DP: Microfinance: An introduction

Over the last few decades, Microfinance, or Microcredit, has become a popular mechanism for economic development and poverty reduction.

The term microcredit can be defined as “programmes that extend small loans to very poor people for self-employment projects that generate income, allowing them to care for themselves and their families” (From the Microcredit Summit, 2-4 February 1997).

This “contemporary” idea of microfinance is widely believed to have been created by Mohammad Yunus, who began lending to poor women in Jobra, Bangladesh in the 1970s.  He later founded his own Microfinance institution (MFI) known as the Grameen Bank. In 2006, Yunus, along with the Grameen Bank, won the Nobel Peace Prize for “their efforts to create economic and social development from below”.

However, microfiance is not a new concept; it has played a large role in civil society for centuries and has taken several different forms, outside of the modern, formal banking sector.

In Latin America, for example, the use of Tandas among poor populations is the most popular form of saving and financing. Tandas are formed among a small group of people who agree to give a specific amount of money to the Tanda every week.  The collected money each week is then given to one of the Tanda members on a rotating basis.  Each member will receive the total amount of the Tanda one week during the arrangement.  This system has proven to be a popular model for those communities in which “modern” financial services through the banking sector are not available.  A good list of the different types of microfinancing can be found on the Grameen Bank Website.

Why are more “institutional” forms of microfinance unavailable to certain populations?

Microfinance programs are typically considered risky and financially not sustainable to most institutions.  Many people interested in microcredit typically are poor families with little capital, and little or no credit history.  Additionally, as microloans typically range from as little as a few dollars to a few hundred dollars, it is typically hard to profit on these programs.  Therefore, most financial institutions do not offer these services.  They choose to focus on the larger clients, with strong credit history, significant collateral, and who are willing to take out loans of significantly higher principals.

This exclusion of the worlds poor from larger financial institutions creates a void in business and financial development in which microcredit institutions, or small communal practices, can fill.

These institutions, however, do not come without their own weaknesses and costs.  Due to the low value of these loans, and the innate uncertainty of the borrowers, interest rates from microfinance institutions (MFIs) tend to be high:

Administrative Costs

The cost of lending $10,000 to one borrower is not the same as lending $100 to 100 borrowers.  Additionally, MFIs face certain difficulties in screening clients and collecting payments. Many clients of MFIs may not have a credit history on record, may not have collateral, and may be illiterate.  MFIs require a significant amount of staff and infrastructure in order to provide their services to their customers.

These costs are passed on to the customer:

MFIs calculate interest rates similarly to larger financial institutions. They take into account the cost of the money lent and the cost of default by borrowers. These costs are proportional to the amount of money lent and are priced as a percentage.

For example, if a bank determines that these costs total an interest rate of 10%, a borrower asking for a 1 year loan of $100 will pay $10 in interest to the bank.  A different borrower asking for a 1 year loan for $300 will pay $30 in interest to the bank.

However, there is one additional cost to the bank calculated into the “price” of the loan.  The transaction fee added to the loan covers the administrative costs involved in preparing the loan. It is typically a fixed rate for all loans made by the bank, as the amount of time spent on preparing the $100 loan is roughly the same as the time required to prepare the $300 loan.

So, to go back to our example, if the bank charges a transaction fee of $25 to its clients, the $100 borrower will be paying a total of $35 to take out the loan, which equates to 35% of the loan’s value.  However, the $300 borrower will be paying a total of $55 in order to take out the loan, which only equates to 18% of the loan’s value.

The world’s poorest pay higher rates, proportionally, to borrow money.

In 2010, the estimated world average for interest rates was around 37% (nytimes).

 

So why provide microcredit?  What are the benefits?

In some cases, these high interest rates provided by MFIs are still cheaper than the costs incurred using less formal methods of borrowing.  According to CGAP, an independent policy and research center on financial access for the worlds poor, the rates given by MFIs are often “far below what poor people routinely pay to village money-lenders and other informal sources, whose percentage interest rates routinely rise into the hundreds and even the thousands”.

In a paper prepared by UNESCO for the 1997 Microcredit Summit , they state:

Over eight million very poor people, especially women, are benefiting today from different microfinance programmes. Experiences of these programmes show that provision of microcredit and savings facilities, when efficiently utilized, enables the poor to build strong microenterprises, increase their income, and participate in economic growth. It also contributes greatly to the empowerment of the poor, especially women, and helps to raise awareness and aspirations for education, health care and other social services. In light of these achievements, microfinance is increasingly being considered as an important tool for poverty reduction.

The film Microfinance: In Their Own Voices gives real world examples of people who have been positively affected by microcredit loans.  It “presents real, personal stories of microfinance clients from different parts of the world, including Kenya, India and the Philippines.”  The video, and more information, can be found on the International Year of Microcredit 2005’s website.

 

So how do Microcredit institutions function?

Microcredit institutions handle their programs differently:

At Grameen Bank, the loans are given to a group of borrowers, who guarantee each other’s loans. In this video, Mohammad Yunus explains how the Grameen Bank began.

Another organization, called Kiva, is an internet platform in which lenders from all over the world can help MFIs lend money to borrowers in another part of the world.  In this video, Kiva explains microfinance and their model in a creative and simple cartoon.  In this TED Talk, Kiva founder Jessica Jackley explains why she created Kiva.

Some organizations, like Zidisha, do direct peer-to-peer financing in which lenders lend money directly to borrowers through the internet platform.  On the website, lenders and borrowers agree on their own interest rates, and terms of payment.

Other microfinance NGOs and MFIs working in Microfinance include MYC4Janta (specialized in student microcredit), Accion, BRAC, FINCA, Women’s World Banking, and Opportunity International. There hundreds of additional organizations currently working in microfinance sector.

 

What about other financial services?

Recently, the idea of microfiance has widened to include other products such as microsavings and microinsurance. These services are now being offered, in addition to microcredit, by many microfinance institutions.

The video below shows how the bank Bancomer in Mexico is working with IDEO to find sustainable microsavings programs for people with little income. It does a great job at really explaining the trial and tribulations of microfinance.


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