Chapter No 2. What is microfinance and how does it work.

Microfinance is the provision of financial services such as loans, savings, insurance, and training to people living in poverty. It is one of the great success stories in the developing world in the last 30 years and is widely recognized as a just and sustainable solution in alleviating global poverty. The industry began by providing small loans to emerging entrepreneurs to start or expand businesses. Opportunity International was one of the first nonprofit organizations to recognize the benefits of providing capital to people struggling to work their way out of poverty. Over the years, with Opportunity leading the way, the microfinance sector has expanded its financial service offerings to better meet client needs. Along with providing more flexible loan products and business and personal development training, Opportunity offers savings and insurance to help clients effectively navigate the daily hardships they face. Without these services, clients are continually at risk of slipping back into poverty because of unforeseen circumstances. Microfinance organizations make it a priority to serve the particular needs of women, since a staggering 70 percent of all those living in extreme poverty are female. Women are often excluded from education, the workplace, owning property and equal participation in politics. They produce one half of the worlds food, but own just one percent of its farmland. Nearly 85 percent of Opportunitys loan clients are women. While Opportunity gladly extends loans to men, these organizations believes the greatest opportunity for interrupting cycles of extreme poverty come from microfinance programs that target female entrepreneurs. When women improve their circumstances, they also improve the lives of their children. By investing in nutrition and education, they help to create a better future for their children and their communities. Despite the success of life-transforming microfinance services, the World Bank says that the industry is not close to meeting the demand. Five hundred million people living in poverty could benefit from a small business loan and only one-third of the worlds population has access to any kind of bank account. The lack of access is particularly severe in sub-Saharan Africa where the World Bank estimates that microfinance is reaching only a small percentage of the economically active population. In sub-Saharan Africas poorest countries, less than 10 percent of the population has an account with a financial institution. In response, Opportunity has committed to building scalable, sustainable and accessible banks throughout the developing world to provide loans, training, savings and insurance products tailored to the specific needs of each region. As the microfinance industry continues to mature, there is a danger that it will drift toward a more secure client base. It is critical that microfinance organizations continue to focus on those with the greatest needsthose who have been displaced, those in rural areas, those who traditional institutions consider unbankablethe most marginalized people. Maintaining that focus, microfinance can help create a world in which the underserved have fair access to economic opportunities and the hope to move beyond poverty.

Microfinance is often defined as financial services for poor and low-income clients offered by different types of service providers. In practice, the term is often used more narrowly to refer to loans and other services from providers that identify themselves as microfinance institutions (MFIs). These institutions commonly tend to use new methods developed over the last 30 years to deliver very small loans to unsalaried borrowers, taking little or no collateral. These methods include group lending and liability, pre-loan savings requirements, gradually increasing loan sizes, and an implicit guarantee of ready access to future loans if present loans are repaid fully and promptly. More broadly, microfinance refers to a movement that envisions a world in which lowincome households have permanent access to a range of high quality and affordable financial services offered by a range of retail providers to finance income-producing activities, build assets, stabilize consumption, and protect against risks. These services include savings, credit, insurance, remittances, and payments, and others. Who are microfinance clients? Typical microfinance clients are poor and low-income people that do not have access to other formal financial institutions. Microfinance clients are often self-employed, household-based entrepreneurs. Their diverse microenterprises include small retail shops, street vending, artisanal manufacture, and service provision. In rural areas, microentrepreneurs often have small income-generating activities such as food processing and trade; some but far from all are farmers. Hard data on the poverty status of clients is limited, but tends to suggest that most microfinance clients fall near the poverty line, both above and below. Households in the poorest 10% of the population, including the destitute, are not traditional microcredit clients because they lack stable cash flows to repay loans. Most clients below the poverty line are in the upper half of the poor. It is clear, however, that some MFIs can serve clients at the higher end of the bottom half. Women often comprise the majority of clients. Over the past decade, some financial institutions have started developing a range of products to meet the needs of other clients, including pensioners and salaried workers. Although little is known about the universe of potential clients, the number of households without effective access to financial services is enormous. What kinds of institutions deliver microfinance? Most MFIs started as not-for-profit organizations like NGOs (non-governmental organizations), credit unions and other financial cooperatives, and state-owned development and postal savings banks. An increasing number of MFIs are now organized as for-profit entities, often because it is a requirement to obtaining a license from banking authorities to offer savings services. For-profit MFIs may be organized as non-bank financial institutions (NBFIs), commercial banks that specialize in microfinance, or microfinance departments of full-service banks. How does microfinance help the poor? It is now widely recognized that microfinance alone is largely inadequate for the poorest. However, discussions on what can be done to address this demonstrates two broad trends:

one is centered around addressing the demand-side constraints of the poorest before introducing microfinance, while the other has been a focus on supply-side constraints of microfinance that make it difficult for the poorest to participate meaningfully. Within this, the thrust of the discussion has been on innovations of the financial product (such as introducing flexibility, more risk responsiveness of products, etc.), rather than the process (such as staff engagement quality, internal group cohesion, etc.) which may be equally important to ensure effective microfinance participation of the poorest. Working on the process domain becomes critical as most scaled-up microfinance very quickly does not usually pay much attention to this aspect once the initial microfinance culture is built. When is microfinance NOT an appropriate tool? Financial services, particularly credit, are not appropriate for all people at all times. For loans that will be used for business purposes, microcredit best serves those who have identified an economic opportunity and can capitalize on it if they have access to a small amount of ready cash. Regardless of how loans are used, MFIs can provide long-term, stable credit access only when clients have both the willingness and ability to meet scheduled loan repayments. Microfinance is particularly inappropriate for the destitute, who may need grants or other public resources to improve their economic situation. Grants are a more efficient way to transfer resources to the destitute than are loans that many will not be unable to repay. Too much risk is placed on the MFI and client, when the only way a client can repay a loan is by starting a successful business. Basic requirements like food, shelter, and employment are often more urgently needed than financial services and should be appropriately funded by government and donor subsidies. Governments and development agencies often use microfinance as a tool to address socioeconomic problems such as relocation of refugees from civil strife, generating employment among demilitarized soldiers, or assistance following a natural disaster. Microfinance may or may not be able to respond to these situations effectively, and certainly not as a stand-alone intervention. Implementing a successful microfinance program to address these types of situations depends upon a number of factors, the most important of which is a client base capable of making regular repayments. Why does the microfinance industry place so much emphasis on sustainability? From a development perspective, financial sustainability is not an end in itself. Rather, it is a tool for reaching the maximum number of clients. MFIs may only operate for a limited time, reach a limited number of clients, or be driven more by political goals than by client needs if services are not priced at sustainable levels. Donors and governments cannot likely provide enough subsidized funds to meet the huge demand for microfinance. Even if there were enough donor and government money, it would be better spent on other development priorities that, unlike microfinance, cannot be delivered without continuing subsidies. Sustainable MFIs have the potential to attract non-subsidized resources to finance expansion of outreach. Experience has even shown that borrowers are more likely to repay lenders who operate without subsidies at they are more confident the institution will be around to give them future loans.

The trade-off between financial viability and reaching very poor people is much less acute than many once thought. A number of financial providers have managed to offer high-quality financial services to very poor people while also covering their costs. Moreover, correlation between MFI profitability and client poverty level has proven to be a statistically weak one. This may be more driven by the vision of particular MFIs than by any inherent unprofitability of low-end microcredit. Is the microfinance industry sustainable? Is the microfinance industry financially sustainableis it profitable after making adjustments for subsidies not likely to continue in the future? Most MFIs are still unprofitable, especially if one includes the many small MFIs that do not report to the international databases described in FAQ #17. A more meaningful way to look at profitability is to consider the overall number of overall clients served by profitable MFIs, rather than the number of profitable MFIs themselves. In 2006, 44% of all microborrowers captured by the MIX database (see FAQ #17) are being served by profitable institutions. If one narrows the focus to private MFIs such as NGOs and licensed institutions, then more than 3/5 of the borrowers are already being served profitably, and the long- term trend is upward. Are MFIs as profitable as banks? Measured by return on assets, MFIs are on average more profitable than the commercial banks in their countries. This does not show that microfinance is inherently more profitable than commercial banking. Rather, the differential is likely due to microfinance being an immature industry in most countries where providers profits have not yet been squeezed down. Measured by return on the equity invested by shareholders, MFIs are on the average less profitable than banks, but this is mainly because MFIs are not yet as fully leveraged as banksi.e., MFIs fund their assets with more of their own money and less of the money deposited by savers. Even so, well-managed microfinance have already shown to be profitable enough to integrate into mainstream financial sectors. What is the governments role in supporting microfinance? Governments most important role is not provision of retail credit services, for reasons mentioned in FAQ #12. Government can contribute most effectively by:

Setting sound macroeconomic policy that provides stability and low inflation Avoiding interest rate ceilings - when governments set interest rate limits, political factors usually result in limits that are too low to permit sustainable delivery of credit that involves high administrative costssuch as tiny loans for poor people. Such ceilings often have the announced intention of protecting the poor, but are more likely to choke off the supply of credit Adjusting bank regulation to facilitate deposit taking by solid MFIs, once the country has experience with sustainable microfinance delivery, Creating government wholesale funds to support retail MFIs if funds can be insulated from politics, and they can hire and protect strong technical management and avoid disbursement pressure that force fund to support unpromising MFIs.

Evidence for reducing poverty Research on the effectiveness of microfinance as a tool for economic development remains mixed, in part owing to the difficulty in monitoring and measuring this impact.[30] At the

2008 Innovations for Poverty Action/Financial Access Initiative Microfinance Research conference, economist Jonathan Morduch of New York University noted there are only one or two methodologically sound studies of microfinance's impact.[31]. Grameen Foundation has released two papers summarizing the state of research on the impact of microfinance on poverty: "Measuring the Impact of Microfinance, Taking Stock of What We Know" by Nathanael Goldberg (now with Innovations for Poverty Action) and an update, "Measuring the Impact of Microfinance: Taking Another Look" by Professor Kathleen Odell. These two papers identify scores of findings indicating positive impact in research conducted over the last twenty years, as well as some findings that suggest limited or negative impact in some cases. The BBC Business Weekly program reported that much of the supposed benefits associated with microfinance, are perhaps not as compelling as once thought. In a radio interview with Professor Dean Karlan of Yale University, a point was raised concerning a comparison between two groups: one African, financed through microcredit and one control group in the Philippines. The results of this study suggest that many of the benefits from microcredit are in fact loaned to people with existing business, and not to those seeking to establish new businesses. Many of those receiving microcredit also used the loans to supplement the family income. The income that went up in business was true only for men, and not for women. This is striking because one of the supposed major beneficiaries of microfinance is supposed to be targeted at women. Professor Karlan's conclusion was that whilst microcredit is not necessarily bad and can generate some positive benefits, despite some lenders charging interest rates between 40-60%, it isn't the panacea that it is purported to be. He advocates rather than focusing strictly on microcredit, also giving citizens in poor countries access to rudimentary and cheap savings accounts.[32] To further the point stated by Prof Karlan, microfinancing begets the general tendency of a small business initially supported on credit to gain profits with time and generate micro savings. In his latest study, the famous two time pulitzer prize winner, Nicholas Donabet Kristof states that there is no evidence of any negative influence of micro financing but countless examples of people now looking at the bigger picture and saving for better things have surfaced. The example of BancoSol(Bolivia), where the number of savers has grown to twice as much as the number of borrowers, further strengthens his theory.[33][34] Sociologist Jonathan H. Westover, Ph.D. found that much of the evidence on the effectiveness of microfinance for alleviating poverty is based in anecdotal reports or case studies. He initially found over 100 articles on the subject, but included only the 6 which used enough quantitative data to be representative, and none of which employed rigorous methods such as randomized control trials similar to those reported by Innovations for Poverty Action and the M.I.T. Jameel Poverty Action Lab. One of these studies found that microfinance reduced poverty. Two others were unable to conclude that microfinance reduced poverty, although they attributed some positive effects to the program. Other studies concluded similarly, with surveys finding that a majority of participants feel better about finances with some feeling worse.[35]

Criticisms Most criticisms of microfinance have actually been criticisms of microcredit, delivered in the absence of other microfinance services such as savings, remittances, payments and insurance.

For example, there has been much criticism of the high interest rates charged to borrowers. The real average portfolio yield cited by the sample of 704 microfinance institutions that voluntarily submitted reports to the MicroBanking Bulletin in 2006 was 22.3% annually. However, annual rates charged to clients are higher, as they also include local inflation and the bad debt expenses of the microfinance institution.[39] Muhammad Yunus has recently made much of this point, and in his latest book[40] argues that microfinance institutions that charge more than 15% above their long-term operating costs should face penalties. Milford Bateman, the author of Why Doesn't Microfinance Work?, argues that microcredit offers only an "illusion of poverty reduction". "As in any lottery or game of chance, a few in poverty do manage to establish microenterprises that produce a decent living," he argues, but "these isolated and often temporary positives are swamped by the largely overlooked negatives." Bateman concludes that "The international development community is now faced with the reality that, overall, microfinance has been a development policy blunder of quite historic proportions."[41] Here Bateman, like many writers, confuses microfinance as a broad sector with microcredit, a single microfinance intervention (see delineation above). The role of donors has also been questioned. The Consultative Group to Assist the Poor (CGAP) recently commented that "a large proportion of the money they spend is not effective, either because it gets hung up in unsuccessful and often complicated funding mechanisms (for example, a government apex facility), or it goes to partners that are not held accountable for performance. In some cases, poorly conceived programs have retarded the development of inclusive financial systems by distorting markets and displacing domestic commercial initiatives with cheap or free money."[42] There has also been criticism of microlenders for not taking more responsibility for the working conditions of poor households, particularly when borrowers become quasi-wage labourers, selling crafts or agricultural produce through an organization controlled by the MFI. The desire of MFIs to help their borrower diversify and increase their incomes has sparked this type of relationship in several countries, most notably Bangladesh, where hundreds of thousands of borrowers effectively work as wage labourers for the marketing subsidiaries of Grameen Bank or BRAC. Critics maintain that there are few if any rules or standards in these cases governing working hours, holidays, working conditions, safety or child labour, and few inspection regimes to correct abuses.[43] Some of these concerns have been taken up by unions and socially responsible investment advocates. For example, BusinessWeek reported that some Mexicans are stumbling with terms of newly available funding.[44][45] Other criticism was raised by the IPO (Initial Public Offering) of a Mexican MFI Banco Compartamos in 2007. As the company put its shares on Mexican Stock Exchange it was able to generate very high profits that were achieved by rising interest rates on their micro-loans that at some point reached 86% per year.[46] In July 2010 India's biggest MFI, SKS Microfinance also went public. In both instances Muhammad Yunus publicly stated his disagreement, saying that the poor should be the only beneficiaries of microfinance.[47][48] Microcredit has been blamed for many suicides in India: aggressive lending by microcredit companies in Andra Pradesh is said to have resulted in over 80 deaths in 2010.[49]

Some problems with microcredit are mistakenly alleged in The Micro Debt, a film by the Danish journalist Tom Heinemann.[50] After a thorough investigation in December 2010 by the Norwegian Foreign Ministry, the alleged problems have been proven to be false and no further actions against the Grameen Bank and its founder, Muhammad Yunnis, have been taken.[51] The documentary by Heinemann also looks at the effectiveness of Grameen Bank and alleges that it has little impact on poverty by highlighting the purported continued poverty of Sufiya Begum, the original loan recipient of Grameen, in Jobra Village. This allegation is disputed, since documentary maker Gayle Ferraro found the woman alive and well, confirming the original Grameen story.[52]

Microfinance in Pakistan INTRODUCTION We are living in an era of scientific inventions and globalization. In spite of tremendous glory in science and technology, 800 million people are bound to sleep hungry and 791 millions of such a chunk of population lives in developing countries that constitute 90% of the starved. Out of them, 284 millions live in South Asia with 49 millions in Pakistan which makes 6% of the worlds total population and 17% of the South Asias poor population. Poverty is undoubtedly a rural phenomenon in Pakistan comprising 28.35% poor population as against 13.6% urban poor (GOP,2000).Emerging modernization in agriculture increased inequity, causes labour displacement and due to the absence of non-form activities, unemployment and poverty increased. One of the key factors for this persistent poverty is the absence of liquidity, which helps in stimulating the economic activity. Two sources of credit are available to the farming community, these include institutional and no institutional agencies. Non-institutional credit is timely available when and whenever the need arises but the creditors charge substantially higher rate of interest on such loans. On the other hand, institutional credit takes some time for sanctioning formalities but relatively low rate of interest is charged. Institutional credit for agriculture facilitates growth in employment and output. This however, requires rapid and broad-based land and labour augmenting technological change. In this way, institutional credit would have more favourable impact on output growth and employment (Malik et al., 1991). There are 5.1 million farms in the country and 93% of these are small and marginal farms accounting for 60% of the total cultivated area. The small farmers whose farm income is very low and family size is relatively large are generally constrained for want of funds to meet their farm input requirements like seed, fertilizer, pesticide, etc. They are not able to use inputs at the desired level for higher production (Sarwar, 2001). Rural poor need credit to allow investment in their farms and small businesses, to smooth consumption and to reduce their vulnerability to weather and economic shocks (FAO, 2000). Micro-credit has tremendous impact on the economic life of the people in the rural areas. A remarkable increase in the level of farmers incomes, improvement in the quality of life and the increased value of assets have been observed and the provision of the credit has uplifted the socio-economic status of small and marginal farmers (PRSP, 1999; Nazli, 2000). Therefore, micro-financing is fulfilling the agricultural and non-agriculture needs by providing the poor with access to financial resources. The appropriateness of micro credit as a tool to reduce poverty depends on local circumstances as well. However, in its most modest form, it fills gap in credit delivery that

are not addressed by other providers; and, in its most ambitious form, it attempts to catalyze economic development that will reduce rural poverty (FAO, 2000). There is a general agreement that micro-credit can reduce vulnerability as it allows people to smooth their cash flow and access to money when they need it (Aslam, 2001). Keeping the effectiveness of micro credit, as a tool to reduce poverty, in view, the above study was planned with the objectives of making an assessment of poverty reduction by micro financing to the poor households and the impact of microfinance approach of credit facilitation on income level of poor households as well as on consumption smoothening.
Khushhali bank of Pakistan In Pakistan, it is estimated that of 6.5 million poor people who need microfinance services, only about 5% are being served by microfinance institutions. To expand microfinance services to the poor, the Khushhali Bank (KB) was established in August 2000 by 14 private and 2 state-owned commercial banks as a flagship microfinance bank. It became an integral part of the Islamic Republic of Pakistan's Poverty Reduction Strategy and its Microfinance Sector Development Program (MSDP), developed with the assistance of the Asian Development Bank (ADB). Khushhali Banks primary objective is to provide sustainable microfinance services to the poor in order to reduce poverty and promote economic development through community building and social mobilization. Through consolidation of several NGOs microfinance operations, Khushhali Bank shortly became one of the largest microfinance institutes in the country with 31 branches covering 33 districts and US$12 million in disbursements. But real expansion occurred after the government of Pakistan signed a loan agreement of US$150 million with the Asian Development Bank in 2002 to support the operations of Khushhali Bank and to promote the microfinance sector in Pakistan. Khushhali Bank obtained a US$70 million component of this loan for microloans to the poorparticularly to women of the country's rural and urban areasand a US$10 million component allocated toward institutional capacity building. Another US$70 million component has been allocated to support policy reforms of the microfinance sector in Pakistan. By the end of 2005, KB had 63 branches and employed 1,576 people. KB reported that in 2003, it provided loans to 100,000 households. It aimed to reach 700,000 households by 2007. The bank's line of products includes short tenure microloans, up to US$500 for working capital and asset purchase, as well as training and consulting. It does not offer deposit services. Its lending is based on the Grameen model, i.e., it loans to community groups without collateral. To ensure that the loan reaches the target segment (e.g., the poor), KB has limited the loan size to about US$150, an equivalent of 36% of the per capita GDP, an amount in which wealthy people would not have interest. In practice, however, different members of the same household often borrow in tandem, rendering the small loan limit an ineffective deterrent. Khushhali Bank also uses another method of targeting: ranking poor prospective borrowers by tracking the economic status of their beneficiaries. This approach, however, is not adopted rigorously and suffers from subjectivity since participating households generally self-select themselves as poor. Moreover, the very aims of the Khushhali Bankobtaining group guarantees for repayment and maintaining a close scrutiny of monthly cash flows to determine the repayment capacity of potential clientscan potentially exclude the poor, a priori. A Khushhali Bank survey was conducted by the Asian Development Bank Institute in May- June 2005. The survey covered 2,881 households, of which 1,416 are KB borrowers and 1,465 non borrowers. Additional data on loan characteristics such as purpose, duration, instalments, and interest rate were provided by Khushhali Bank. When matching survey data and KB data on borrowers, 18 observations were lost due to unknown reasons and thus data from 1,398 client households were used in the final analysis. The survey covered KB borrowers from 11 regions: 8 rural and 3 urban. Table 1 shows that out of 2,881 households, 2,126 (74%) were rural households and 726 (26%) were urban households. This sampling of rural versus urban households is consistent with Khushhali Banks portfolio, in which around 75% of Khushhali Banks lending goes to the rural population. To be representative, the survey design covers the same distribution with 74% of rural households.

Table 1: Survey Participants by Region

Region
D.G.Khan D.I.Khan Jacobabad Karachi Kohat Lahore Loralai Muzaffarabad Nawabshah Quetta R.Y.Khan Total

Urban

Rural 363 248 312 242

Total 363 248 312

392 208 208 260 262 132 732 254 2149 260 262 132 254 2881