There has been a long-standing debate on the ability and effectiveness of the formal banking system as a vehicle for financial inclusion. The thrust has been to increase the number of small banks, as they play a very important role in the supply of credit to small business units, small farmers and other unorganised sector entities.

Various initiatives were put in place to promote small banks geared towards small borrowers. It was envisaged that they would be able to explore business potential more tailored to the socio economic background in the area of operation and extend banking services to the people in that area.

In India Local Area Banks (LABs) were conceived as low cost structures and for providing efficient and competitive financial intermediation services in their areas of operation in the rural and semi-urban areas. The overall performance of functioning LABs is less than satisfactory, as they have become high cost structures.

Thus while small banks have the potential for financial inclusion, performance of the small banks in India has been unsatisfactory. Among the many tools that are used for “including the excluded”, microfinance is considered among the most successful. The current definition and practice of microfinance has also undergone a significant change to address `financial inclusion’.

MFIs in trouble Microfinance institutions (MFIs) are set to address two most important gaps – first, in terms of creating access to a formal banking system, and second, in building confidence among self-help group (SHG) women to access the formal system. A systematic review of the empirical assessment on the benefits of microfinance reveals that MFI initiatives, unless clearly linked to a specified development programme, have not had significant positive effects.

A major benefit is the accessibility to loans at a relatively cheaper rate compared to the informal moneylenders, coupled with reduction in economic vulnerability. The SHG-linked programmes have also been successful in mobilising voluntary savings from poor households. This access to finance has also led to consumption smoothening of poor households who face seasonality in incomes. However, the flip side of the newfound access to finance and consumption smoothening is that it can exacerbate debt trap conditions.

Increased microloans without a corresponding increase or a non-existent income gives rise to this problem. This is accentuated by the fact that the interest costs for MFs have remained stable over a period and the recent rate cuts have had almost no impact in this sector.

Currently, microfinance initiatives are in a state of flux. This is because the last decade has witnessed a proliferation of MFIs and SHGs, increasing the penetration levels. In some cases, given the level of competition among MFIs, beneficiaries have had significant bargaining power in the choice of service and quantum of loan.

There have also been instances where groups have switched MFIs mid-way, owing to a loan take over programme. Thus we are witnessing a market ‘take-over’ of a hitherto social intervention, posing challenges to the current institutional architecture. Further, the emphasis till recently for most MFIs was to disburse a large number of loans with increased number of accounts and increase the number of SHGs through which they operate. With almost no growth in newer SHGs in states like Tamil Nadu or Andhra Pradesh, the emphasis would have to shift to a more sustained operation strategy.

An integrated financial development model could possibly lead to sustainable results and maximise the social development impact.

Mere financing will not do The current financial inclusion activities by the MFIs need to move beyond providing basic training facilities to creating ownership-linked initiatives.

A diversified menu of micro loan products linked to sustainable income generation activities via micro enterprises or a creation of community-based pooled enterprise could possibly make it more attractive and compatible with the requirements of women. In addition, linking such developmental initiatives to an institution to nurture, monitor and handhold those activities in the formative stages is crucial for sustainability.

A microloan, if linked to a specific activity leading to economic or social benefit in the medium to long run, would be a sustainable model. But realising economic and social benefits requires continuous access to a broad range of financial services and not a one-time access to loans. Mere provision of financial services has mixed or a limited short run positive impact.

Therefore, the development of a financial infrastructure and intermediaries committed towards growth and viability is crucial. Some of the MFIs have already woken up to this challenge and have started working towards it in small way. But this would be successful in alleviating poverty only if the intermediaries develop alongside the emphasis of financial inclusion.

While MFIs do break down many barriers to financial inclusion, there are limitations. MFI penetration in the country is skewed and excludes some areas neglected by the banking sector, suggesting a need for policy incentives.

Further, there is a need for MFIs to consider adopting more flexible operating models, providing skills training and offering services such as portability of accounts to provide greater access for a longer duration of time.

A model to retain and recycle within the target population could possibly lead to a sustained route for poverty alleviation.

The writers are Professors in the Departments of Humanities and Social Sciences, and Management Studies respectively at IIT-Madras