Module One: Introduction to MicroFinance

Microfinance has evolved as an economic development approach intended to benefit

low-income women and men. The term refers to the provision of financial services to
low-income clients, including the self-employed. Financial services generally include
savings and credit; however, some microfinance organizations also provide insurance
and payment services. In addition to financial intermediation, many MFIs provide social
intermediation services such as group formation, development of self- confidence, and
training in financial literacy and manage- ment capabilities among members of a group.
Thus the definition of microfinance often includes both financial intermediation and
social intermediation. Microfinance is not simply banking, it is a development tool.

Microfinance activities usually involve:

 Small loans, typically for working capital

 Informal appraisal of borrowers and investments
 Collateral substitutes, such as group guarantees or compulsory savings
 Access to repeat and larger loans, based on repayment performance
 Streamlined loan disbursement and monitoring
 Secure savings products.

Although some MFIs provide enterprise development services, such as skills training
and marketing, and social services, such as literacy training and health care, these are
not generally included in the definition of microfinance. MFIs can be nongovernmental
organizations (NGOs), savings and loan cooperatives, credit unions,government banks,
commercial banks, or nonbank financial institutions. Microfinance clients are typically
self-employed, low-income entrepreneurs in both urban and rural areas. Clients are
often traders, street vendors, small farmers, service providers (hairdressers, rickshaw
drivers), and artisans and small producers, such as black- smiths and seamstresses.
Usually their activities provide a stable source of income (often from more than one
activity). Although they are poor, they are generally not considered to be the “poorest
of the poor.” Moneylenders, pawnbrokers, and rotating savings and credit associations
are informal microfinance providers and important sources of financial intermediation.

Background

Microfinance arose in the 1980s as a response to doubts and research findings about
state delivery of subsidized credit to poor farmers. In the 1970s govern- ment agencies
were the predominant method of pro- viding productive credit to those with no previous
access to credit facilities—people who had been forced to pay usurious interest rates or
were subject to rent- seeking behavior. Governments and international donors assumed
that the poor required cheap credit and saw this as a way of promoting agricultural pro-
duction by small landholders. In addition to providing subsidized agricultural credit,
donors set up credit unions inspired by the Raiffeisen model developed in Germany in
1864. The focus of these cooperative financial institutions was mostly on savings
mobiliza- tion in rural areas in an attempt to “teach poor farmers how to save.”

Beginning in the mid-1980s, the subsidized, targeted credit model supported by many
donors was the object of steady criticism, because most programs accumulated large
loan losses and required frequent recapitalization to continue operating. It became
more and more evident that market-based solutions were required. This led to a new
approach that considered microfinance as an integral part of the overall financial
system. Emphasis shifted from the rapid disbursement of subsidized loans to target
populations toward the building up of local, sustainable institutions to serve the poor.

At the same time, local NGOs began to look for a more long-term approach than the
unsustainable income- generation approaches to community development. In Asia Dr.
Mohammed Yunus of Bangladesh led the way with a pilot group lending scheme for
landless people. This later became the Grameen Bank, which now serves more than 2.4
million clients (94 percent of them women) and is a model for many countries. In Latin
America ACCION International supported the develop- ment of solidarity group lending
to urban vendors, and Fundación Carvajal developed a successful credit and training
system for individual microentrepreneurs.

Changes were also occurring in the formal financial sector. Bank Rakyat Indonesia, a
state-owned, rural bank, moved away from providing subsidized credit and took an
institutional approach that operated on market principles. In particular, Bank Rakyat
Indonesia developed a transparent set of incentives for its borrowers (small farmers)
and staff, rewarding on-time loan repay- ment and relying on voluntary savings
mobilization as a source of funds.

Since the 1980s the field of microfinance has grown substantially. Donors actively
support and encourage microfinance activities, focusing on MFIs that are committed to
achieving substantial outreach and financial sustainability. Today the focus is on
providing financial services only, whereas the 1970s and much of the 1980s were
characterized by an integrated package of credit and training—which required subsidies.
Most recently, microfinance NGOs (including PRODEM/BancoSol in Bolivia, K-REP in
Kenya, and ADEMI/BancoADEMI in the Dominican Republic) have begun transforming
into formal financial institutions that recognize the need to provide savings services to
their clients and to access market funding sources, rather than rely on donor funds.
This recognition of the need to achieve financial sustainability has led to the current
“financial systems” approach to microfinance. This approach is characterized by the
following beliefs:

 Subsidized credit undermines development.

 Poor people can pay interest rates high enough to cover transaction costs and the
consequences of the imperfect information markets in which lenders operate.
 The goal of sustainability (cost recovery and eventually profit) is the key not only to
institutional permanence in lending, but also to making the lending institution more
focused and efficient.
 Because loan sizes to poor people are small, MFIs must achieve sufficient scale if
they are to become sustainable.
 Measurable enterprise growth, as well as impacts on poverty, cannot be
demonstrated easily or accurately; outreach and repayment rates can be proxies for
impact. One of the main assumptions in the above view is that many poor people
actively want productive credit and that they can absorb and use it. But as the field
of microfinance has evolved, research has increasingly found that in many situations
poor people want secure savings facilities and consumption loans just as much as
productive credit and in some cases instead of productive credit. MFIs are beginning
to respond to these demands by providing voluntary savings services and other
types of loans.

Size of the Microfinance Industry

During 1995 and 1996 the Sustainable Banking with the Poor Project compiled a
worldwide inventory of MFIs. The list included nearly 1,000 institutions that provided
microfinance services, reached at least 1,000 clients, and had operated for a
minimum of three years. From this inventory, more than 200 institutions responded
to a two-page questionnaire covering basic institutional characteristics.
According to the survey results, by September 1995 about US$7 billion in
outstanding loans had been provided to more than 13 million individuals and groups.
In addition, more than US$19 billion had been mobi- lized in 45 million active
deposit accounts.

The general conclusions of the inventory were:

 Commercial and savings banks were responsible for the largest share of the
outstanding loan balance and deposit balance.
 Credit unions represented 11 percent of the total number of loans in the sample
and 13 percent of the outstanding loan balance.
 NGOs made up more than half of the sample, but they accounted for only 9
percent of the total number of outstanding loans and 4 percent of the outstanding
loan balance.
 Sources of funds to finance loan portfolios differed by type of institution. NGOs
relied heavily on donor funding or concessional funds for the majority of their
lending. Banks, savings banks, and credit unions funded their loan portfolios with
client and member deposits and commercial loans.
 NGOs offered the smallest loan sizes and relatively more social services than
banks, savings banks, or credit unions.
 Credit unions and banks are leaders in serving large numbers of clients with
small deposit accounts.
The study also found that basic accounting capacities and reporting varied widely
among institutions, in many cases revealing an inability to report plausible cost and
arrears data. This shortcoming, notably among NGOs, highlights the need to place
greater emphasis on financial monitoring and reporting using standardized practices.
Overall, the findings suggest that favorable macroeconomic conditions, managed
growth, deposit mobilization, and cost control, in combination, are among the key
factors that contribute to the success and sustainability of many microfinance
institutions.

Why is Microfinance Growing?

Microfinance is growing for several reasons:

1. The promise of reaching the poor. Microfinance activities can support income
generation for enterprises operated by low-income households.
2. The promise of financial sustainability. Microfinance activities can help to build
financially self-sufficient, subsidy-free, often locally managed institutions.
3. The potential to build on traditional systems. Microfinance activities sometimes
mimic traditional systems (such as rotating savings and credit associations). They
provide the same services in similar ways, but with greater flexibility, at a more
affordable price to microenterprises and on a more sustainable basis. This can make
microfinance services very attractive to a large number of low-income clients.
4. The contribution of microfinance to strengthening and expanding existing formal
financial systems. Microfinance activities can strengthen existing formal financial
institutions, such as savings and loan cooperatives, credit union networks,
commercial banks, and even state-run financial institutions, by expanding their
markets for both savings and credit—and, potentially, their profitability.
5. The growing number of success stories. There is an increasing number of well-
documented, innovative success stories in settings as diverse as rural Bangladesh,
urban Bolivia, and rural Mali. This is in stark contrast to the records of state-run
specialized financial institutions, which have received large amounts of funding over
the past few decades but have failed in terms of both financial sustainability and
outreach to the poor.
6. The availability of better financial products as a result of experimentation and
innovation. The innovations that have shown the most promise are solving the
problem of lack of collateral by using group-based and character-based approaches;
solving problems of repayment discipline through high frequency of repayment
collection, the use of social and peer pressure, and the promise of higher repeat
loans; solving problems of transaction costs by moving some of these costs down to
the group level and by increasing outreach; designing staff incentives to achieve
greater outreach and high loan repayment; and providing savings services that meet
the needs of small savers.

What Are the Risks of Microfinance?

Sound microfinance activities based on best practices play a decisive role in

providing the poor with access to financial services through sustainable institutions.
However, there have been many more failures than successes:
 Some MFIs target a segment of the population that has no access to business
opportunities because of lack of markets, inputs, and demand. Productive credit is of
no use to such people without other inputs.
 Many MFIs never reach either the minimal scale or the efficiency necessary to
cover costs.
 Many MFIs face nonsupportive policy frameworks and daunting physical, social,
and economic challenges.
 Some MFIs fail to manage their funds adequately enough to meet future cash
needs and, as a result, they confront a liquidity problem.
 Others develop neither the financial management systems nor the skills required
to run a successful operation.
 Replication of successful models has at times proved difficult, due to differences
in social contexts and lack of local adaptation.
Ultimately, most of the dilemmas and problems encountered in microfinance have to
do with how clear the organization is about its principal goals. Does an MFI provide
microfinance to lighten the heavy burdens of poverty? Or to encourage economic
growth? Or to help poor women develop confidence and become empowered with-
in their families? And so on. In a sense, goals are a matter of choice; and in
development, an organization can choose one or many goals—provided its
constituents, governance structure, and funding are all in line with those goals.