reels under yet another stressful period, it’s more important than ever for lenders to invest in strong underwriting technology and build resilient income and obligation modeling to ensure that credit-hungry borrowers don’t end up driving themselves to the ground – and with them, the lender’s business.

That’s all for this week. I will see you next week. As always, I’ll leave some reading recommendations below.

Reading List

• Fund flows to NBFCs hit in H1 as banks turn cautious

• Stress building again six years after India’s shadow-banking sector blew up

• Rise in delinquencies: Banks buckle up, go slow on issuing new credit cards

• Incremental credit-to-deposit ratio drops to 30 month low of 77.7%

• Digital payment's rise leads to shutting of ATMs

Thank you for reading. If you liked this edition, forward it to your friends, peers, and colleagues. You can also connect with me on Twitter here and follow FinBox on LinkedIn to always get all updates.

Cheers,

Mayank

All opinions expressed are my own and do not necessarily reflect the views of FinBox or its promoters