Microfinance

Description of Microfinance. Explanation.

Definition Microfinance. Description.

Microfinance is the supply of small loans and other financial services to people with a low income who would otherwise have no access to credit from traditional banks and financial institutions. Microfinance is seen by some as a viable solution to reduce poverty, enabling those at the Bottom of the Pyramid to reshape their destiny.

Microfinance basically consists of offering small loans to poor working people of developing countries, who carrying out their daily business activities, are able to repay their debts at the end of a fixed period, usually a day or a week. The value of the loans generally ranges from 1$ to a maximum of 200$. The money is lent from local organizations, so called Microfinance Institutions (MFI), when certain conditions are met.

The concept of microfinance when applied to insurance services take the name of Microinsurance.

Why Microfinance

Traditionally banks were unable to serve the base of the pyramid, because the fixed costs (assessment of potential borrowers, their repayment prospects and security; administration of outstanding loans, collecting from delinquent borrowers, etc) were too high in the case of small loans. Also poor people typically have few assets to serve as collateral.

On the other hand it was clear that the poor people represented a huge potential market in need for financial services that wasn’t served at all.

What are the Needs of Poor People?

Microfinance experts thus studied patterns and specific needs of a typical base of the pyramid customer. Stuart Rutherford in his recent book "The Poor and Their Money", cited 4 types of needs of the poor (compare: Maslow’s Hierarchy of Needs, Packhard’s Hidden Needs, and McClelland's Theory of Needs):

Lifecycle Needs: childbirth, weddings, children education or professional training, funerals, the building of a new house, age of maturity.
Personal Emergencies: sickness, injury, unemployment, thefts, harassments or death.
Disasters: fires, floods, cyclones and other natural disasters or a war.
Investment Opportunities: business growth or stability, land or equipments purchases, house improvement, securing a job, etc.

Origin of Microfinance. History

The history of microfinance goes back to 1974 when Professor of Economics at University of Chittagong, Dr. Muhammad Yunus, with the intent of finding a practical solution to poverty, experienced the first microfinance attempt himself. During a visit to a rural village in Bangladesh, he lent 27$ to a community of 42 people who were otherwise unable to make out a living. The result was that those people were able to invest that amount in their small woodwork business, sell their products, buy food and other basic stuff and give to the money back to the professor with interest. Inspired by his successful experience and after in-depth studies on the topic, he started a professional micro-financial activity and in 1983 he created the Grameen Rural Bank, the first Microfinance Institution that today accounts for 1 billion $ in loans spread to over 7 millions borrowers.

Professor Muhammad Yunus and Grameen Bank were awarded the Nobel Peace Prize 2006 for 'for their efforts to create economic and social development from below'.

During the 80’s and the 90’s, after many researches and experiments proving the business viability and profitability of Yunus' concept, microfinance institutions grew constantly in number till topping 3000 in 2006. Most microfinance institutions started their business as non-profit organizations sustained by grants and subsidies, and have been able to turn into for-profit corporations attracting investors globally.

Major banks, attracted by high growth rates, started instituting funds focused on microfinance that allow investors from all over the world to invest in this new industry, movement or Microfinance Channel, as it has been defined by management scholars.

The Microfinance Concept in More Detail

The concept of microfinance is based on a primary principle holding that most human beings will do their best to be well off, provided they have the required tools. This is one of the reason, combined with a strict selection of borrowers, why microcredit has the highest repayment rate if compared to all other form of loans issued by traditional banks.

Unfortunately, studies demonstrated that microfinance cannot work everywhere and not everybody is a good candidate for microcredit. In order to be useful and successful for the borrower while viable and profitable for an institution, the following microfinance conditions must be met.

Developing or third world economies. Microfinance is characterized by low-amount financial services and that is why it finds application in developing or third world economies. Poor people living in industrialized countries cannot leverage 10$ to grow their small business.
A socio-economical environment that offers market opportunities for small craft businesses. The vast majority of microcredit is issued to borrowers who have environmental-friendly craftiness of any sort, such as woodworks, sewing, agriculture, etc…that perfectly fit sustainable development of local small communities. Regions with extremely low density, very poor infrastructures, lack of law and order, or having a large portion of the population affected by diseases are better of with grants or investments in infrastructure and education. In some parts of Africa the economic system is so weak that people would have nothing to do with a small amount of money, especially where barter is still the most common form of trade.
The mentality to honestly escape poverty. Values and mentality matter: it is fundamental that borrowers are members of a community that commit to honestly escape poverty. Many studies demonstrated that women, who are currently the largest and most preferred category of microcredit clients, are better loans payers than men because of the care they have for their families’ well being. Moreover, community pressure put forth by people living in small local communities, such as in villages located in India or Guatemala, helps borrowers to maintain a high level of commitment to repay their debts. If a borrower couldn’t pay an installment the other villagers would probably help her. If she would be unwilling to meet her obligations the pressure exerted on her from the other villagers (happy with microcredit) would be too high.

Effects of Microfinance

Besides helping to reduce poverty, the following effects were found:

The empowerment of women and the promotion of gender-equity. Especially in rural communities where their role is more marginal, women acquire decision power and a more active role in their family development and well being.
A boost to growth and stability to local small businesses located in developing countries.
The opportunity for low-income individuals to take advantage from favorable economic conditions due to removing a Barrier to Entry.
The development of a planning attitude in people who couldn’t satisfy their basic needs. Most microfinance clients have been able to break a closed loop of poverty by acquiring assets, sending their children to school, and improving their living conditions.

Microfinance Forum (24)

Microfinance for Housing (MFH)
"Housing is a basic need of the human being. After eating and clothing, housing is the most important. Nowadays the construction a house is a difficult and costly task. So there are various financial institutions which help household to obtain a house.
The low segment housing sector in many developing countries is undeveloped and constrained by several factors such as:
- Access to housing finance,
- Fund mobilization,
- Stringent regulatory framework,
- Land title,
- Difficulties in procuring building materials,
- Finding skilled construction workers,
- Awareness and access to housing technologies.
Current pro-poor housing policies at national and sub-national level are found insufficient to meet the challenge. In India there is inadequate housing finance at lower segment resulting in a huge gap in demand and supply of housing credit.
A Microfinance for housing (MFH) programme has emerged as one of the sources for housing credit for low-income groups and it is growing steadily in India."

Microfinance Needs Trust
"The basis of the relationship is trust. No trust, no microfinance. It is why people are returning that money. No trust, no returns whatever the interest rate and who borrows (businesses, households, females or males, manufacturing or services).
In this I found microfinance similar to regular finance. For example Islamic finance, World Bank microfinance, also new brands from commercial banks, ensuring the affordability to the money market with their low interest rates (lesser than the saving account)."

Non-interest Banking
"What's your view on non-interest banking? Is it advisable for a developing country like Nigeria?"

During its Evolutionary Path, Microfinance is Getting More Expensive...
"The idea behind microfinance if implemented well can solve rural poverty and propel development from below. However, during its evolutionary path, the proprietors of microfinance have factored in hidden costs and interest rates which in one way shoots the very foot that is supposed to support development. The lenders pay hefty interest rates and at the end of it all don't develop themselves but the microfinances. The high interest rates are in some cases explained by the high risks associated with doing the business, but can't there be a better system that includes many whilst taking into consideration their plight?"

Microfinance Impact on Rural Development
"Microfinance in the rural areas when properly channeled is of great significance to the development of the rural folks and rural areas.
Many institutions like IFAD, DFID etc. have come into the scene expanding financial services in new directions by making use of technology and innovations to reach many poor people in remote rural communities as well as offering them a lot of products.
However, with all these huge strides, large number of rural folks cannot boast of having a secure way of saving money and other sundry services. Hence it could be inferred that only a minority number of rural people actually benefit from financial services. Another area to pinpoint are the challenges associated with increasing access to financial services such as lack of adequate capacity, low education, weak infrastructure and also institutions. I would want to highlight that in the face of the fast changing global economic terrain comprising financial crisis, high inflation rates, climate change etc., rural financing is key."

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