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Micro Finance: Theoretical Framework and Empirical Evidence An Indian Experience

Ms. R. M. Vasanthakumari and Ms. Vani. J. Sharma*

The emergence of micro finance as a viable alternative to the conventional banking in accomplishing the goal of poverty alleviation has been recognized world over. It has become a major tool of development and found to be the only practical and most appropriate solution to the deep seated challenges of poverty. It is often said that micro finance appears to deliver the 'holy trinity' of outreach, impact and sustainability. The developmental purposes to which, micro finance can be put include, livelihood, promotion, developing the local economy, empowerment, building democratic people's organisations and changing wider systems or institutions within society.  In India as also in other countries, Self Help Groups have been recognized by the policy makers as the effective conduits for accomplishing the distributional objectives of monetary policy. Group model as developed by Bangladesh Grameen Bank is by and large followed in most of the South East Asian Countries barring Indonesia, which has adopted Unit Desa or village Bank
System. Each system has its own merits and demerits. However, India has adopted somewhat a similar model to Bangladesh Grameen model yet, has its own uniqueness. India has made rapid strides in micro finance making it the largest programme in the world. In this backdrop, the present paper endeavors to present Indian experience reflecting its strengths and weaknesses and sets few issues for strengthening the viability of the programme. The paper is divided into four sections. Section-I traces the genesis including the theoretical background and origin, Section-II deals with the policy framework in mainstreaming the micro finance programme in India, Section-III delineates the  progress of micro finance in India, Section-IV details major strengths and weaknesses of micro finance sector in India and Section-V  contains concluding remarks

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Theoretical Framework
1)     Theoretical Background:  

As far as micro finance is concerned, the debate world over is between two schools of thought i.e., finance school and the poverty school, whose ideologies are conflicting with each other. The poverty school emphasizes the need to reach the poor  people and may be suspicious of financial sustainability believing it is likely to lead a micro finance provider away from  its focus on poorer clients. It is acknowledged that micro credit/finance has sought to resolve the tensions between the focus on poverty and a commitment to sustainability of integrating them- combining outreach and sustainability. It is said that micro credit provider can become sustainable by recycling resources over and over again. 

According to Mahajan and Ramola (1996) "the formal financial sector may achieve financial sustainability but has little outreach to poor clients. Traditional efforts by non-governmental organizations (NGOs) may reach poor clients, but are often unsustainable. Micro finance on the other hand, combines both outreach and sustainability. Such practice is perhaps most clearly embodied in the micro finance, which marries the best of the formal financial sector in terms of sustainability with outreach to poor clients of the development NGO.  

Since independence, the Government of India in general and Reserve Bank of India in particular have made concerted efforts to provide the poor access to credit. However, the limited success of co-operatives forged the need for nationalization of commercial banks and later on establishment of Regional Rural Banks, which have mandated credit programmes for the low income households.   Despite the phenomenal physical outreach of the formal credit institutions achieved in the past several decades, the rural poor continue to depend on informal sources of credit on account of the cumbersome procedures associated with formal credit. The credit needs of the rural poor are determined in a complex socio-economic milieu, where it is difficult to adopt project lending approach as followed by the banks. The credit needs are small, frequent, usually emergent and they arise at unpredictable times. For the poor, the consumptive credit needs often precede and also determine their productivity. For various reasons, the credit flow to the poor for meeting all their requirements did not get institutionalized. Some of the major causes lie in the difficulties in dealing effectively with a large number of small borrowers, who require credit as said earlier, frequently and in small sums, and also the banks' perceptions of the risk and creditworthiness of these borrowers. To address these problems effectively the micro finance has been tried as a viable alternative in reaching the hitherto unreached and fill up the gap in the demand and supply.

Micro finance is the provision of thrift credit and other financial services or products of very small amounts to the poor for enabling them to raise their income level and living standards. Micro finance has potential to augment growth with social justice. The empirical evidence relating to cross sections of countries is replete with the facts that it is possible to lend profitably with very low arrears to very poor in a truly sustainable manner without subsidisation.

Micro finance is not financial intervention alone. It is a holistic approach covering social intermediation along with a provision of financial services needed by the poor such as thrift, credit and insurance. Credit under micro finance programme is extended on the basis of social collaterals in the form of joint liability with or without Self-Help Group. Credit intervention is based on the past performance of the borrower with gradual increase in subsequent doses of credit. In short, micro finance is the cutting edge of the development of the poor.

2)     Origin of Micro Finance:

The origin of micro finance is quite absorbing. Ipso facto, micro finance combines the strengths of both formal and informal systems of purveying credit. Availability of hassle free credit in a systematic manner is the unique feature of micro finance system. Micro finance in informal system was in vogue in India in the form of chit funds, etc., since time immemorial. It came into existence under formal system with the advent of co-operative movement in India in the beginning of the last century. The micro finance is primarily based on the principles of co-operation namely, mutual help, democratic functioning, etc. Though, the co-operative movement was initially envisaged with unlimited liability and small size of societies consisting of homogenous groups, over the years in the quest for improving the viability of co-operatives, large societies with limited liabilities were organized. This apart, the evolution of State partnership in co-operatives with entrenched bureaucracy, etc., distanced co-operative movement from the spirit of micro finance movement. Nevertheless, micro finance movement in its present form is the valuable contribution of Bangladesh to the world and Prof. Mohammed Yunus is considered the father of modern micro finance movement. Mostly the rural poor were caught in the clutches of money lenders as their access to credit from the banking system was constrained due to lack of collaterals and their ignorance. Hence, a beginning was made with a research project at Jabra village by Prof. Mohammed Yunus of Chittagong University way back in 1976 by giving small loans without collaterals to the poor who were organized into small groups. The idea worked well and demand for credit increased manifold. The process was repeated and the institution promoted by Yunus expanded its operations and came into existence as a specialized institution for financing the rural poor under Grameen Bank Ordinance of the Government of Bangladesh in 1983. The success of Grameen Bank model inspired its replication in one or the other form in many parts of the world. Under Bangladesh model, borrowers or savers join together to form groups consisting of five members to transact the business.  The philosophy of voluntarism and one for all and all for one is the backbone of  micro finance movement. The group also leads to mutual empowerment along with the advantage of peer pressure on the behaviour of group members.   



Policy Framework

In the Indian context, the interventions of voluntary agencies in the socio-economic development of masses can be traced back to pre-independence days. Owing to the inability of formal financial system to reach the poor due to lack of collaterals, asymmetric information and high transaction costs, a number of voluntary agencies/NGOs entered the domain of rural credit for organizing the poor into informal groups for mutual economic and social empowerment. However, the origin of micro finance movement in its present shape dates back to 1986, when the Sixth General Assembly of APRACA at Kathmandu in Nepal considered a proposal for promotion of linkages between formal institutions and Self-Help Groups. As a sequel to it, in India, the National Bank for Agriculture and Rural Development (NABARD) in consultation with Reserve Bank of India organized workshops and national consultations and ultimately launched a pilot project in 1992 for linking 500 Self Help Groups with commercial banks i. e., the formal sector. The pilot project was further extended to Regional Rural Banks and Co-operative Banks in 1993.

In order to address the critical issues for a healthy and orderly growth of the micro-finance sector in the country, and to evolve supportive policy and a regulatory framework, the Reserve Bank of India constituted a Working Group under the Chairmanship of Shri S.K. Kalia, the then Managing Director of NABARD in November 1994. The Group recommended inter-alia that the banks should treat the linkage programme as business opportunity for reaching the rural poor and making it a part of their corporate strategy. SHGs have been recognized as one of the most suitable conduits for delivering the micro finance services. Accordingly, Reserve Bank of India has accorded greater autonomy to the banks. The freedom has been given to the banks in respect of margin security norms and interest rates etc., under this scheme. The banks are allowed to open saving bank accounts of SHGs under the SHGs Banks linkage programme.

Further in 1999, RBI set up a Micro Credit Special Cell to suggest appropriate measures for upscaling, mainstreaming and smoothening flow of micro credit.  Based on the report, a number of measures were taken. Important among them are freedom to choose any model, conduit, branch in any area, freedom to prescribe their own lending rates, devise their own loan and saving products and related terms and conditions, deregulation of interest rates charged on micro finance institutions by the banks and exemption of non profit NBFCs from registration and prudential regulations. Further, micro finance is reckoned as priority sector@ lending under sub-target of lending to the weaker sections.

Some other initiatives have also been taken recently to upscale and streamline the programme of micro finance. Prime Minister's Office set up Study Groups on technology issues, resource flow, capacity building and legal and regulatory issues. Action matrix is also being firmed up. RBI considers micro finance as an extremely important area of focus for credit delivery. Recently, RBI had arranged wide-ranging interfaces with a cross section of providers. Furthermore, RBI has also set up Informal Groups on micro finance specifically to look into: i) structure/sustainability; ii) funding; iii) regulatory issues and iv) capacity building. Future initiatives are expected to follow the recommendations of these Groups.

During the current year 2002-03, RBI is planning a series of interactive sessions to review the progress made in this vital area and to put in place a more vibrant micro finance delivery in the country where complementary and competitive models of micro finance would be encouraged. The Reserve Bank also likes to identify any policy or co-ordination gap for giving further impetus to the on-going micro finance movement.  In this context, RBI has been interacting on all micro finance related policy issues with a wider group of experts and micro finance professionals.  



Progress of Micro Finance in India

The linkage programme of SHGs with commercial banks is gaining momentum. Both National Bank for Agriculture and Rural Development (NABARD) and Small Industries Development Bank of India (SIDBI)@: have succeeded in linking SHGs, which is progressing satisfactorily to benefit more number of people.  As on September 9, 2002, about 0.505 million SHGs engaged in micro enterprises were financed under the scheme (of which 90 per cent were women SHGs) (Table-1and Graph-1).

The significant increase in the number of SHGs credit linked during the year was possible because of the active involvement of 1030 NGOs and other Self Help Promoting Institutions (SHPI), 314 banks and many other agencies including developmental departments of different State Governments.

Table-1: SHG Credit Linkage Cumulative Progress as on 31 March 2002

                                   (Amount in US $ million)@


No. of SHGs

Bank Loan


















































#: as on September 9, 2002  
@: See the note.

Source: National Bank for Agriculture and Rural Development

Graph-1 Cummulative Number of SHGs Linked to Banks

The banks participating in the linkage programme were provided cent percent refinance at the concessional interest rate of 6.5 per cent per annum

This was further facilitated by the RBI circular issued to banks in February 2000 for mainstreaming the micro credit and reckoning it as priority sector lending.

The credit-linking programme covered 412 Districts in 27 States and Union Territories. A notable feature is that 90 per cent of the groups formed were exclusively of women members. The repayment of bank loans issued to the SHGs was above 95 per cent.

Cumulatively till March 31, 2002, the bank loans disbursed to the SHGs aggregated US $ 215.20 million while NABARD's refinance availed of by the banks aggregated US $ 166.90 million forming about 77.6 per cent of the total disbursements. Further, the bank loans disbursed to SHGs increased to US $ 244.11 million as on September 9, 2002. According to the Union Budget for 2002-03, the target of 0.1 million additional self-helf groups during the current year is expected to be achieved taking the total so far to more than 0.35 million covering more than 7.0 million families, making it the largest micro credit programme in the world. As the scheme of micro-credit through SHGs is progressing well, the target for the same has been raised to 0.13 million for 2002-03.    



Strengths and issues of concern of Indian Micro Finance Sector


(A) Strengths of Indian Micro Finance Sector:  

India is the largest democracy in the world. Unity in diversity is the greatest strength of India. Despite vast differences in terms of language, caste, religion, etc., driven by the co-operative spirit, people are interwoven with common affiliations and social obligations. The factors like personal rapport and proximity and like-mindedness have added to the spread of the programme.

Many SHGs have come into existence in India spontaneously and have exhibited tremendous democratic functioning and group dynamism. Their adroitness in assessing and appraising the credit needs of members, their business like functioning and efficiency in recycling the funds often with repayment rates nearing cent percent are additional positive features. Some of the best practices followed under micro finance sector in India include inter alia: 1) broad based definition of micro finance 2) adoption of multi model approach 3) greater freedom to micro finance institutions 4) creation of Micro Finance Development Fund 5) the use of computers in micro finance and 6) certain other important best practices.  These aspects have been discussed in greater details in the following paragraphs.  

1). Broad-based Definition  

In India definition of Micro-finance is unique in the sense that it has the potential to offer an array of credit and savings products as well as other finance services, which are required by the poor.  Micro-finance in India is defined  as " Provision of thrift credit and other financial services and products of very small amount mainly to the poor in rural and urban areas for enabling them to reach their income level and thereby improving the standard of living".  As a result of this broad-based definition, micro-finance institutions are in a better leverage to help the poor.

 2). Multi Agency approach  

It has been decided to involve various agencies in mainstreaming and upscaling of micro-finance.  All the major credit institutions viz., commercial banks, co-operative banks, regional rural banks have been involved in micro finance programme.  In all, three distinct linkage models are being followed. Under Model-I, banks themselves take up the work of forming and nurturing the groups, opening their saving accounts and providing them bank loans. Up to March 2002, 16 per cent of the total number of SHGs financed were from this category. Under Model-II, SHGs are formed by NGOs and formal agencies but are directly financed by banks. This model continues to have the major share, with 75 per cent of SHGs financed up to March 2002 falling under this category. Under Model-III, SHGs are financed by banks using NGOs and other agencies as financial intermediaries. In areas where formal banking system faces constraints, the NGOs are encouraged to approach suitable bank for bulk loan assistance. The share of cumulative number of SHGs linked under this model up to end-March 2002, continued to be relatively small at 9 per cent. The linkage programme is gaining a momentum.  

3). Establishment of Micro Finance Development  Fund:  

Micro Finance Development Fund (MFDF) in NABARD with a start up contribution of US $ 8.76 million from RBI and US $ 8.76 million from NABARD was set up in 2000-01. Further, US $ 4.38 million was contributed to the fund by 11 commercial banks. As at end-March 2002, the Fund aggregated to US $ 21.33 million. Under this fund, NABARD, banks and other institutions to provide start up funds to micro finance institutions and infrastructural support for training system, arrangement and data building under micro finance  

4). Greater Freedom to the Micro Finance Institutions:  

i) RBI has allowed banks to formulate their own models or choose any conduit/ intermediary for extending micro credit. Banks are allowed to choose suitable branch/pocket/ area where micro credit programmes can be implemented.

ii) Banks are permitted to prescribe their own lending norms keeping in view the ground realities.

iii) Banks are also allowed to devise appropriate loan and saving products and related terms and conditions including the size of loan, unit cost, unit size, maturity period, grace period, margins and purpose of borrowing including for housing and shelter needs.

iv) Interest rates on bank's loans given to micro finance institutions are completely deregulated.

v) Bank lending under micro finance is treated as part of priority sector targets as well as under sub-target of lending to the weaker sections.

vi) The micro finance institutions registered as not for profit NBFCs have been exempted from registration and prudential requirements. RBI has permitted such NBFCs to provide credit not exceeding US $ 0.001 million for business activity and US $ 0.003 million for meeting the cost of a dwelling unit to the poor.

vii) Unsecured advances given by banks to SHGs against group guarantees be excluded for the purpose of computation of the prudential norms on unsecured guarantees and advances until further notice.

This apart, the Government of India has also allowed foreign direct investment in micro credit to encourage foreign participation in various micro finance projects.     

5). Computerisation of Micro finance Operations  

Generally, the facilitator tracks member accounts at the village level with hand written sheets and passbooks. A good measure of time is devoted to manually updating the records and little time is spent on interface and discussions on economic and social aspects.  Elsewhere in southern part of the country a micro credit institution known as Swayam Krishi Sangam (SKS) has introduced Smart Card into its micro credit programme.  The facilitators carry a Hand Held Computer (HHC) to the meeting.  The HHC downloads information from the branch computer in the village.  Each member has a smart card, which electronically holds member's information and records of transactions.  During the meeting each member inserts her or his smart card in the HHC and transactions are updated both in the smart card and the HHC.  At the end of each day, facilitator uploads the information from HHC to branch computer and all accounts are updated. A record along with HHC is kept in the village so that members can confirm their accounts.  In this manner smart cards eliminates the need for manual record keeping, which greatly enhances time for interface.

Similarly, another micro finance institution popularly known as called SEWA Bank has adopted a specially designed software, which maintains area-wise and occupation-wise information on overdue accounts.  This software has been given to field workers, which has greatly facilitated the transaction of business. Computerization has now also made available the services of a substantial part of the workforce, hitherto deployed in operational work-areas for collection purposes.    

6). Upscaling the Outreach to the Urban Poor  

The emphasis of micro finance programmes in most of the countries has been on rural areas. However, there has been a growing migration of rural poor in search of employment to urban areas. As a consequence, the number of poor in urban areas has multiplied. The access of urban poor to the formal banking sector is equally constrained due to lack of collaterals. Hence, there is a need to expand the outreach of micro finance to cover the urban poor. Recognising such an imperative, some of the micro finance institutions such as SEWA Bank and SRFS (Sungamitra Rural Financial Services) and also a number of NGOs have started organizing the poor into SHGs and operating on the principles of micro finance in urban areas.  

(B) Some Issues of Concern:

i) Fragile Sustainability:

By and large micro finance institutions in India are still in nascent stage. However, some of the case studies representing major models of micro finance institutions in India taken up by us for this paper, reveal the inherent weaknesses, which pose a serious concern about the viability of these institutions. A closer examination of the profiles of these institutions reveals that most of these institutions are depending heavily on the grants/donations from outside sources. For instance, in case of Swayam Krishi Sangam (SKS) grants and donations formed around 95 to 99 percent of its total income.  Although, their income is rising, but increase in their expenditure has outweighed the increase in income resulting into an excess of expenditure over income. Added to this, the expenditure incurred on salaries and allowances has a major share in the total expenditure, which for instance, amounted to as high as 59.0 per cent of total expenditure in case of SKS in 2001-02. The total cost including interest paid and operational charges per US $ 100 of the loan works out to be as high as US $ 53.3 in case of SEWA Bank in 2001-02. Similarly, interest earning per US $ 100 works out to US $ 44.7 in case of SEWA Bank. Though, these ratios have worked out to be somewhat lower in case of other institutions, in case of most of these institutions, either there is a mismatch between income and expenditure or the cost of administering the loan is high or interest earnings have turned out to be low. These factors expose the fragile nature of such programmes. Added to this, higher interests on the loans given to SHGs pose a serious concern over the viability of these institutions in the long term (Table-2). In this context, the selection of appropriate areas having efficient infrastructure will also help to reduce the transaction costs.

Table-2: Performance Indicators of Micro Finance Institutions

       (Amount in US $ million)@













Total Income


















Total Expenditure









Percentage of expenditure









on salaries and allowances









Excess of expenditure









over income




(-) 0.005


(-) 0.075

(-) 0.011

(-) 0.011



















Interest earning per









US $ 100 of loan *









Total expenses per









US $ 100 of loan *









SKS: Swayam Krishi Sangam,   SEWA: Mahila SEWA Sahakari Bank Ltd.





SRFS: Sangamithra Rural Financial Services








  *: Amount in dollars.>
@: See the note









Source: Computed from the Balance Sheets of respective MFIs









Micro finance market in India has made rapid strides both in terms of SHGs linked with the banks and the number of beneficiaries covered. The freedom given by the Reserve Bank of India has paved the way for its fast upscaling. Multi-model approach involving banks, NBFCs, Trusts, Foundations and NGOs has paid rich dividends. Establishment of Micro Finance Development Fund has also helped the various entities for orderly development of micro-finance sector by providing required infrastructure and training system. Some of the impact assessment studies conducted by RBI, NABARD and select micro finance institutions reveal that micro finance has a very positive impact on the lives of the poor. It has emerged as a cost-effective, operationally simple and low-risk strategy for expanding client base and business. It has afforded a positive institutional alternative and has cut into the informal sector hold on rural market. Infact micro finance is making the informal sector accept benchmarking of formal credit. Micro finance is not simply a banking activity; it is emerging as a developmental tool. Micro finance has ushered in the economic independence of women and change in inter & intra-household dynamics.  

Computerisation of micro finance operations will go a long way in the sustainable development of micro finance sector. This apart, selection of appropriate areas having efficient infrastructure and network of intermediaries will also help to reduce the transaction costs. Last but not the least, in an anxiety to have faster upscaling and mainstreaming of micro finance sector, we should not dilute the basic principles of micro finance and load it with bureaucratic pressures as has been experienced in the past in the other segments of formal sector.
: Values have been coverted from Rupees to US Dollar as indicated below:

Average Exchange Rates of the Indian Rupee visa-vis the Us Dollar


Rupees per unit of US Dollar























                               @: as at end-September 2002
                               Source: Handbook of Statistics on Indian Economy-2001 RBI.  

* List of Reference:  

*         RBI (1994), Report of the Working Group on supportive Policy and Regulatory Framework for Micro-finance (Chairman: S.K. Kalia), Mumbai.

*         RBI (1999), Report on Micro Credit, Micro Credit Special Cell, Mumbai.

*         NABARD (2002), Annual Report- 2001-02, Mumbai

*         V.Puhazhendhi and K.J.S Satyasai (2000), Micro Finance for Rural People- An Impact Evaluation, NABARD,  Mumbai    

*         V.Puhazhendhi (2000), Evaluation Study of Self Help Groups in Tamil Nadu, NABARD, Mumbai   

*         Fisher, T. and M.S. Sriram (2002). Beyond Micro Credit: Putting Development Back into Micro-Finance, Vistaar Publications, New Delhi.

*         Dadhich.C.L (2002) "Relevance of Micro-finance in Socio-economic Resurgence of Mumbai" The City A Publication of Bombay First, Vol. 1, No.3.

*         Sungamithra Rural Financial Services (2001), Annual Report: 2000-01, Mysore.

*         Sungamithra Rural Financial Services (2002), Annual Report: 2001-02, Mysore.

*         Swayam Krishi Sangam  (2001), Annual Report: 2000-01, Hyderabad.

*         Swayam Krishi Sangam  (2002), Annual Report: 2001-02, Hyderabad.

*         Shri Mahila SEWA Sahakari Bank Ltd. (2002), Annual Report: 2001-02.

* Ms. R. M.Vasnthakumari is Adviser in the Department of Economic Analysis and Policy and Ms. Vani. J. Sharma is Chief General Manager in the Rural Planning and Credit Department of Reserve Bank of India, Mumbai. The views expressed in this paper are those of the authors. The authors are grateful to Dr.C.L Dadhich and his staff of Division of Rural Economics, DEAP and Shri S.Ghosh, Manager, RPCD for their invaluable assistance.

@ Priority sector lending refers to bank advances that are in accordance with the direction of the Government and Central Bank. Under priority sector targets have been stipulated for the banks to channelise the credit into priority areas like agriculture, small scale industries, exports and others.
SIDBI established the Foundation for Micro Credit in November 1998 to provide a complete range of financial and non-financial services and capacity building support to the institutions engaged in the delivery of micro finance products and services.