Microfinance Definition and Full Description
Microfinance, also called microcredit, is a type of banking service offered to unemployed or low-income individuals or groups who otherwise would not otherwise have access to financial services.
While institutions involved in microfinance often offer lending—micro loans can range from $100 to $25,000—many banks offer additional services such as checking and savings accounts in addition to microinsurance products, and some even offer financial and business education. The goal of microfinance is ultimately to give the poor a chance to become self-sufficient.
Microfinance services are offered to the unemployed or low-income individuals because most of those who have fallen into poverty, or who have limited financial resources, do not have enough income to do business with traditional financial institutions.
Although excluded from banking, those who live on less than $2 a day try to save, borrow, get credit or insurance, and are already making their debt payments. Thus, many poor people usually look to family, friends, and even sharks (who often charge exorbitant interest rates) for help.
Microfinance allows individuals to obtain affordable small business loans safely and in a manner consistent with ethical lending practices. Although it is found worldwide, the majority of microfinance operations occur in developing countries, such as Uganda, Indonesia, Serbia and Honduras. Many MFIs focus on helping women in particular.
MFIs support a wide range of activities ranging from providing the basics – such as bank checking and savings accounts – to start-up capital for small entrepreneurs and educational programs that teach the principles of investing. These programs can focus on skills such as bookkeeping and cash flow management, and technical or professional skills, such as accounting.
History
Microfinance is not a new concept. Small operations have existed since the eighteenth century. The first appearance of microlending is attributed to the Irish loan fund system, introduced by Jonathan Swift, which sought to improve the conditions of poor Irish citizens. Microfinance in its modern form became widely popular in the 1970s.
The first organization that received attention was the Grameen Bank, which was started in 1976 by Muhammad Yunus in Bangladesh. In addition to providing loans to its clients, Grameen Bank also suggests that its clients subscribe to “16 Resolutions”, a basic list of ways the poor can improve their lives.
The “16 resolutions” touch on a variety of topics ranging from a request to stop the practice of issuing dowries at marriage to keeping drinking water healthy. In 2006, the Nobel Peace Prize was awarded to Yunus and Grameen Bank for their efforts in developing the microfinance system.
The SKS Microfinance program in India also serves a large number of poor clients. Founded in 1998, it has grown into one of the largest microfinance operations in the world. SKS operates in a similar way to Grameen Bank, bringing all borrowers into groups of five working together to ensure that their loans are repaid.
There are other microfinance operations around the world. Some of the larger organizations work closely with the World Bank, while other smaller groups work in different countries. Some institutions enable lenders to choose exactly who they want to support, classifying borrowers according to criteria such as poverty level, geographic area, and type of small business.
Others are specifically targeted. There are organizations in Uganda, for example, that focus on providing women with capital to undertake projects such as growing eggplant and opening small cafes.
Some groups focus their efforts only on companies that aim to improve society as a whole through initiatives such as providing education and job training and working towards a better environment.
Microfinance Loan Terms
Like traditional lenders, microfinance must charge interest on loans, and set up specific repayment plans with payments due at regular intervals. Some lenders require loan recipients to put a portion of their income into a savings account, which can be used as insurance if the customer defaults. If the borrower successfully repaid the loan, this means that he has just received additional savings.
Because many applicants cannot provide collateral, microcredit institutions often pool borrowers together as a buffer. After receiving the loans, the beneficiaries pay their debts together. Since the success of the program depends on the contributions of everyone, this creates a form of peer pressure that can help ensure reimbursement.
For example, if an individual is having trouble using their money to start a business, that person can seek help from other group members or from a loan officer. By repaying, loan recipients begin to develop a good credit history, which allows them to take out larger loans in the future.
Interestingly, although these borrowers are often considered very poor, repayment amounts on microloans are often actually higher than the average repayment rate on more traditional forms of financing. For example, the microfinance institution Opportunity International reported repayment rates of close to 99% in 2019.
Benefits of Microfinance
The World Bank estimates that more than 500 million people have benefited directly or indirectly from microfinance-related operations. The International Finance Corporation (IFC), part of the larger World Bank Group, estimates that as of 2014, more than 130 million people have directly benefited from microfinance-related operations. However, these operations are only available to approximately 20% of the three billion people who qualify to be among the world’s poor.
In addition to providing microfinance options, IFC has helped establish or improve credit reporting offices in 30 developing countries. He also called for the addition of relevant laws in 33 countries governing financial activities.
The benefits of microfinance extend beyond the immediate effects of giving people a source of capital. Entrepreneurs who create successful businesses, in turn, create jobs, trade, and generally improve the economy within the community.
The For-Profit Controversy
Although there have been countless intimate success stories ranging from small entrepreneurs starting their own water supply business in Tanzania, to a $1,500 loan that allowed a family to open a grill in China, to immigrants in the United States who were able to build their business Private business, microfinance has sometimes been subjected to criticism.
While interest rates on microfinance are generally lower than those of traditional banks, critics have accused these operations of making money from the poor. Especially since the trend is in for-profit microfinance institutions, such as BancoSol in Bolivia and SKS mentioned above (which actually started as a non-profit organization (NPO) but became a for-profit in 2003).
Mexico’s Compartamos Banco is one of the largest and most controversial. The bank started in 1990 as a non-profit organization. However, after 10 years, the management decided to transform the enterprise into a traditional for-profit company. In 2007, it went public on the Mexican stock exchange, and its initial public offering (IPO) raised more than $400 million.
Concerns about for-profit microfinance
In addition to Compartamos Banco, several major financial institutions and other large corporations have launched for-profit microfinance divisions, including CitiGroup, Barclays and General Electric, for example. Other companies have set up mutual funds that invest primarily in microfinance companies.
Compartamos Banco and its for-profit peers have been criticized by many, including the grandfather of modern microfinance himself, Muhammad Yunus. The immediate realistic fear is that, out of a desire to make money, the top microfinance bankers will charge higher interest rates, potentially setting up a debt trap for low-income borrowers.
But Yunus and others also have a fundamental concern: that the incentive for microcredit should be poverty alleviation, not profit. By their very nature – and their commitment to shareholders – these publicly traded companies work against the original mission of microfinance, helping the poor above all.
In response, Compartamos and other for-profit microfinance institutions are facing that commercial marketing allows them to operate more efficiently, attracting more capital by attracting profit-seeking investors. By turning into a profitable business, their argument goes, the microfinance bank is able to expand its reach, providing more money and more loans to low-income applicants. For now, though, philanthropic and business microfinance financiers coexist.
Not-for-Profit Microfinance vs. For-Profit Microfinance
In addition to the gap between non-profit and for-profit MFIs, there are other criticisms. Some say that individual $100 microloans aren’t enough to provide independence—in fact, they keep recipients in subsistence-level occupations, or just cover basic needs, such as food and shelter.
These critics argue that the best approach is to create jobs by building new factories and producing new goods. They cite examples from China and India, where the development of large industries has stabilized employment and increased wages, which in turn has helped millions out of the lowest levels of poverty.
Other critics said that having the interest payments, however low, remains a burden. Despite healthy repayment rates, there are still borrowers who cannot or cannot repay loans, due to the failure of their projects, personal disaster or other reasons. Therefore, this additional debt can make the recipients of the microcredit even poorer than they were when they started.
What are the general terms of a microfinance loan?
Like traditional lenders, microfinance must charge interest on loans, and set up specific repayment plans with payments due at regular intervals. Some lenders require loan recipients to put a portion of their income into a savings account, which can be used as insurance if the customer defaults. If the borrower successfully repaid the loan, this means that he has just received additional savings. Because many applicants cannot provide collateral, microcredit institutions often pool borrowers together as a buffer. After receiving the loans, the beneficiaries pay their debts together.
What are the benefits of microfinance?
The World Bank estimates that more than 500 million people have benefited directly or indirectly from microfinance-related operations. The International Finance Corporation (IFC), part of the larger World Bank Group, estimates that as of 2014, more than 130 million people have directly benefited from microfinance-related operations. In addition, IFC has helped establish or improve credit reporting bureaus in 30 developing countries. He also called for the addition of relevant laws in 33 countries governing financial activities. The benefits of microfinance extend beyond the immediate effects of giving people a source of capital. Entrepreneurs who create successful businesses, in turn, create jobs, trade, and generally improve the economy within the community.
What are some criticisms of microfinance?
While interest rates on microfinance are generally lower than those of traditional banks, critics have accused these operations of making money from the poor. Also, many major financial institutions and other large corporations have launched for-profit microfinance divisions raising concerns that these big bankers, motivated by a desire to make money, will charge higher interest rates that may create a debt trap for low-income borrowers. Additionally, some have argued that individual microloans are not sufficient to provide a realistic path to independence. Finally, critics said that having interest payments, however low, remains a burden.