what is microfinance

What is microfinance? A complete guide.

Microfinance is the extension of small loans to the very poor, in combination with other financial services, such as savings accounts, training, health services, networking, and peer support. This allows them to pursue entrepreneurial projects that generate extra income, thus helping them to better provide for themselves and their families.

In this way, microfinance allows families to work to end their own poverty – with dignity. Microfinance programs around the world, using a variety of models, have shown that poor people achieve strong repayment records – often higher than those of conventional borrowers. Repayment rates are high because, through a system of peer support used in many microcredit models, borrowers are responsible for each other’s success and ensure that every member of the group is able to pay back their loans. 

Origins

Microlending was invented in Bangladesh by Muhammad Yanus.  In 1976, Muhammad Yunus visited the village of Jobra and witnessed some of the worst poverty in India at the time.  An economist by education, he theorized that lending small amounts of money to the villagers of Jobra could help increase self-employment and substantially reduce poverty.  Yanus lent $27 USD to several women in the village, and earned 83 cents of interest on the loans, proving the concept’s viability. 

Later, in 1986, Muhammad Yunus founded Grameen bank, the worlds first microlending institution.  By 2007, Grameen bank had made more than $6 billion in business loans to micro-entrepreneurs in developing countries who had no credit history and thus no access to traditional banking.

Yanus would go on to win the nobel peace prize in 2006 for his work.

Since then, microcredit has been adopted by hundreds of both for-profit and non-profit organizations to help spur economic activity in the developing world. 

Micro-credit vs micro-finance – is there a difference?

Generally speaking, microcredit and microfinance have the same meaning, and can be used interchangeably.  Both generally refer to small loans designed to people in impoverished or rural areas start small businesses. 

Some use the term microfinance to describe a broader spectrum of financial services including micro-loans, micro-insurance, micro-savings, and electronic money transfer.  Those same people use the term microcredit to specifically refer to microloans that are given for the purpose of economic development.

What is microcredit?

A small introduction to a huge movement

Microcredit is the extension of small loans and other financial services (such as savings accounts) to the very poor. This allows them to pursue entrepreneurial projects that generate extra income, thus helping them to better provide for themselves and their families.

La Maman Mole Motuke lived in a wrecked car in a suburb of Kinshasa, Zaire with her four children. If she could find something to eat, she would feed two of her children; the next time she found something to eat, her other two children would eat. When organizers from a microcredit lending institution interviewed her, she said that she knew how to make chikwangue (manioc paste), and she only needed a few dollars to start production. After six months of training in marketing and production techniques, Maman Motuke got her first loan of US $100, which she used to buy the production materials necessary to start her own business.

Today, Maman Motuke and her family no longer live in a broken-down car: they now rent a house with two bedrooms and a living room. Her four children go to school consistently, eat regularly, and dress well. She is currently saving to buy some land in a suburb farther outside of the city and hopes one day to build a house there.

Why give loans to very poor people for self-employment endeavors?

In many developing countries, the self-employed comprise more than 50 percent of the labor force. Access to small amounts of credit at  reasonable interest rates – instead of the exorbitant ones often charged by traditional moneylenders – allows poor people to move from initial, perhaps tiny, income-generating activities to small microenterprises. In most cases, microcredit programs offer a combination of services and resources to their clients including savings facilities, training, networking, and peer support.

In this way, microcredit allows families to work to end their own poverty – with dignity. Microcredit programs around the world, using a variety of models, have shown that poor people achieve strong repayment records – often higher than those of conventional borrowers. Repayment rates are high because, through a system of peer support and pressure used in many microcredit models, borrowers are responsible for each other’s success and ensure that every member of their group is able to pay back her loans.

How microfinance works

Microfinance institutions (MFIs) fund small entrepreneurs in developing countries.  These entrepreneurs run what are knowns as micro-enterprises. Since these entrepreneurs have no credit history, loans offered by traditional moneylenders are not available to them. This video by Kiva does a great job of explaining how microfinance works.

 

These microcredit loans typically have a high default rate and thus high interest rates, but nevertheless have been shown to help with economic stimulation and poverty alleviation in impoverished areas.  They are designed to create income-generating activities.  

Since the default rates are so high, the loans have been traditionally accompanied with high interest rates.  However, many in the industry have been working to equip loan officers with ways to better determine creditworthiness.  In the developed world, most people have credit history from credit bureaus that loan officers can review. Those data-points do not exist, but the prominence of mobile phones and the data from the phones has been used to help determine creditworthiness.

Additionally, many microcredit institutions require financial literacy training as a way to help the microentrepreneurs succeed and increase the repayment rates of the microfinance loans.

Microfinance institutions

The microfinance industry is extremely large.  According to India Microfinance, the following organizations are the top 10 largest microfinance services in the world:

  1. MBK Ventura (Indonesia)
  2. SDBL (Sri Lanka)
  3. Shakti (Bangladesh)
  4. GFSPL (India)
  5. CARD Bank (Philippines)
  6. BURO Bangladesh (Bangladesh)
  7. SKS (India)
  8. Spandana (India)
  9. Grameen Bank (Bangladesh)
  10. Lead Foundation (Egypt)

Many of these are financial institutions, essentially commercial banks who earn a profit.  There are also nonprofit organizations that provide loans to low-income people. Some larger non-profit microfinance providers are Accion and Kiva. 

Other non-profits such as CGAP are focused on social performance.  They provide no loans at all, but solely bring awareness to the movement and provide research to help microfinance institutions improve their abilities to make loans to microentrepreneurs.

Microfinancing in the United States

Though microcredit originated to help the developing world, the movement has made its way to the United States to help aid low-income households.  Grameen America, for example, provides micro financial products in the US, including small business credits with loan sizes up to $1500. Grameen America provides loans to people living below the US poverty line – $15,000 per year – who are ignored by traditional banks and have no other means to build assets.

Does Microfinance Work?

The data has shown that microfinance is a way to stop the cycle of chronic poverty, reduce unemployment, increase entrepreneurship and aid hardworking people in places that offer little opportunity, many have been critical of the movement.

Organizations like the Grameen Bank – which is a for-profit institution – have proven that microfinance can be profitable while encouraging global development.

However, microfinance isn’t perfect and still has a number of problems to be solved.

Some reports, such as those from the world bank, argue that microfinance can actually increase levels of poverty among low-income populations.  The world bank points out that microfinance is unable to reach the poorest of the poor, and that it is difficult for lending organizations to make profitable loans.

Additionally, some studies have shown that microloans simply go towards paying living expenses instead of investing in businesses.  This results in no additional cash flow and thus low repayment rates.

Conclusion

The goal of the microcredit summit is to bring awareness to not only the successes but also the shortcomings of microfinance so that all involved can work towards making all aspects of microfinance – microcredit loans, micro-savings, micro-insurance, and even payday loans – help economic development and poverty alleviation around the world.  The goal is financial inclusion, so that those without access to traditional banking services like credit unions and small business loans can rise above the poverty line and thrive.

Top Photo Credit: Flickr User Peter Haden