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1. What is microfinance?

"Microfinance is the supply of loans, savings, and other basic financial service
s to the poor." (CGAP)
As the financial services of microfinance usually involve small amounts of money
– small loans, small savings etc. – the term "microfinance" helps to differenti
ate these services from those which formal banks provide.
Why are they small? Someone who doesn't have a lot of money isn't likely to want
to take out a $5,000 loan, or be able to open a savings account with an opening
balance of $1,000. Hence – "micro".
2. What is an MFI?
A microfinance institution (MFI) is an organization that provides microfinance s
ervices, ranging from small non-profit organizations to large commercial banks.
"Historical context can help explain how specialized MFIs developed over the las
t few decades. Between the 1950s and 1970s, governments and donors focused on pr
oviding subsidized agricultural credit to small and marginal farmers, in hopes o
f raising productivity and incomes. During the 1980s, microenterprise credit con
centrated on providing loans to poor women to invest in tiny businesses, enablin
g them to accumulate assets and raise household income and welfare. These experi
ments resulted in the emergence of nongovernmental organizations (NGOs) that pro
vided financial services for the poor. In the 1990s, many of these institutions
transformed themselves into formal financial institutions in order to access and
on-lend client savings, thus enhancing their outreach.
An MFI can be broadly defined as any organization—credit union, down-scaled comm
ercial bank, financial NGO, or credit cooperative—that provides financial servic
es for the poor." (CGAP)
"The World Bank estimates that there are now over 7000 microfinance institutions
, serving some 16 million poor people in developing countries. The total cash tu
rnover of MFIs world-wide is estimated at US$2.5 billion and the potential for n
ew growth is outstanding." - Data Snapshots on Microfinance - The Virtual Librar
y on Microcredit
3. Why would poor people need financial services?
"The great challenge before us is to address the constraints that exclude people
from full participation in the financial sector... Together, we can and must bu
ild inclusive financial sectors that help people improve their lives."
- Kofi Annan, UN Secretary General
It's easy to imagine poor people don't need financial services, but when you thi
nk about it they are using these services already, although they might look a li
ttle different.
"Poor people save all the time, although mostly in informal ways. They invest in
assets such as gold, jewelry, domestic animals, building materials, and things
that can be easily exchanged for cash. They may set aside corn from their harves
t to sell at a later date. They bury cash in the garden or stash it under the ma
ttress. They participate in informal savings groups where everyone contributes a
small amount of cash each day, week, or month, and is successively awarded the
pot on a rotating basis. Some of these groups allow members to borrow from the p
ot as well. The poor also give their money to neighbors to hold or pay local cas
h collectors to keep it safe.
However widely used, informal savings mechanisms have serious limitations. It is
not possible, for example, to cut a leg off a goat when the family suddenly nee
ds a small amount of cash. In-kind savings are subject to fluctuations in commod
ity prices, destruction by insects, fire, thieves, or illness (in the case of li
vestock). Informal rotating savings groups tend to be small and rotate limited a
mounts of money. Moreover, these groups often require rigid amounts of money at
set intervals and do not react to changes in their members' ability to save. Per
haps most importantly, the poor are more likely to lose their money through frau
d or mismanagement in informal savings arrangements than are depositors in forma
l financial institutions."- (CGAP)
4. Why don't they just go to a bank?
"The poor rarely access services through the formal financial sector. They addre
ss their need for financial services through a variety of financial relationship
s, mostly informal." (CGAP)
Why is this? For a moment pretend that you are a poor goatherder walking into a
bank:
◦You don't have any money to open a savings account with
◦You don't have any collateral to secure a loan with
◦You don't have a credit record as you have never been formally employed and you
've never taken out a loan before
◦You might even be unable to complete the necessary paperwork as you are illiter
ate.
Formal financial institutions were not designed to help those who don't already
have financial assets – they were designed to help those who do. Imagine trying
to get a loan in the United States without any savings, an employer or a credit
report.
So what do poor people do?
"Credit is available from informal commercial and non-commerical money-lenders b
ut usually at a very high cost to borrowers. Savings services are available thro
ugh a variety of informal relationships like savings clubs, rotating savings and
credit associations, and mutual insurance societies that have a tendency to be
erratic and insecure." (CGAP)

"Poverty is not created by the poor. It is created by the structures of society


and the policies pursued by society. Change the structure as we are doing in Ban
gladesh, and you will see that the poor change their own lives. Grameen's experi
ence demonstrates that, given the support of financial capital, however small, t
he poor are fully capable of improving their lives." - Banker to the Poor
- Muhammad Yunus, Grameen Bank, Founder
5. Why don't banks accommodate poor people?
Some do. Grameen Bank in Bangladesh was formed out of a project providing small
loans to women in the village of Jobra. Bancosol, a commercial bank in Bolivia,
is also a bank which provides microfinance services for the poor of Bolivia.
However, the majority of formal banks do not provide microfinance products as mi
crofinance is an expensive enterprise – you can make a lot more money on a large
loan than a small loan, and you won't make much money holding savings accounts
with very little funds in them. Banks can make more money if they only provide f
inancial services to those who already have money.
6. Why are microcredit interest rates so high?
The nature of microcredit – small loans – is such that interest rates need to be
high to return the cost of the loan.
"There are three kinds of costs the MFI has to cover when it makes microloans. T
he first two, the cost of the money that it lends and the cost of loan defaults,
are proportional to the amount lent. For instance, if the cost paid by the MFI
for the money it lends is 10%, and it experiences defaults of 1% of the amount l
ent, then these two costs will total $11 for a loan of $100, and $55 for a loan
of $500. An interest rate of 11% of the loan amount thus covers both these costs
for either loan.
The third type of cost, transaction costs, is not proportional to the amount len
t. The transaction cost of the $500 loan is not much different from the transact
ion cost of the $100 loan. Both loans require roughly the same amount of staff t
ime for meeting with the borrower to appraise the loan, processing the loan disb
ursement and repayments, and follow-up monitoring. Suppose that the transaction
cost is $25 per loan and that the loans are for one year. To break even on the $
500 loan, the MFI would need to collect interest of $50 + 5 + $25 = $80, which r
epresents an annual interest rate of 16%. To break even on the $100 loan, the MF
I would need to collect interest of $10 + 1 + $25 = $36, which is an interest ra
te of 36%. At first glance, a rate this high looks abusive to many people, espec
ially when the clients are poor. But in fact, this interest rate simply reflects
the basic reality that when loan sizes get very small, transaction costs loom l
arger because these costs can't be cut below certain minimums." (CGAP)
7. What are the effects of microfinance?
"Several years ago two friends of mine were speaking with a group of 40 clients
at a micro-bank in South Asia. Through the translator, they asked the 40 women w
hat impact the bank had had on the husbands of the non-borrowers; not their husb
ands, but the husbands of women who are not with the bank. The clients said, 'Be
fore we took our loans, our husbands were day-labourers, working for others when
ever they could find work. When we took our loans our husbands stopped being day
-labourers and worked with us - bicycle rickshaw, husking rice, growing garlic o
n leased land. This caused a shortage of day-labourers in this area, so the husb
ands of the non-borrowers who were day-laborers-their wages went up.' That was t
he impact of this bank on the husbands of the non-borrowers."
- Sam Daley-Harris, Microcredit Summit Campaign, Director
"Comprehensive impact studies have demonstrated that:
◦Microfinance helps very poor households meet basic needs and protect against ri
sks;
◦The use of financial services by low-income households is associated with impro
vements in household economic welfare and enterprise stability or growth;
◦By supporting women's economic participation, microfinance helps to empower wom
en, thus promoting gender-equity and improving household well-being;
◦For almost all significant impacts, the magnitude of impact is positively relat
ed to the length of time that clients have been in the programme." (UNCDF Microf
inance)
"Poor people, with access to savings, credit, insurance, and other financial ser
vices, are more resilient and better able to cope with the everyday crises they
face. Even the most rigorous econometric studies have proven that microfinance c
an smooth consumption levels and significantly reduce the need to sell assets to
meet basic needs. With access to microinsurance, poor people can cope with sudd
en increased expenses associated with death, serious illness, and loss of assets
.
Access to credit allows poor people to take advantage of economic opportunities.
While increased earnings are by no means automatic, clients have overwhelmingly
demonstrated that reliable sources of credit provide a fundamental basis for pl
anning and expanding business activities. Many studies show that clients who joi
n and stay in programs have better economic conditions than non-clients, suggest
ing that programs contribute to these improvements. A few studies have also show
n that over a long period of time many clients do actually graduate out of pover
ty.
By reducing vulnerability and increasing earnings and savings, financial service
s allow poor households to make the transformation from "every-day survival" to
"planning for the future." Households are able to send more children to school f
or longer periods and to make greater investments in their children's education.
Increased earnings from financial services lead to better nutrition and better
living conditions, which translates into a lower incidence of illness. Increased
earnings also mean that clients may seek out and pay for health care services w
hen needed, rather than go without or wait until their health seriously deterior
ates." (CGAP)
"Empirical evidence shows that, among the poor, those participating in microfina
nce programs who had access to financial services were able to improve their wel
l-being—both at the individual and household level—much more than those who did
not have access to financial services.
◦In Bangladesh, Bangladesh Rural Advancement Committee (BRAC) clients increased
household expenditures by 28% and assets by 112%. The incomes of Grameen members
were 43% higher than incomes in non-program villages.
◦In El Salvador, the weekly income of FINCA clients increased on average by 145%
.
◦In India, half of SHARE clients graduated out of poverty.
◦In Ghana, 80% of clients of Freedom from Hunger had secondary income sources, c
ompared to 50% for non-clients.
◦In Lombok, Indonesia, the average income of Bank Rakyat Indonesia (BRI) borrowe
rs increased by 112%, and 90% of households graduated out of poverty.
◦In Vietnam, Save the Children clients reduced food deficits from three months t
o one month." (CGAP)
8. When is microcredit not appropriate?
"Microcredit may be inappropriate where conditions pose severe challenges to loa
n repayment. For example, populations that are geographically dispersed or have
a high incidence of disease may not be suitable microfinance clients. In these c
ases, grants, infrastructure improvements or education and training programmes a
re more effective. For microcredit to be appropriate, the clients must have the
capacity to repay the loan under the terms by which it is provided." (Internatio
nal Year of Microcredit)

9. Why do so many MFIs focus on women?


"Today I'm a very respected women in the community. I have come out of the crowd
of women who are looked down upon. Due to the loan that I received... you have
made me to be a champion out of nobody."
- Rose Athieno, Produce Reseller, Uganda
"Microfinance programs have generally targeted poor women. By providing access t
o financial services only through women—making women responsible for loans, ensu
ring repayment through women, maintaining savings accounts for women, providing
insurance coverage through women—microfinance programs send a strong message to
households as well as to communities.
Many qualitative and quantitative studies have documented how access to financia
l services has improved the status of women within the family and the community.
Women have become more assertive and confident. In regions where women's mobili
ty is strictly regulated, women have become more visible and are better able to
negotiate the public sphere. Women own assets, including land and housing, and p
lay a stronger role in decision making.
In some programs that have been active over many years, there are even reports o
f declining levels of violence against women." (CGAP)
10. Can microfinance be profitable?
Yes.
"The November 2001 issue of the MicroBanking Bulletin includes data from 62 self
-sufficient MFIs. The average return on assets for this group is 5.5%, which com
pares favorably to commercial-bank returns. Indeed, there are grounds for hope t
hat microfinance can become attractive to mainstream retail bankers.
At the same time, some worry that an excessive concern for profit in microfinanc
e will lead MFIs away from poor clients to serve better-off clients who want lar
ger loans. It is true that programs serving very poor clients are somewhat less
profitable than those reaching better-off clients, but this may say more about m
anagers' objectives than an inherent conflict between serving the very poor and
profitability. MFIs serving the very poor are showing rapid financial improvemen
t. Microfinance programs like Bangladesh Rural Advancement Committee and ASA in
Bangladesh have already demonstrated that very poor clients can be reached profi
tably: both institutions had profits of more than 4% of assets in 2000.
There are cases where microfinance can not be made profitable, for example, wher
e potential clients are extremely poor and risk-averse or live in remote areas w
ith very low population density. In such settings, microfinance may require cont
inuing subsidies. Whether microfinance is the best use of these subsidies will d
epend on evidence about its impact on the lives of these clients." (CGAP)
11. Is microfinance the solution to poverty?

"My own view is that we have to approach extreme poverty a little like the way i
n which a doctor might approach a patient. By that I mean do a diagnosis and und
erstand what is it that is really ailing the particular country, the particular
region. Sometimes its terrible governance and the question is how to improve the
governance and the hope for the kind of change that is needed. In other places
it's the terrible burden of disease that may be addressable by good public healt
h measures. In other places it is to show how to grow more food. In other places
its how to get business going and microfinance has proven to be an incredibly p
owerful tool.
Once the basics are in place, the people are eating and can survive, then microf
inance can play a huge role in helping a poor community find ways through the ma
rket to get new opportunities, to earn new income, to start saving, making inves
tments and start the process of climbing the ladder of economic development in y
our children, in your business or your farm and continuing up the process of imp
roving skills, specialisation, new business ventures and so on. We've learnt tha
t microfinance can be a wonderful tool for that."
- Jeffrey Sachs, The Earth Institute at Columbia University, Director
No. Microfinance is but one strategy battling an immense problem.
"In the last two decades, substantial progress has been made in developing techn
iques to deliver financial services to the poor on a sustainable basis. Most don
or interventions have concentrated on one of these services, microcredit. For mi
crocredit to be appropriate however, the clients must have the capacity to repay
the loan under the terms by which it is provided. Otherwise, clients may not be
able to benefit from credit and risk being pushed into debt problems. This soun
ds obvious, but microcredit is viewed by some as "one size fits all." Instead, m
icrocredit should be carefully evaluated against the alternatives when choosing
the most appropriate intervention tool for a specific situation.
Microcredit may be inappropriate where conditions pose severe challenges to stan
dard microcredit methodologies. Populations that are geographically dispersed or
nomadic may not be suitable microfinance candidates. Microfinance may not be ap
propriate for populations with a high incidence of debilitating illnesses (e.g.,
HIV/AIDS). Dependence on a single economic activity or single agricultural crop
, or reliance on barter rather than cash transactions may pose problems. The pre
sence of hyperinflation, or absence of law and order may stress the ability of m
icrofinance to operate. Microcredit is also much more difficult when laws and re
gulations create significant barriers to the sustainability of microfinance prov
iders (for example, by mandating interest-rate caps).
Examples of Some Alternative Strategies
Grants can be used to help overcome the social isolation, lack of productive ski
lls, and low self-confidence of the extreme poor, and to prepare them for eventu
al use of microcredit. Small grants and other financial entitlements can work we
ll as first steps to "graduate" the poor from vulnerability to economic self-suf
ficiency. A successful example is the BRAC Income Generation for Vulnerable Grou
ps Development program in Bangladesh. This program has graduated more than 660,0
00 destitute women through free food, training, health care, and savings to BRAC
's mainstream microcredit program.
Investments in infrastructure, such as roads, communications, and education, pro
vide a foundation for economic activities. Community-level investments in commer
cial or productive infrastructure (such as market centers or small-scale irrigat
ion schemes) also facilitate business activity.
Employment programs prepare the poor for self-employment. Food-for-work programs
and public works projects fit this model. In many cases, these programs may be
out of reach for cash-strapped local governments but within the purview of donor
s.
Non-financial services range from literacy classes and community development to
market-based business-development services. While non-financial services should
be provided by separate institutional providers, there are clear, complementary
links with the demand for and impact of microcredit. For example, improved acces
s to market opportunities stimulates - and depends on - securing credit to cover
the costs (product design, transport, etc.) of taking advantage of those opport
unities.
Legal and institutional reforms can create incentives for microfinance by improv
ing the operating environment for both microfinance providers and their clients.
For example, streamlining microenterprise registration, abolishing caps on inte
rest rates, loosening regulations governing non-mortgage collateral, strengtheni
ng the judicial system, and reducing the cost and time of property and asset reg
istration can foster a supportive climate for microfinance."

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