In India, where access to formal credit is often elusive, low-income individuals or micro-enterprises often rely on informal credit sources or simultaneously borrow from both formal and informal financial sectors. Research by Banerjee and Duflo (2007) highlights that even in areas where banks operate, an overwhelming 95% of borrowers living on less than US $2 a day in Hyderabad, India, still turn to informal lenders. Whereas, micro-enterprises have historically encountered numerous obstacles in obtaining formal credit. Banks often show reluctance in extending loans to small-scale businesses due to challenges in evaluating their creditworthiness and associated risks. According to a 2022 report by the Lok Sabha Standing Committee on Finance, the Micro, Small, and Medium Enterprises (MSME) sector faces a credit gap of approximately ₹20 lakh crore to ₹25 lakh crore, leaving around 47% of the credit demand unmet.
This dual dependence raises critical economic and policy questions. Why do some individuals opt for informal credit despite the availability of banks? What drives others to straddle both financial sectors? More importantly, is there a causal link between institutional development, income levels, and reliance on informal lending? If such a connection exists, what underlying factors shape this relationship? A strong reliance on informal financial sources carries the risk of ensnaring individuals in a continuous cycle of debt, which can have detrimental effects on their economic and social circumstances. Understanding these dynamics is crucial for designing policies that promote financial inclusion while curbing exploitative lending practices.
India’s financial landscape is characterised by a dual lending system that includes both formal and informal credit channels. While banks, Non-Banking Financial Companies (NBFCs), and Microfinance Institutions (MFIs) cater to a large portion of the population, a significant number of people, particularly in rural and semi-urban areas, continue to rely on informal credit systems. The absence of strict regulations in this sector has led to exploitative practices, including exorbitant interest rates and coercive recovery methods. The government is now considering legislative measures to curb unregulated lending while ensuring financial inclusion.
The Debt Trap of Informal Credit
Informal lending serves as a critical financial source for individuals who lack access to formal banking services. However, these systems often exploit borrowers due to a lack of oversight. Traditional moneylenders operate based on personal trust and local reputation, offering quick loans but charging interest rates as high as 30% annually. In addition to moneylenders, social and familial networks, chit funds, pawn brokers, and trade credit arrangements contribute to the informal lending ecosystem. While these alternatives provide convenience, their unregulated nature exposes borrowers to severe financial distress. The lack of legal oversight allows lenders to impose arbitrary terms, engage in aggressive collection tactics, and deny borrowers any formal grievance redressal mechanism.
Emergence of digital lending platforms has transformed the credit landscape in India, offering swift financial assistance to borrowers through mobile applications and online portals. Many of these platforms, however, operate without proper regulatory approvals and engage in predatory lending practices. Hidden charges, excessive interest rates, and privacy violations are common concerns. Some digital lenders exploit personal data, using it as leverage to coerce repayment through threats or public shaming. The Reserve Bank of India (RBI) has recognised these challenges and introduced regulatory guidelines to monitor digital lending activities. These include registration requirements, transparency in loan terms, a ban on coercive recovery methods, and stricter data privacy protections.
Borrowing on the Brink
India’s formal financial sector is composed of commercial banks, NBFCs, and MFIs. Commercial banks serve as the primary source of credit, offering diverse financial products, including working capital loans, term loans, and credit guarantees. The credit disbursed by Scheduled Commercial Banks (SCBs) witnessed significant growth, reaching ₹164.3 lakh crore in March 2024. The agricultural sector has also benefited from formal credit expansion, with agricultural loans growing from ₹13.3 lakh crore in FY21 to ₹20.7 lakh crore in FY24, largely driven by the Kisan Credit Card (KCC) scheme. The industrial sector saw a rise in credit availability, supported by increased bank lending to both small and large enterprises. NBFCs, on the other hand, cater to individuals and businesses that may not meet the stringent eligibility criteria of commercial banks. Their rapid growth has contributed to expanding financial access, particularly in the personal loan and industrial credit segments. MFIs play a crucial role in providing microcredit to underserved communities, empowering small business owners, women entrepreneurs, and self-employed individuals. As of September 2024, NBFC-MFIs accounted for ₹1.61 trillion in outstanding loans, covering nearly 40% of India’s microfinance sector.
The Need for Regulatory Intervention
Despite the expansion of formal credit systems, informal lending continues to thrive, with estimates suggesting that it accounts for nearly 40% of total lending in India. More than half of the urban poor remain dependent on informal credit sources, contributing to an unorganised lending market valued at approximately US $100 billion. The government has proposed the Banning of Unregulated Lending Activities (BULA) Bill to address these issues. This legislation aims to establish clear guidelines for lending practices, prohibit exploitative lending activities, and create mechanisms to protect borrowers from financial exploitation. While implementing such a law, the government must strike a balance between borrower protection and maintaining credit access for small traders, MSMEs, and rural borrowers.
The proposed bill to regulate unregulated lending raises important constitutional and legislative considerations. According to the Seventh Schedule of the Indian Constitution, “money-lending and money-lenders” fall under the State List, granting states exclusive legislative competence to regulate these activities. Several states already have existing laws governing moneylenders, setting conditions on licensing, interest rates, and operational procedures. However, lending intersects with broader financial matters under the Union List, which grants Parliament exclusive powers over banking and financial corporations. The Concurrent List also provides pathways for Central intervention in financial agreements, economic planning, and consumer protection. If framed as essential for maintaining economic stability and preventing financial fraud, the regulation of unregulated lending could fall under the Centre’s legislative authority. Article 249 of the Constitution further allows Parliament to legislate on State subjects if necessary in the national interest. The unregulated lending sector often transcends state boundaries, creating systemic risks such as data misuse and predatory practices. A uniform national framework may be justified to ensure borrower protection across all states. However, coordination with state governments will be essential to harmonise the proposed law with existing state-specific money-lending regulations.
At the same time, the Act must strike a balance between regulation and accessibility. If informal lenders are abruptly pushed out without viable alternatives, underserved populations may face a credit vacuum, negatively impacting consumption and small business activity. The government will need to ensure that formal institutions, including NBFCs and microfinance providers, step in to fill the gap by expanding financial services to previously excluded groups.
Global Approaches to Lending Regulation
Several countries have successfully implemented regulatory frameworks to control lending activities while ensuring financial inclusion. Kenya mandates licensing for digital lenders, preventing unauthorised entities from exploiting borrowers. The Philippines requires microfinance institutions to register and report their activities, ensuring transparency. Indonesia regulates peer-to-peer lending platforms to prevent fraudulent lending practices. South Africa enforces laws that cap interest rates, ensure loan affordability, and prohibit aggressive debt collection tactics. India can take inspiration from these models to develop a comprehensive regulatory framework that protects borrowers without restricting access to legitimate credit sources.
Credit or Crises?
As India’s lending ecosystem surges forward like a high-speed train, it’s essential to ensure the tracks are safe for everyone, especially the passengers who might not be holding a first-class ticket. While India’s lending landscape is undergoing rapid transformation, it is crucial to ensure that the growth of digital and informal lending does not come at the expense of consumer protection and financial stability. The rise of unregulated lending has exposed vulnerable borrowers to predatory practices, and the government’s proposed legislation to curb such activities is a promising step toward safeguarding the interests of individuals and preserving the integrity of the financial ecosystem. However, the true success of these regulatory measures will depend on their careful implementation and collaboration with state authorities to avoid unintended consequences, such as limiting access to credit for those who need it most. By adopting best practices from global financial systems, India can build a balanced framework that promotes financial inclusion while protecting consumers from exploitation. As the country continues to embrace digital innovation, finding a harmony between progress and regulation will be key to ensuring that economic growth is both sustainable and equitable for all.