Regulation in India's microfinance sector aims to address feckless borrowing and reckless lending – but will the new restrictions entrench poverty, rather than end it?

One of the many crushing burdens for India's poor bear is debt; unable to make ends meet, they turn to traditional moneylenders. They are willing to extend credit, but at unconscionably high rates – sometimes exceeding 80%, and keeping borrowers in lifelong penury. Popular cinema and classic literature tells many pathos-filled narratives of India's poor caught in that karmic cycle of poverty. Those stories inevitably end in tragedy.

The poor borrow money as the rich do, to meet their needs. In their case, to buy food and medicines, as well for socially important but economically unproductive events, such as family weddings. The rural poor are beyond the reach of banks, dependent on moneylenders. State-aided self-help groups, as in the southern state of Andhra Pradesh, were supposed to offer relief by providing small loans, but many of the groups were mired with corruption so that even to get a small loan, the borrowerhad to pay a bribe to a government official.

Microfinance institutions were meant to change that by freeing them from the moneylenders' grip. But lack of regulatory oversight, unbridled political cynicism and the myopic herd-like mentality of the private sector combined to threaten to push India's poor in the arms of the moneylenders again. Andhra Pradesh, where the crisis was most acute, passed legislation to restrict the private sector. Now the Reserve Bank has made policy recommendations that can revive the sector while protecting the borrowers.

Microfinance institutions are supposed to lend money to the poor so that they could invest in small businesses, in education, and in health. The Bangladesh model of the Grameen Bank of Nobel Laureate, Mohammed Yunus, depended on donor funds; in India, the private sector stepped in. Indian microfinance institutions raised capital through loans from other banks at concessional rates, or through markets. Last year was a bonanza for them: one of them, SKS Microfinance, raised more than $350m, its public offering oversubscribed 13 times.

NGOs, which had dominated the sector, simply could not compete; towards the end of the last year, several large private, for-profit firms dominated the sector in India. (The private sector accounts for only 50 of India's 1,000 microfinance institutions, but the top four account for 80% of the market now.)

As Vijay Mahajan, a microfinance pioneer in India puts it, there was reckless lending – and feckless borrowing. Some borrowers took multiple loans without sufficient collateral. It was a disaster waiting to happen. It did, with reports of a few borrowers committing suicide. Andhra Pradesh promptly imposed restrictions, which nearly killed the private microfinance institutions.

Without private institutions, the borrowers would often end up dependent on moneylenders again. The moneylender had one advantage that the private institution and even the state did not have. He has a historic relationship with the community, although it is an exploitative relationship. He extended credit beyond the borrower's ability to repay, keeping the borrower in long-term debt.

While India has officially banned the system known as bonded labour in India, as Patrick French shows in his new book, India: A Portrait, isolated cases of modern forms of slavery exist. Reliable statistics are difficult to get, but the annual report of India's ministry of labour shows that some 500,000 labourers were released and rehabilitated last year. Activists claim some 40 million people, many of them underprivileged dalits, continue to live in penury.

This is where microfinance institutions are supposed to step in. The institutions began promisingly – their loan portfolio exceeded $7bn and was extended to 30 million families. The rate microfinance institutions charged was stiff (24% to 30%) but it was lower than what the moneylender would charge.

But the borrowers operated in a culture that lacked the discipline of repayment. Politicians have historically provided largesse to borrowers, through loan melas (festivals), or by writing off debt on the eve of elections. With many lenders chasing borrowers, some borrowers took on multiple loans. When they couldn't repay, they found they had no recourse. Suicides – even if unconnected with the debt – became the last straw.

The Andhra government stopped lenders from visiting borrowers weekly, and insisted those who had borrowed from self-help groups could only borrow from a private firm after getting a clearance from the self-help group. Now the Reserve Bank has stepped in, with an expert committee capping interest rates at 24%, for loans of $550, and restricting a borrower to two loans.

These are prudent business practices. State officials aren't happy, but the alternative to the private sector is the moneylender. As Vineet Rai of Intellecap, a social sector advisory, notes in a recent report, the real issue is: who owns India's poor – the state or the private sector? The Indian state has enjoyed a monopoly in serving the poor, and its record isn't exactly great. Microfinance is not the only solution to poverty. But restricting alternatives to poor borrowers will keep them poor, instead of liberating them.

The regulatory change suggested by the Reserve Bank are positive, but the blunter changes the Andhra Pradesh government had initiated – with borrowers required to obtain a certificate from self-help groups before taking fresh loans, and moves forbidding weekly meetings between the borrower and the lender – seem designed to protect the state's monopoly, with the corruption it entailed. This central intervention regulates the industry, diminishes choice, and will limit poor people's access to finance, but it will protect the vulnerable among them.