Exploring Models of Microfinance: From Theory to Practice in India

Access to formal credit has long been a challenge for millions of low-income households in rural India. Banks require collateral, paperwork, and credit histories that most poor families simply don’t have. Microfinance emerged as a direct response to this gap – providing small loans, encouraging savings, and building financial habits at the grassroots level. But microfinance is not a single, uniform system. Over decades, theorists and practitioners have developed a range of distinct models, each with its own logic, structure, and target group. Understanding these models – from theoretical frameworks to India-specific implementations – is key to understanding how rural financial inclusion actually works on the ground.

What is microfinance and why do models matter? 🔗

Microfinance refers to the provision of small loans and financial services – savings, insurance, remittances – to low-income individuals who lack access to conventional banking. In India, loans below ₹1 lakh are generally classified as microloans, and the sector serves a vast and diverse population across rural and semi-urban areas. The design of a microfinance model matters because it directly shapes who gets credit, at what cost, through what process, and with what accountability. A poorly designed model can trap borrowers in debt; a well-designed one can genuinely transform livelihoods. This is why both theorists and policymakers have invested considerable effort in developing and refining different approaches.

Theoretical models of microfinance 🔗

Before exploring how microfinance operates in India specifically, it helps to understand the foundational theoretical models that inform practice worldwide. Scholars and practitioners have identified at least eight distinct microfinance lending models, each governed differently and suited to different contexts.

Associations 🔗

An association-based model brings together a group of individuals – often from the same community or trade – who pool resources and extend credit to members. The group itself sets the rules, manages funds, and enforces repayment. The key advantage is social cohesion: members know each other well, which reduces the risk of default. The accountability is horizontal – peer-to-peer – rather than imposed by an external institution.

Community banking 🔗

Community banking – closely linked to what is often called the village banking model – involves a community-managed institution that accepts small deposits and extends loans to members. The Grameen Bank model, which originated in Bangladesh, is the most influential version of this approach. Modern microfinance was born in Bangladesh in the 1970s when Professor Muhammad Yunus began an experimental project providing credit to the rural poor, which ultimately led to the establishment of Grameen Bank. The critical mechanism in this model is group lending, where a small group of borrowers take joint responsibility for loan repayment, which has consistently achieved high repayment rates and made lending more sustainable.

Co-operatives and credit unions 🔗

Cooperatives are member-owned financial entities governed on democratic principles – one member, one vote. Members contribute savings, which are then lent out to fellow members at reasonable interest rates. Credit unions operate similarly but are usually chartered under specific cooperative or credit union legislation. Credit union funds are normally kept in a bank for safekeeping, and their status must be approved by the regulatory agency overseeing credit unions. In India, Primary Agricultural Credit Societies (PACS) function on cooperative principles and serve as one of the oldest rural credit delivery channels.

NGO-led models 🔗

Non-Governmental Organisations (NGOs) have played a major role in microfinance, particularly in mobilising and training community groups before linking them to formal banks. The NGO acts as an intermediary – it does not always lend money itself, but organises beneficiaries, builds capacity, and facilitates bank linkage. In India, NGOs formally function as Self Help Group Promoting Institutions (SHPIs), a role recognised and supported by NABARD.

For-profit banks and NBFCs 🔗

Commercial banks and Non-Banking Financial Companies (NBFCs) have increasingly entered the microfinance space. There is an India-wide trend towards the formal registration of MFIs as for-profit Non-bank Finance Companies (NBFCs), which has also enabled diversification into micro-insurance and remittances. While this has expanded outreach significantly, it has also introduced concerns about high interest rates and profit-oriented behaviour displacing social objectives.

Rotating Savings and Credit Associations (ROSCAs) 🔗

ROSCAs are one of the oldest and most widespread informal microfinance mechanisms. Members contribute a fixed amount periodically, and the entire pool is given to one member at a time on a rotating basis. In India, the equivalent is known as a chit fund. ROSCAs exist in both rural and urban areas across developing countries, among both women and men, and have been shown to positively influence household income and consumption. Their strength lies in simplicity and trust – no external lender is needed, just a committed group.

Bank guarantee model 🔗

In the bank guarantee model, a third party – often a development agency, NGO, or government body – provides a guarantee to a bank, enabling the bank to lend to borrowers who would otherwise not qualify. The guarantor reduces the bank’s risk, making it more willing to extend credit to the poor. This model is particularly useful in bridging the gap between formal banking and informal communities.

India-specific models: the SHG linkage approach 🔗

India has developed its own distinctive microfinance architecture, shaped by the scale of rural poverty, the role of NABARD, and decades of policy experimentation. The dominant model is the SHG-Bank Linkage Programme (SHG-BLP), pioneered by NABARD.

The SHG linkage model 🔗

What started as a pilot to link around 500 SHGs to formal financial institutions in 1992-93 has now become the largest microfinance programme in the world in terms of client base and outreach. As of March 2024, the programme covers 17.75 crore households, with over 83% of groups being exclusively women-led groups.

The SHG model works as follows: a group of 10-20 individuals (usually women from similar socioeconomic backgrounds) comes together, begins saving regularly, and manages an internal lending pool. Once the group demonstrates financial discipline over a period of 6 months to a year, it becomes eligible for a bank loan – typically a multiple of the group’s own savings corpus. SHGs that follow the ‘Panchsutras’ – regular meetings, regular savings, internal lending, timely loan repayment, and proper maintenance of accounts – are considered high quality and have consistently proved themselves to be reliable bank customers.

The model operates across three structural variants:

Model I – SHGs are directly linked to banks without any NGO intermediary. The bank itself deals with the group. Model II – NGOs or other promoting institutions facilitate the formation and nurturing of SHGs, but the bank directly extends credit to the group. Model III – NGOs act not just as promoters but also as financial intermediaries, borrowing from banks and on-lending to SHGs. This three-way structure involves SHGs, banks, and NGOs, and was reviewed and streamlined by a working group in 1995, leading to RBI-approved guidelines that allowed SHGs to open bank accounts through a simple inter se agreement.

The modified SHG model and NGO-MFI partnerships 🔗

In the modified SHG model, Microfinance Institutions (MFIs) partner with NGOs and function as the lending arm, while the NGO continues to handle community mobilisation and group promotion. This separation of functions – social mobilisation by NGOs, financial services by MFIs – allows each entity to focus on what it does best. MFIs in India include NBFC-MFIs, NGOs, cooperatives, banks, and small finance banks, offering credit, insurance, and savings products.

The Joint Liability Group (JLG) model, which is closely associated with the Grameen Bank approach, is also widely used in India. Here, groups of five members take individual loans but hold collective responsibility for repayment. The JLG model is used by private MFIs in India and is functionally similar to the Grameen Bank model, where groups of five members aggregate into larger centres, often at the village level.

The Grameen Bank: the global benchmark 🔗

No discussion of microfinance models is complete without a closer look at the Grameen Bank of Bangladesh, which remains the single most replicated microfinance institution in the world. Founded by Muhammad Yunus – who was awarded the Nobel Peace Prize in 2006 for this work – the Grameen Bank demonstrated that the poor are bankable: that they repay loans reliably when the right structures are in place.

The Grameen model relies on group formation, peer pressure, and regular weekly meetings. Each borrower belongs to a group of five, and groups are clustered into larger centres. Loans begin small and increase as the borrower’s repayment track record develops. Studies comparing Grameen-model MFIs and SHG-based models have found that both significantly contribute to increases in women’s income and savings, though SHGs tend to be more effective at improving access to training, social services, and market information.

The success of Grameen Bank also highlighted the key mechanism behind high repayment rates in microfinance: group lending transfers the responsibility of creditworthiness from bank staff to borrowers themselves, reducing the moral hazard and information asymmetry problems that make conventional lending to the poor so difficult.

Comparing models: repayment, reach, and sustainability 🔗

Research comparing the SHG-bank linkage model and MFI model found that MFI recipients experience better livelihood impact in certain domains, while SHG members show greater improvement in savings habits, mobility, and access to health services. Neither model is universally superior – each suits different contexts, community capacities, and policy environments.

The SHG-BLP is celebrated for its low cost, women-centric design, and integration with formal banking. But its limitation is that the loan amounts – especially in the early cycles – are often too small to fund meaningful livelihood investments. MFIs, on the other hand, can disburse larger and faster loans, but average interest rates charged by MFIs in India range from 20% to 26%, considerably higher than traditional bank rates of 8-12%, raising concerns about over-indebtedness.

The 2010 microfinance crisis in Andhra Pradesh – triggered by coercive recovery practices by some MFIs – brought these trade-offs sharply into focus. It demonstrated that financial inclusion without adequate regulation and social safeguards can cause more harm than good. Since then, the RBI has tightened the regulatory framework for NBFC-MFIs, and the importance of balancing financial sustainability with borrower welfare has become a central policy priority.

The role of NABARD and government in sustaining the models 🔗

NABARD’s Micro Credit Innovations Department, established in 1998, has been the principal institutional driver of India’s microfinance ecosystem, providing refinance support to banks, funding NGO promotion activities, and co-ordinating with national livelihood programmes like DAY-NRLM (Deen Dayal Antyodaya Yojana – National Rural Livelihoods Mission). NABARD refinances banks up to 95% of their lending to SHGs, JLGs, and MFIs, and as of March 2024, cumulative refinance disbursed for SHG lending has crossed ₹1,17,895 crore. This financial backstop has been critical to making the SHG-BLP viable at scale across diverse and often underserved regions.

What do you think? Given that the SHG model excels at empowerment and savings discipline while MFIs offer faster and larger loans – do you think these two approaches should be seen as competitors, or could they be designed to complement each other more effectively? And with microfinance reaching over 15 crore households in India, is scale alone a sufficient measure of success, or should repayment rates and poverty impact carry equal weight in evaluating these models?

References

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2. https://www.scribd.com/document/97437025/8-Microfinance-Lending-Models
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5. https://www.nabard.org/content.aspx?id=477
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8. https://pubs.lib.umn.edu/index.php/reconsidering/article/download/574/568/744
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