India’s economic growth is fuelled by micro, small, and medium enterprises ( MSMEs ), which still face a huge financing gap. Microfinance has become a key driver of financial inclusion, particularly for small businesses and underserved communities. However, rising non-performing loans ( NPLs ) and overleveraging pose growing concerns in the microfinance sector.

India’s GDP is projected to grow by 6.5% in FY 2024-25, according to the Ministry of Statistics and Programme Implementation. MSMEs significantly contribute to the nation’s economy, playing a crucial role in manufacturing, exports, and employment. With 59.3 million registered MSMEs employing more than 250 million people, these enterprises generate a significant share of the country’s economic output.

However, many small businesses remain underserved by financial services, and some of them are unbanked or underbanked. As such, microfinance institutions ( MFIs ) and platforms play an important role in bridging this gap.

India’s microfinance sector has grown by over 2,100% in the past 12 years, with its total loan portfolio expanding from 17,264 crores ( US$2.01 billion ) in March 2012 to 3.93 lakh crores ( US$45.83 billion ) as of November 2024, according to the Ministry of Finance.

There are many single-person or small family businesses in the rural areas of India, and these groups are often unbanked or underbanked. They require financial support to start or operate their businesses.

In response, a large number of MFIs have emerged, offering loans for housing and MSME businesses. Many of these institutions have launched CSR ( corporate social responsibility ) initiatives, such as supporting women entrepreneurs, people with disabilities, and water sanitation projects. Microfinance loans typically have tenors below two years and are collateral-free for borrowers with an annual income of up to 300,000 rupees ( about US$3,498 ).

Microfinance is critical to financial inclusion in India, helping low-income borrowers participate in the country’s economic growth. This has led to regulatory easing in recent years, allowing more individuals to access financial support during the post-pandemic economic recovery.

Digitalization process

Borrowers in rural India still heavily rely on cash, making repayment collection a significant challenge for microfinance institutions. However, with encouragement from national initiatives, these institutions are gradually becoming more digitalized.

Unified Payments Interface ( UPI ) was launched in April 2016 by the National Payments Corporation of India ( NPCI ) to facilitate digital payments. Initially designed for peer-to-peer transactions, UPI quickly expanded to businesses, including MFIs, enabling instant loan disbursements and EMI ( equated monthly installment ) repayments without cash handling.

Borrowers can use UPI apps like Google Pay, PhonePe, Paytm, and BHIM to make payments via QR codes, UPI IDs, or AutoPay mandates for recurring transactions. Over time, UPI has transformed the microfinance industry in the country by reducing operational costs and enhancing transaction security, especially in rural and semi-urban areas.

NPL concerns

However, the combination of technological convenience and relaxed credit regulations is expected to drive up the non-performing loan ( NPL ) ratio in the microloan segment by FY 2025-26 ( FY26 ), according to S&P Global’s latest report.

Portfolio at risk – the share of loans which are overdue for 30-180 days – climbed to 6.4% in December 2024 from 2% in December 2023, according to Micro Finance Institution Network ( MFIN ) data. 

Meanwhile, loose monitoring has allowed borrowers to access multiple lenders, increasing borrower leverage, S&P Global says in its report. The credit boom was further amplified by the deregulation of microfinance lending rates in 2022, making the MSME sector highly lucrative for lenders.

“Tightening regulations and stricter underwriting standards in Indian microfinance will rein in growth plans for sector lenders and defuse risk buildup for overleveraged borrowers,” says S&P Global Ratings credit analyst Shinoy Varghese. “However, these same trends will weigh on asset quality, given that many clients rely on new loans to repay old ones.”

This rapid expansion led the self-regulatory Microfinance Institutions Network ( MFIN ) to implement stricter borrowing rules in August 2024. Since then, lending in the sector has contracted.

According to MFIN, the gross loan portfolio in the microfinance segment shrank by 3.5% year-on-year basis to around 3.85 trillion rupees ( US$44.88 billion ) at the end of December 2024 on curtailed funding and strict credit underwriting.

A slowdown in lending is expected to add to asset quality stress, S&P Global says. During the microfinance lending boom following the pandemic, many borrowers repaid loans from one lender by borrowing from another. To address this, MFIN introduced caps on lenders in August 2024 and plans to tighten these further starting in April 2025.

“In our view, many microfinance institutions have tightened their lending norms beyond the fresh guidelines laid out by the MFIN,” says Varghese. “This should keep a check on asset quality strains. We expect the non-performing loan ratio to peak by March 31 2026.”

The national government continues to selectively support MSMEs in the latest Union Budget ( 2025-26 ), according to the Ministry of Micro, Small, and Medium Enterprises. A series of measures has been introduced to strengthen the MSME sector, including a new financial support scheme for first-time entrepreneurs from disadvantaged backgrounds and sector-specific initiatives to enhance productivity in industries such as footwear, leather, and toy manufacturing.