CHAPTER-3

LITERATURE REVIEW

Based on work by Eoin Wrenn for Trócaire, 2005

WhatIsMicrofinance

Microfinance, according to Otero (1999, p.8) is “the provision of financial services to low-income poor and
very poor self-employed people”. These financial services according to Ledgerwood (1999) generally include
savings and credit but can also include other financial services such as insurance and payment services. Schreiner
and Colombet (2001, p.339) define microfinance as “the attempt to improve access to small deposits and
small loans for poor households neglected by banks.” Therefore, microfinance involves the provision of financial
services such as savings, loans and insurance to poor people living in both urban and rural settings who are
unable to obtain such services from the formal financial sector.

1. Microfinance and microcredit.

In the literature, the terms microcredit and microfinance are often used interchangeably, but it is important
to highlight the difference between them because both terms are often confused. Sinha (1998, p.2) states
“microcredit refers to small loans, whereas microfinance is appropriate where NGOs
and MFIs1 supplement the loans with other financial services (savings, insurance, etc)”. Therefore
microcredit is a component of microfinance in that it involves providing credit to the poor, but microfinance also
involves additional non-credit financial services such as savings, insurance, pensions and payment services
(Okiocredit, 2005).

2. The History of Microfinance

Microcredit and microfinance are relatively new terms in the field of development, first coming to
prominence in the 1970s, according to Robinson (2001) and Otero (1999). Prior to then, from the 1950s
through to the 1970s, the provision of financial services by donors or governments was mainly in the form of
subsidised rural credit programmes. These often resulted in high loan defaults, high loses and an inability to
reach poor rural households (Robinson, 2001).

Robinson states that the 1980s represented a turning point in the history of microfinance in that MFIs such as
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Grameen Bank and BRI began to show that they could provide small loans and savings services profitably
on a large scale. They received no continuing subsidies, were commercially funded and fully sustainable, and
could attain wide outreach to clients (Robinson, 2001). It was also at this time that the term “microcredit” came to
prominence in development (MIX3, 2005). The difference between
microcredit and the subsidised rural credit programmes of the 1950s and 1960s was that microcredit insisted
on repayment, on charging interest rates that covered the cost of credit delivery and by focusing on clients
who were dependent on the informal sector for credit (ibid.). It was now clear for the first time that microcredit
could provide large-scale outreach profitably.
The 1990s “saw accelerated growth in the number of microfinance institutions created and an increased emphasis
on reaching scale” (Robinson, 2001, p.54). Dichter (1999, p.12) refers to the 1990s as “the microfinance
decade”. Microfinance had now turned into an industry according to Robinson (2001). Along with the growth
in microcredit institutions, attention changed from just the provision of credit to the poor (microcredit), to the
provision of other financial services such as savings and pensions (microfinance) when it became clear that
the poor had a demand for these other services (MIX, 2005).

The importance of microfinance in the field of development was reinforced with the launch of the
Microcredit Summit in 1997. The Summit aims to reach 175 million of the world’s poorest families,
especially the women of those families, with credit for the self-employed and other financial and business
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services, by the end of 2015 (Microcredit Summit, 2005). More recently, the UN, as previously stated, declared
2005 as the International Year of Microcredit.

3. Providers and models of microfinance interventions

MIX defines an MFI as “an organisation that offers financial services to the very poor.” (MIX, 2005).
According to the UNCDF (2004) there are approximately 10,000 MFIs in the world but they only reach four
percent of potential clients, about 30 million people. On the other hand, according to the
st
Microcredit Summit Campaign Report (Microcredit Summit, 2004) as of December 31 2003, the 2,931
microcredit institutions that they have data on, have reported reaching “80,868,343 clients, 54,785,433 of whom
were the poorest when they took their first loan”. Even though they refer to microcredit institutions, they
explain that they include “programs that provide credit for self-employment and other financial and business
services to very poor persons” (Microcredit Summit, 2004).

The differences between these sources highlight a number of points. Firstly, how the two terms,
microcredit and microfinance are often confused and used interchangeably, though in the strictest sense
microcredit should refer only to the provision of credit to the poor. Secondly, the difference between the
statistics shows how difficult it is to get a true picture of how many MFIs are in existence
today and how many clients they are reaching. The IMF5 state that “no systematic and comprehensive
data on MFIs is collected and there are no authoritative figures on key characteristics of the microfinance
industry, such as the number and size of MFIs, their financial situation, or the population served” (2005, p.6).

Despite the lack of data on the sector, it is clear that a wide variety of implementation methods are employed
by different MFIs. The Grameen Bank (2000a) has identified fourteen different microfinance
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models of which I will focus on three; Rotating Savings and Credit Association (ROSCAs), the
Grameen Bank and the Village Banking models, as these are the three microfinance models that I
encountered during my field research.

◆ Rotating Savings and Credit Associations

These are formed when a group of people come together to make regular cyclical contributions to a common
fund, which is then given as a lump sum to one member of the group in each cycle (Grameen Bank, 2000a).
According to Harper (2002), this model is a very common form of savings and credit. He states that the members
of the group are usually neighbours and friends, and the group provides an opportunity for social interaction
and are very popular with women. They are also called merry-go- rounds or Self-Help Groups (Fisher and
Sriram, 2002).

◆ The Grameen Solidarity Group model

This model is based on group peer pressure whereby loans are made to individuals in groups of four to seven
(Berenbach and Guzman, 1994). Group members collectively guarantee loan repayment, and access to
subsequent loans is dependent on successful repayment by all group members. Payments are usually made
weekly (Ledgerwood, 1999). According to Berenbach and Guzman (1994), solidarity groups have proved
effective in deterring defaults as evidenced by loan repayment rates attained by
organisations such as the Grameen Bank, who use this type of microfinance model7. They also

highlight the fact that this model has contributed to broader social benefits because of the mutual trust
arrangement at the heart of the group guarantee system. The group itself often becomes the building block to a
broader social network (1994, p.121).

◆ Village Banking Model

Village banks are community-managed credit and savings associations established by NGOs to provide access to
financial services, build community self-help groups, and help members accumulate savings (Holt, 1994). They
have been in existence since the mid-1980s. They usually have 25 to 50 members who are low-income
individuals seeking to improve their lives through self-employment activities. These members run the bank, elect
their own officers, establish their own by-laws, distribute loans to individuals and collect payments and
services (Grameen Bank, 2000a). The loans are backed by moral collateral; the promise that the group stands
behind each loan (Global Development Research Centre, 2005).

The sponsoring MFI lends loan capital to the village bank, who in turn lend to the members. All
members sign a loan agreement with the village bank to offer a collective guarantee. Members are usually
requested to save twenty percent of the loan amount per cycle (Ledgerwood, 1999). Members’ savings are tied to
loan amounts and are used to finance new loans or collective income generating activities and so they stay
within the village bank. No interest is paid on savings but members receive a share of profits from the village
bank’s re-lending activities.Many village banks target women predominantly, as according to Holt (1994,
p.158) “the model anticipates that female participation in village banks will enhance social status and
intrahousehold bargaining power”.

4. Microfinance and its impact in development

Microfinance has a very important role to play in development according to proponents of microfinance. UNCDF
(2004) states that studies have shown that microfinance plays three key roles in development. It:
◆ helps very poor households meet basic needs and protects against risks,
◆ is associated with improvements in household economic welfare,
◆ helps to empower women by supporting women’s economic participation and so promotes gender equity.

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Otero (1999, p.10) illustrates the various ways in which “microfinance, at its core combats poverty ”. She
states that microfinance creates access to productive capital for the poor, which together with human capital,
addressed through education and training, and social capital, achieved through local organisation building,
enables people to move out of poverty (1999). By providing material capital to a poor person, their sense of
dignity is strengthened and this can help to empower the person to participate in the economy and society
(Otero, 1999).

The aim of microfinance according to Otero (1999) is not just about providing capital to the poor to combat
poverty on an individual level, it also has a role at an institutional level. It seeks to create institutions that
deliver financial services to the poor, who are continuously ignored by the formal banking sector.
Littlefield and Rosenberg (2004) state that the poor are generally excluded from the financial services sector
of the economy so MFIs have emerged to address this market failure. By addressing this gap in the market in
a financially sustainable manner, an MFI can become part of the formal financial system of a country and so can
access capital markets to fund their lending portfolios, allowing them to dramatically increase the number of poor
people they can reach (Otero, 1999).

More recently, commentators such as Littlefield, Murduch and Hashemi (2003), Simanowitz and Brody (2004)
and the IMF (2005) have commented on the critical role of microfinance in achieving the Millennium
Development Goals9. Simanowitz and Brody (2004, p.1) state, “Microfinance is a key

strategy in reaching the MDGs and in building global financial systems that meet the needs of the most poor
people.” Littlefield, Murduch and Hashemi (2003) state “microfinance is a critical contextual factor with strong
impact on the achievements of the MDGs…microfinance is unique among development interventions: it can
deliver social benefits on an ongoing, permanent basis and on a large scale”. Referring to various case
studies, they show how microfinance has played a role in eradicating poverty, promoting education, improving
health and empowering women (2003).
However, not all commentators are as enthusiastic about the role of microfinance in development and it is
important to realise that microfinance is not a silver bullet when it comes to fighting poverty. Hulme and
Mosley (1996), while acknowledging the role microfinance can have in helping to reduce poverty, concluded
from their research on microfinance that “most contemporary schemes are less effective than they might be”
(1996, p.134). They state that microfinance is not a panacea for poverty-alleviation and that in some cases the
poorest people have been made worse-off by microfinance. Rogaly (1996, p.109/110) finds five major faults with
MFIs. He argues that:
◆ they encourage a single-sector approach to the allocation of resources to fight poverty,
◆ microcredit is irrelevant to the poorest people,
◆ an over-simplistic notion of poverty is used,
◆ there is an over-emphasis on scale,
◆ there is inadequate learning and change taking place.

Wright (2000,p.6) states that much of the scepticism of MFIs stems from the argument that microfinance
projects “fail to reach the poorest, generally have a limited effect on income…drive women into greater
dependence on their husbands and fail to provide additional services desperately needed by the poor”. In
addition, Wright says that many development practitioners not only find microfinance inadequate, but that it
actually diverts funding from “more pressing or important interventions” such as health and education (2000,
p.6). As argued by Navajas et al (2000), there is a danger that microfinance may siphon funds from other
projects that might help the poor more. They state that governments and donors should know whether the
poor gain more from microfinance, than from more health care or food aid for example. Therefore, there is a
need for all involved in microfinance and development to ascertain what exactly has been the impact of
microfinance in combating poverty.
Considerable debate remains about the effectiveness of microfinance as a tool for directly reducing poverty,
and about the characteristics of the people it benefits (Chowdhury, Mosley and Simanowitz, 2004). Sinha
(1998) argues that it is notoriously difficult to measure the impact of microfinance programmes on
poverty. This is so she argues, because money is fungible and therefore it is difficult to isolate credit impact, but
also because the definition of ‘poverty’, how it is measured and who constitute the ‘poor’ “are fiercely contested
issues” (1998, p.3).

Poverty is a complex issue and is difficult to define, as there are various dimensions to poverty. For some,
such as World Bank, poverty relates to income, and poverty measures are based on the percentage of
people living below a fixed amount of money, such as US$1 dollar a day (World Bank, 2003).

5. The impact of microfinance on poverty

There is a certain amount of debate about whether impact assessment of microfinance projects is necessary
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or not according to Simanowitz (2001b). The argument is that if the market can provide adequate proxies
for impact, showing that clients are happy to pay for a service, assessments are a
waste of resources (ibid.). However, this is too simplistic a rationale as market proxies mask the range of client
responses and benefits to the MFI (ibid.) Therefore, impact assessment of microfinance interventions is
necessary, not just to demonstrate to donors that their interventions are having a positive impact, but to
allow for learning within MFIs so that they can improve their services and the impact of their projects
(Simanowitz, 2001b, p.11).

significant difference between increasing income and reducing poverty (1999). He argues that by increasing
the income of the poor, MFIs are not necessarily reducing poverty. It depends what the poor do with this money,
oftentimes it is gambled away or spent on alcohol (1999), so focusing solely on increasing incomes is not
enough. The focus needs to be on helping the poor to “sustain a specified level of well-being” (Wright, 1999,
p.40) by offering them a variety of financial services tailored to their needs so that their net wealth and income
security can be improved.

It is commonly asserted that MFIs are not reaching the poorest in society. However, despite some
commentators’ scepticism of the impact of microfinance on poverty, studies have shown that microfinance has
been successful in many situations. According to Littlefield, Murduch and Hashemi (2003, p.2) “various
studies…document increases in income and assets, and decreases in vulnerability of microfinance clients”. They
refer to projects in India, Indonesia, Zimbabwe, Bangladesh and Uganda which all show very positive impacts of
microfinance in reducing poverty. For instance, a report on a SHARE project in India showed that three-
quarters of clients saw “significant improvements in their economic well-being and that half of the clients
graduated out of poverty” (2003, p.2).
Dichter (1999, p.26) states that microfinance is a tool for poverty reduction and while arguing that the record of
MFIs in microfinance is “generally well below expectation” he does concede that some positive impacts
do take place. From a study of a number of MFIs he states that findings show that consumption smoothing
effects, signs of redistribution of wealth and influence within the household are the most common impact of MFI
programmes (ibid.).
Hulme and Mosley (1996, p.109) in a comprehensive study on the use of microfinance to combat poverty,
argue that well-designed programmes can improve the incomes of the poor and can move them out of
poverty. They state that “there is clear evidence that the impact of a loan on a borrower’s income is related to
the level of income” as those with higher incomes have a greater range of investment opportunities and so
credit schemes are more likely to benefit the “middle and upper poor” (1996, pp109-112). However, they also
show that when MFIs such as the Grameen Bank and BRAC provided credit to very poor households, those
households were able to raise their incomes and their assets (1996, p.118).

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Mayoux (2001, p.52) states that while microfinance has much potential the main effects on poverty have
been:
◆ credit making a significant contribution to increasing incomes of the better-off poor, including women,
◆ microfinance services contributing to the smoothing out of peaks and troughs in income and
expenditure thereby enabling the poor to cope with unpredictable shocks and emergencies.

Hulme and Mosley (1996) show that when loans are associated with an increase in assets, when borrowers
are encouraged to invest in low-risk income generating activities and when the very poor are encouraged to save;
the vulnerability of the very poor is reduced and their poverty situation improves. Johnson and Rogaly (1997,
p.12) also refer to examples whereby savings and credit schemes were able to meet the needs of the very poor.
They state that microfinance specialists are beginning to view improvements in economic security, rather than
income promotion, as the first step in poverty reduction (ibid.) as this reduces beneficiaries’ overall vulnerability.

Therefore, while much debate remains about the impact of microfinance projects on poverty, we have seen that
when MFIs understand the needs of the poor and try to meet these needs, projects can have a positive impact on
reducing the vulnerability, not just of the poor, but also of the poorest in society.