The poor stay poor, not because they are lazy, but because they have no access to capital - Milton Friedman
1) The expense of the outreach
Microfinance institutions, by virtue of the model, service small ticket loans to the urban poor and underbanked in remote hinterlands. The outreach comes with logistical and field force overheads. This results in margin erosion and need for digitization and process automation.
In India, MFI outreach is very low and counts to only 8% compared to 65% in Bangladesh.
2) Growth of the Self-Help-Groups (SHGs)
Many MFI's follow the SHG or the Joint Liability Group (JLG) model. These models are selected randomly regardless of the situation, which increases the risk of borrowings for the weaker sections beyond they can bear and is irreversible.
With the government's involvement in promoting the self-help groups, the groups have experienced fast growth, which has brought in stress for the microfinance institutions. This puts adverse effects on the sustainability of the MFIs in the long run.
3) Higher Rate of Interest Compared to the Mainstream Banks
Microfinance institutions have low transaction volume; however, the cost of those transactions are fixed and are high; this causes a significant challenge to all the institutions.
The mainstream banks have laid deep roots in the market, and it has been evolving with the need of the times. People find a variety of products at the same place and low cost compared to MFIs. Most of the mainstream banks have a low-interest rate on their loan, ranging from 8-12% while the MFIs have a high rate of interest charged on the loans that amount to 12-30% of the principal amount.
The RBI issued guidelines to eliminate the 26% limit of interest on the MFIs. Many MFIs have benefited from the guidelines, but the borrowers have driven away with the interest rates' increment.
Microfinance institutions have a low volume of transactions whereas the cost of those transactions are fixed and are high
4) Lack of Investment Validation
Investment valuation may be a crucial capability for the healthy functioning of an MFI. The evolving and developed markets within which MFIs operate have limited activity. That's why it becomes tough for MFI to realize access to information for valuation purposes.
Lack of consistent and reliable valuation procedures, MFI management teams, cannot realize the amount of quality info they have to build investment decisions.
5) Missing of Targets
It is a common mistake by the MFIs to neglect the urban poor; they primarily try to focus on the rural poor.
Only 800 MFIs in India have been found to focus on the urban poor.
6) Loan Default
The institution deals with a marginalized section of society and intends to improve their standard of living; however, people's inability to manage their debts leads to loan default hindering the growth of Microfinance Institutions.
There happens to be a significant increase in borrowing, while risk management remains inefficient. The sectors give loans without collateral which increases the risk of loan default and bad debts.
Good growth needs effective planning which is still seen missing in most of the MFIs. Further, the lack of apex control which leads to being among the reasons for the Microfinance crisis of 2008 in India also becomes a cause of over-indebtedness.
Late payments are almost 70% in MFIs, which further creates a hurdle for the institution's working capital and profit.
7) Geographical factors
Many MFIs noticed that it is difficult to work and deal with clients in far-flung areas, and hence geographical factors play an essential role in creating up challenges for the MFIs.
Targeting the rural poor, microfinance institutions often try to get into the BPL area, but it becomes difficult for them to reach the customers due to lack of infrastructure.
8) Over-dependence of the banking system for the fund
Around 80% of the funds of the Microfinance institution comes from commercial banks. Most of the MFIs are registered as NGOs and need the banks for stabilized funding for their lending activities.
These banks are mostly private and charge a greater rate of interest over a shorter period. The over-dependence of these MFIs on banks makes them incompetent and less active towards dealing.
9) Low knowledge of financial services
Another major hindrance in microfinance institutes' paths is the lack of knowledge among the citizens about the basic fundamental concepts.
The microfinance industry's lack of financial service is a challenge for both the customer and the institutions. This does not only eliminate people from joining the MFIs but also makes them financially excluded.
What are the solutions?
Proper Regulation - When the microfinance was in its emergent stage, and individual establishments were liberated to usher in innovative, operational models, a restrictive surrounding requirement wasn't a big concern. However, now the institution needs restrictions that protect the interest of stakeholders and promotes growth.
Field superintendence - In addition to correct regulation of the microfinance sector, field visits can be accepted as a medium for monitoring the conditions on the ground and initiating corrective action if needed. this can keep an eye on the performance of ground employees of MFIs and their loan recovery practices.
Focus on rural poor - Instead of reducing the initial cost at places where there are MFIs, these institutions could start targeting the rural poor and establish new branches over the areas.
Complete variety of product - MFIs ought to offer a complete variety of products together with credit, savings, remittance, financial advice and many more; this will help in diverting the dependency of people from the commercial banks.
Transparency of interest rates - The MFIs should abide by an actual Interest rate on the products and amounts which should be mentioned to the customers.
Technology to scale back overhead - MFIs ought to use new technologies and IT tools & applications to scale back their operational costs. Microfinance institutions should be inspired to adopt cost-cutting measures to scale back their operating costs.
Different sources of fund - In the absence of adequate funds, the expansion and the reach of MFIs become restricted and to beat this downside, MFIs could hunt for alternative sources for funding their loan portfolio.