India's Credit Market Dilemma: Resilience Amid Rising Defaults

India's non-banking financial companies (NBFCs) stand at a crossroads. The sector, long a cornerstone of financial inclusion and economic growth, is grappling with a surge in defaults, particularly in the microfinance segment. Yet, within this turmoil lies a paradox: while systemic risks loom, pockets of resilience and innovation are emerging. For investors, the challenge is to discern where caution is warranted and where opportunity persists.

The Rising Tide of Defaults

The microfinance industry, a critical arm of India's NBFC ecosystem, has seen its delinquency rate climb to 4.3% in Q2 2025, up from 2% in the same period the previous year. This rise is not uniform. States like Bihar, Tamil Nadu, and Uttar Pradesh account for 62% of new late payments, reflecting regional economic fragility and uneven borrower resilience. Small finance banks, which often serve lower-income demographics, face the steepest challenges, with delinquencies at 5.4% for loans overdue 31–180 days. In contrast, NBFCs have managed a lower rate of 2.3%, underscoring their relative adaptability.

The contraction in the microloan portfolio—down 4.3% quarter-on-quarter to ₹4.1 lakh crore—highlights the sector's vulnerability. Yet, the 7.6% year-on-year growth suggests that demand for credit remains robust, albeit under strain. This duality—shrinking portfolios amid persistent demand—points to a market in flux, where structural shifts are outpacing regulatory and operational adjustments.

Policy and Profitability: A Delicate Balance

The Indian government and regulators have responded with a mix of urgency and pragmatism. Meetings between microfinance institutions (MFIs) and the Department of Financial Services have yielded calls for a credit guarantee scheme, relaxed asset norms, and targeted funds for high-risk regions like the Northeast. These measures aim to stabilize the sector while preserving its role in financial inclusion.

However, profitability remains under pressure. For microfinance-focused NBFCs, profits have plummeted by 95%, and credit costs are projected to rise from 2.6% in FY24 to 4% in FY25. This squeeze is compounded by the sector's reliance on high-cost funding, such as non-convertible debentures and commercial papers, which become more burdensome as liquidity tightens.

Opportunities in Resilience

Amid these challenges, certain NBFCs are demonstrating resilience through strategic innovation. Aditya Birla Capital Limited (ABCL), for instance, has leveraged digital transformation to strengthen its risk management and expand its customer base. Its omnichannel platform, ABCD, now serves 5.5 million customers, while its B2B platform, Udyog Plus, has digitized lending for the MSME sector. ABCL's financials reflect this agility: consolidated revenue grew 20% year-on-year in FY25, with a 2.25% return on assets in its NBFC segment. Its gross stage 2 and 3 delinquency ratio improved by 71 bps year-on-year to 3.78%, a testament to disciplined credit practices.

Similarly, Piramal Enterprises Limited (PEL) has restructured its balance sheet to mitigate legacy risks. By reducing its wholesale AUM from ₹43,175 crore to ₹10,353 crore between FY22 and Q3 2025, it has shifted focus to retail lending, where its GNPA (Gross Non-Performing Assets) stands at 2.8%, well within RBI thresholds. PEL's recent reverse merger with its subsidiary, Piramal Capital and Housing Finance Ltd., is expected to streamline operations and enhance transparency, aligning with regulatory expectations.

The Role of Technology and Regulation

The NBFC sector's future hinges on its ability to adapt to technological disruption and regulatory evolution. Fintechs, with their data-driven models and AI-powered risk assessments, are outpacing traditional lenders in efficiency and scalability. Collaborative models, such as co-lending partnerships between NBFCs and fintechs, are gaining traction but require significant investment in digital infrastructure.

Regulatory shifts, including the RBI's push for risk-based supervision and external benchmarking of lending rates, will further reshape the landscape. While these measures aim to enhance stability, they also increase compliance costs and reduce pricing flexibility. For investors, the key is to identify NBFCs that can navigate these changes without compromising profitability.

Investment Implications

The NBFC sector's risk-reward profile in 2025 is nuanced. While repo rate cuts in FY26 may provide margin relief, the benefits will be unevenly distributed. Large NBFCs like Bajaj Finance and Cholamandalam face re-rating risks due to unmet AUM and asset quality targets, whereas mid-sized players with strong digital foundations and diversified portfolios—such as ABCL and PEL—offer more compelling opportunities.

However, caution is warranted. The microfinance segment, despite its growth potential, remains fragile. Investors should prioritize NBFCs with robust credit metrics, proactive risk mitigation strategies, and a clear path to regulatory compliance. Exposure to high-risk regions and unsecured lending should be carefully evaluated, given the sector's susceptibility to macroeconomic shocks.

Conclusion

India's NBFC sector is at a pivotal juncture. Rising defaults and regulatory scrutiny test its resilience, but innovation and strategic adaptation offer a path forward. For investors, the challenge is to balance the sector's systemic importance with its inherent risks. Those who focus on firms like ABCL and PEL—companies that combine technological agility with prudent risk management—may find themselves well-positioned to navigate the credit market's evolving dilemma.