Microfinance Sector Suffers from Vicious Cycle of Over-Indebtedness, High Rates: RBI Deputy Governor Rao

Mumbai, June 10, 2025 – The microfinance sector in India, once hailed as a beacon of financial inclusion and grassroots empowerment, is now grappling with structural challenges that threaten its sustainability and credibility. In a candid assessment of the current landscape, Reserve Bank of India (RBI) Deputy Governor M. Rajeshwar Rao sounded the alarm over what he termed a “vicious cycle” of over-indebtedness, persistently high interest rates, and growing borrower distress.

Speaking at a financial inclusion summit in Mumbai on Monday, Rao addressed industry leaders, policymakers, and economists, urging a reevaluation of existing microfinance practices. His speech focused on critical issues undermining the sector’s original purpose of uplifting the underserved and unbanked populations.

Mounting Concerns Over Over-Indebtedness

Rao emphasized that over-indebtedness among microfinance borrowers has reached “concerning levels,” particularly in states where credit penetration has grown rapidly without corresponding financial literacy or regulatory safeguards.

"Multiple borrowings, encouraged by loosely coordinated credit bureaus and competition among lenders, are pushing vulnerable households into a debt trap," he said. "The very tools of empowerment are becoming instruments of despair."

Over-indebtedness arises when borrowers take loans from multiple microfinance institutions (MFIs), often without the full knowledge of lenders or without assessing their true repayment capacity. Rao pointed out that many borrowers, driven by the need for short-term cash flow, end up juggling repayments across multiple lenders, leading to a cycle of refinancing, default, and in some tragic cases, social distress and suicides.

Persistently High Interest Rates Despite Low Borrowing Costs

Another red flag raised by the Deputy Governor was the mismatch between declining interest rates in the broader financial system and the persistently high rates charged by MFIs.

“Despite falling cost of funds, microfinance borrowers continue to pay exorbitant effective interest rates ranging from 22% to 28%, sometimes higher, which defeats the purpose of inclusive finance,” Rao stated.

The RBI had introduced a revised regulatory framework for microfinance in 2022 that removed the interest rate cap but required lenders to price loans responsibly based on cost-plus-margin and risk-based models. However, Rao argued that lenders have not passed on the benefit of lower cost of capital to borrowers.

He further noted that this interest burden, combined with limited income-generating opportunities in rural and semi-urban areas, is putting immense pressure on repayment behavior and borrower well-being.

Regulatory Framework Needs Reinforcement

Rao acknowledged the RBI’s efforts in bringing regulatory parity between different types of microfinance players—including NBFC-MFIs, banks, and small finance banks—but said enforcement and supervision must evolve to meet on-the-ground realities.

“There needs to be tighter coordination between credit bureaus, better monitoring of borrower indebtedness, and clear accountability on the part of lenders,” he said.

He advocated for the implementation of a common borrower registry and real-time tracking systems that could alert lenders when a customer crosses a threshold of indebtedness. He also suggested that all lenders, irrespective of size or structure, must be held to the same standards of borrower due diligence and grievance redressal.

Impact on Financial Inclusion Goals

The situation threatens to derail India’s broader financial inclusion goals. Microfinance was once the poster child for these efforts, credited with bringing millions of low-income families, especially women, into the formal credit system. However, Rao cautioned that if unchecked, the current trajectory could reverse this progress.

“People who once viewed microfinance as a ladder out of poverty are beginning to see it as a burden,” he said. “This perception shift is dangerous, both socially and financially.”

He urged MFIs to refocus their mission from profit maximization to responsible lending. “Financial inclusion is not about high-yield portfolios, it’s about long-term empowerment,” Rao reminded.

Role of Technology and Digital Inclusion

Rao also pointed to the potential of technology to bring transparency and discipline to the microfinance space. He called for the use of AI-driven credit assessment tools, mobile-based repayment tracking, and digital literacy initiatives to improve both lender practices and borrower behavior.

“Technology can be the bridge between financial access and financial health, but only if used ethically,” he said. “It is time for the microfinance sector to embrace fintech not just as a business model, but as a force for good.”

He emphasized the importance of ensuring that digital finance tools do not become new avenues for exploitation. With the growth of digital lending apps, Rao warned that regulatory arbitrage and lack of accountability could further complicate the sector’s challenges.

Calls for Self-Regulation and Industry Responsibility

In addition to formal regulatory mechanisms, Rao called upon microfinance institutions and industry bodies like Sa-Dhan and MFIN to play a more active role in self-regulation.

He recommended setting up internal benchmarks for responsible pricing, credit penetration caps in saturated geographies, and periodic borrower surveys to understand the real impact of microfinance lending.

“There is room for a code of conduct that goes beyond compliance and embraces compassion,” he said.

The Human Cost of Poor Practices

Perhaps the most sobering part of Rao’s speech was his reference to the human cost of current microfinance practices. He cited anecdotal cases of women borrowers being publicly humiliated for defaults, families losing their livestock or homes as collateral, and entire communities facing social ostracization due to unpaid loans.

“These stories should haunt us,” Rao said. “They are not just exceptions. They are warnings.”

Way Forward

As India prepares for another wave of financial growth in its post-pandemic economic journey, the role of microfinance remains critical. However, the sector must address its deep-rooted challenges to avoid becoming counterproductive.

Rao concluded his speech with a call for collaborative reform, urging regulators, lenders, technology providers, and civil society to work together to realign microfinance with its original mission.

“It is time we ask ourselves: Are we lending to empower or to profit? The answer to that question will define the future of microfinance in India.”

His remarks have since sparked intense debate across the industry, with some MFIs welcoming the critique and pledging introspection, while others argue that high operational costs and default risks justify the current lending model.

Nevertheless, Rao’s speech has put the spotlight back on microfinance—reminding all stakeholders that true financial inclusion must prioritize dignity, sustainability, and equity over expansion at any cost.