Microfinance is the provision of financial services to low-income clients, including consumers and the self-employed, who traditionally lack access to banking and related services.
More broadly, it is a movement whose object is “a world in which as many poor and near-poor households as possible have permanent access to an appropriate range of high quality financial services, including not just credit but also savings, insurance, and fund transfers.” Those who promote microfinance generally believe that such access will help poor people out of poverty.
The challenge
Traditionally, banks have not provided financial services to clients with little or no cash income. Banks must incur substantial costs to manage a client account, regardless of how small the sums of money involved. For example, the total revenue from delivering one hundred loans worth $1,000 each will not differ greatly from the revenue that results from delivering one loan of $100,000. But the fixed cost of processing loans—of any size—is considerable: assessment of potential borrowers, their repayment prospects and security; administration of outstanding loans, collecting from delinquent borrowers and so on. There is a break-even point in providing loans or deposits below which banks lose money on each transaction they make. Poor people usually fall below it.
In addition, most poor people have few assets that can be secured by a bank as collateral. As documented extensively by Hernando de Soto and others, even if they happen to own land in the developing world, they may not have effective title to it. This means that the bank will have little recourse against defaulting borrowers.
Seen from a broader perspective, it has long been accepted that the development of a healthy national financial system is an important goal and catalyst for the broader goal of national economic development (see for example Alexander Gerschenkron, Paul Rosenstein-Rodan, Joseph Schumpeter, Anne Krueger etc.). However, the efforts of national planners and experts to develop financial services for their nations' majorities have often failed since World War II, for reasons summarized well by Adams, Graham & Von Pischke in their classic analysis 'Undermining Rural Development with Cheap Credit'.
Because of these difficulties, when poor people borrow they often rely on relatives or a local moneylender, whose interest rates can be very high. An analysis of 28 studies of informal moneylending rates in fourteen countries in Asia, Latin America and Africa concluded that 76% of moneylender rates exceed 10% per month, including 22% that exceed 100% per month. Moneylenders usually charge higher rates to poorer borrowers than to less poor ones. While moneylenders are often demonized and accused of usury, their services are convenient and fast, and they can be very flexible when borrowers run into problems. Hopes of quickly putting them out of business have proven unrealistic, even in places where microfinance institutions are very active.
Over the past centuries practical visionaries from the Franciscan monks who founded the community-oriented pawnshops of the fifteenth century, to the founders of the European credit union movement in the nineteenth century (such as Friedrich Wilhelm Raiffeisen) and the founders of the microcredit movement in the 1970s (such as Muhammad Yunus) have tested practices and built institutions designed to bring the kinds of livelihood opportunities and risk management tools that financial services provide to the doorsteps of poor people. While the success of Grameen Bank (which now serves over seven million poor Bangladeshi women) has inspired the world, it has proved difficult to replicate this success in practice. In nations with lower population densities, meeting the operating costs of a retail branch by serving nearby customers has proven considerably more challenging.
Although much progress has been made, the problem has not been solved yet, and the overwhelming majority of people who earn less than $1 a day, especially in the rural areas, continue to have no practical access to formal sector finance. Microfinance has been growing rapidly with $25B currently at work in microfinance loans. It is estimated that the industry needs $250 billion to get capital to all the poor people who need it. The industry has been growing rapidly and there have been concerns that the rate of capital flowing into microfinance is a potential risk unless managed well.
Boundaries and principles
Theoretically, microfinance may encompass any efforts to increase access to, or improve the quality of, financial services poor people currently use or could benefit from using. For example, poor people borrow from informal moneylenders and save with informal collectors. They receive loans and grants from charities. They buy insurance from state-owned companies. They receive funds transfers through remittance networks (like Hawala).
There are not many bright lines that can sharply distinguish microfinance from similar activities. Claims could be made that a government that orders state banks to open deposit accounts for poor consumers, or a moneylender that engages in usury, or a charity that runs a heifer pool are engaged in microfinance. Furthermore, correcting the problem of access is best done by expanding the number of financial institutions available to them, as well as the capacity of those institutions. In recent years there has been increasing emphasis on expanding the diversity of those institutions as well, since different institutions serve different needs.
Some principles that summarize a century and a half of development practice were encapsulated in 2004 by Consultative Group to Assist the Poor (CGAP) and endorsed by the Group of Eight leaders at the G8 Summit on June 10, 2004:
- Poor people need not just loans but also savings, insurance and money transfer services.
- Microfinance must be useful to poor households: helping them raise income, build up assets and/or cushion themselves against external shocks.
- “Microfinance can pay for itself.” Subsidies from donors and government are scarce and uncertain, and so to reach large numbers of poor people, microfinance must pay for itself.
- Microfinance means building permanent local institutions.
- Microfinance also means integrating the financial needs of poor people into a country’s mainstream financial system.
- “The job of government is to enable financial services, not to provide them.”
- “Donor funds should complement private capital, not compete with it.”
- “The key bottleneck is the shortage of strong institutions and managers.” Donors should focus on capacity building.
- Interest rate ceilings hurt poor people by preventing microfinance institutions from covering their costs, which chokes off the supply of credit.
- Microfinance institutions should measure and disclose their performance – both financially and socially.
Microfinance can also be distinguished from charity. It is better to provide grants to families who are destitute, or so poor they are unlikely to be able to generate the cash flow required to repay a loan. This situation can occur for example, in a war zone or after a natural disaster.
Debates at the boundaries
There are several key debates at the boundaries of microfinance.
Practitioners and donors from the charitable side of microfinance frequently argue for restricting microcredit to loans for productive purposes–such as to start or expand a microenterprise. Those from the private-sector side respond that because money is fungible, such a restriction is impossible to enforce, and that in any case it should not be up to rich people to determine how poor people use their money.
Perhaps influenced by traditional Western views about usury, the role of the traditional moneylender has been subject to much criticism, especially in the early stages of modern microfinance. As more poor people gained access to loans from microcredit institutions however, it became apparent that the services of moneylenders continued to be valued. Borrowers were prepared to pay very high interest rates for services like quick loan disbursement, confidentiality and flexible repayment schedules. They did not always see lower interest rates as adequate compensation for the costs of attending meetings, attending training courses to qualify for disbursements or making monthly collateral contributions. They also found it distasteful to be forced to pretend they were borrowing to start a business, when they were often borrowing for other reasons (such as paying for school fees, dealing with health costs or securing the family food supply). The more recent focus on inclusive financial systems (see section below) affords moneylenders more legitimacy, arguing in favour of regulation and efforts to increase competition between them to expand the options available to poor people.
Modern microfinance emerged in the 1970s with a strong orientation towards private-sector solutions. This resulted from evidence that state-owned agricultural development banks in developing countries had been a monumental failure, actually undermining the development goals they were intended to serve (see the compilation edited by Adams, Graham & Von Pischke). Nevertheless public officials in many countries hold a different view, and continue to intervene in microfinance markets.
There has been
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