The Hidden Debt Trap of India's Financial Inclusion Dream

In a small village in Karnataka, Savithramma, a 45-year-old mother of two, sits under the dim glow of a single bulb, clutching a worn-out passbook from her Jan Dhan bank account. It’s a symbol of India’s ambitious financial inclusion dream, one that promised her access to the formal banking system. Yet, when she needed money to repair her home after a monsoon flood, the bank turned her away. With no collateral and a patchy credit history, she had nowhere to turn but to a local moneylender, who offered her a loan at a staggering 40% interest rate. Now, she’s trapped in a cycle of debt, borrowing more just to keep up with repayments, her dreams of stability slipping further away.

India’s financial inclusion program, particularly the Pradhan Mantri Jan Dhan Yojana (PMJDY), has been hailed as a global success, bringing banking to 96% of households by 2021. But beneath the surface lies a troubling paradox: access to bank accounts hasn’t translated into access to affordable credit, pushing low-income households toward predatory lenders and deepening financial distress.

The Financial Inclusion Paradox

India’s PMJDY, launched in 2014, was a landmark initiative to bring the unbanked into the formal financial system. By 2021, approximately 96% of Indian households had at least one member with a bank account, a remarkable achievement. Progress has been limited to the liability side of lenders, which is the opening of deposits. In other words, while bank accounts are widespread, access to affordable credit remains elusive for the poorest segments of society.

The lack of credit access stems from systemic barriers:

• Credit Scoring Gaps: Institutional lending relies heavily on credit scores, which low-income individuals often lack due to limited financial histories.

• Risk Aversion: Banks and non-banking financial companies (NBFCs) exhibit high risk aversion toward low-income borrowers, particularly those earning ₹1-2 lakh annually, who are seen as high-risk due to their economic instability.

• Collateral Requirements: Without assets to offer as collateral, many are excluded from formal lending channels.

The Rise of Informal Lending

With formal credit out of reach, low-income households are turning to informal sources—moneylenders, chit funds, or even local shopkeepers, who charge exorbitant interest rates, often ranging from 40% to 50% or higher. Data from the Centre for Monitoring Indian Economy (CMIE) reveals a stark trend: between 2018-19 and 2022-23, the number of borrowers from economically weaker sections relying on formal channels contracted by 4.2%, while those borrowing from informal sources grew by 5.8%.

This shift has dire consequences:

• Debt Traps: High interest rates lead to a cycle of borrowing to repay existing loans, pushing families deeper into poverty.

• Coercive Recovery Practices: Reports from Karnataka highlight aggressive recovery tactics by informal lenders and even some microfinance institutions (MFIs), leading to harassment and, in extreme cases, borrower suicides.

• Economic Strain: The reliance on informal credit undermines the financial stability of households, reducing their ability to save or invest in productive activities.

Microfinance Under Stress

Microfinance loans, often seen as a bridge between formal and informal credit, are also showing signs of strain. Data indicates that overdue microfinance loans (more than 90 days) rose from 1.8% in December 2022 to 3.2% by December 2024. In Karnataka, delinquency rates for microfinance loans have climbed from 3.6% to 6.8%, reflecting broader financial distress.

The reasons are multifaceted:

• Policy Changes: The RBI’s 2022 decision to raise the cap on collateral-free microfinance loans from ₹1.25 lakh to ₹3 lakh has led to over-leveraging, as borrowers’ incomes haven’t kept pace with loan sizes.

• Aggressive Lending Practices: Some MFIs and NBFCs have prioritized growth over prudent underwriting, leading to higher defaults.

• Economic Slowdown: India’s economic growth is projected at 6.4% for FY25, the slowest in four years, putting additional pressure on low-income borrowers.

Systemic Issues in the Financial Sector

The broader financial sector is grappling with its own challenges, which exacerbate the credit access problem:

• Non-Performing Assets (NPAs): While gross NPAs have fallen to a multi-year low of 2.5% in September 2024, the legacy of bad loans from the 2010s continues to make banks cautious. The 2004-09 credit boom, followed by the global financial crisis, left banks with ₹10.3 trillion in NPAs by March 2018, primarily from public sector banks (PSBs).

• Retail Credit Boom: Banks have shifted focus to retail lending, but personal loans and credit card debt are showing signs of stress. In FY24, 40% of new NPAs came from retail loans (excluding home loans), with high delinquency rates in small loans below ₹50,000.

• NBFC and Fintech Challenges: NBFCs and fintechs, key players in digital lending, are facing regulatory scrutiny and rising defaults. The RBI’s tightened rules in 2022 disrupted fintech operations, while NBFCs like Bajaj Finance and Piramal Enterprises have reported increased credit costs due to over-leveraged borrowers.

Regional and Global Context

India’s credit crisis is not unique but reflects global trends in financial inclusion and informal lending:

• Regional Disparities: In states like Karnataka and Tamil Nadu, coercive recovery practices by MFIs have led to government interventions, such as the Karnataka Micro Loan and Small Loan Ordinance, 2025, aimed at curbing predatory practices.

• Global Perspective: Developing economies like Vietnam and China have higher domestic credit-to-GDP ratios (148% and 182%, respectively, in 2020) compared to India’s 55%, highlighting India’s underutilized credit potential. However, reliance on informal lending is a common issue in regions with weak formal credit systems, such as sub-Saharan Africa and parts of Southeast Asia.

What is the primary reason India’s poor are turning to informal lenders despite having bank accounts?

A) Lack of financial literacy

B) High interest rates from banks

C) Limited access to formal credit

D) Preference for local lenders

Answer the question and share your thoughts in the comments to receive a free downloadable guide for the first 100, on “Navigating India’s Credit Landscape: Tips for Financial Empowerment.”

Leaked from the Future

What does the future hold for India’s financial inclusion journey? Will the rise of informal lending spiral into a full-blown debt crisis, or can innovative solutions bridge the credit gap? Our exclusive “Leaked from the Future” report and predictive analysis to explore:

• Best-Case Scenario: Digital credit scoring and fintech innovations democratize access to affordable loans.

• Worst-Case Scenario: Rising defaults and unregulated lending lead to economic instability.

• Hypotheses: How AI-driven credit assessment and stricter MFI regulations could reshape the landscape by 2030.

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Chetan Desai (chedesai@gmail.com)