Microfinance
A subset of finance that focuses on providing financial services to the marginalized community.
What is Microfinance?
Microfinance is a subset of finance that focuses on providing financial services to the marginalized community, otherwise unserved by traditional banking norms. Micro, meaning small, refers to the provision to offer finance facilities at lower amounts.
The marginalized community comprises underserved, poor, or low-income individuals with little to no savings for their future. People of lower socio-economic classes often struggle to prove their creditworthiness to banks and are denied loans based on their inability to pay the banks.
This invisible restriction confines their access to quality resources, which causes them to move to local money lenders in their respective rural areas, who charge high-interest rates exorbitantly. These high-interest loans make their debt much harder to pay, which traps them in a debt cycle.
Over the years, these financing services have broadened and now provide individuals with savings and current account access, insurance for businesses at lower premiums, and small business developmental loans.
These microloans can range from $100 to $25,000 at a lower interest rate. The fundamental principle behind providing this credit facility is to foster financial inclusivity for all.
This financial inclusion can help a nation develop its economy by providing access to capital for people to gain an increased living standard and the chance to become successful entrepreneurs.
It has helped recognize and aid women entrepreneurs to become self-sufficient and empower them to become role models for future generations.
Key Takeaways
- It is a subset of finance that focuses on providing financial services to the marginalized community who otherwise fall outside the scope of financing through usual banking provisions.
- The basic fundamental principle behind providing this credit facility is to foster financial inclusivity for all.
- The clients for the MFI reside mainly in rural areas, particularly self-employed individuals who work on farms engaging in agriculture or petty trade in household income-generating activities. In urban areas, the clients can range from small shopkeepers to artisans and street vendors to daily wage workers.
- In October 1983, 'Grameen Bank' was established by Dr. Mohammed Yunus, a pioneer in economics that led him to earn the Nobel Peace Prize in 2006 for his contribution to society.
Microfinance and Financial Inclusion
These institutions generally serve the poor and the vulnerable outside the scope of accessing conventional financial institutions. These people have very little income and often do not maintain an active bank account.
In rural areas, these are commonly self-employed individuals who work on farms engaging in agricultural activities or petty trade in household income-generating activities. In urban areas, the clients can range from small shopkeepers to artisans and street vendors to hourly and daily wage workers.
The clients and the institutions generally have a close relationship and often meet regularly to advise them. The institution has the deep-rooted groundwork in the family's finances and living circumstances to assess the repayment probability.
History of Microfinance
It always had its roots in the unorganized sector. The concept was first to be read in the writings of theorist Lysander Spooner, who briefly explained the advantages of giving small credit to poor farmers and entrepreneurs.
In the 18th century, Jonathan Swift, the writer of the famous book - 'Gulliver's Travels' started Irish Loan Funds to provide credit to the poor of Dublin without any collateral or credit. Although it was mainly for charitable purposes, it significantly helped improve the standard of living among the Irish people.
Friedrich Wilhelm Raiffeisen of Germany opened its first cooperative bank to support rural farmers by providing credit in the same era.
Later, it was crystallized into an institution in the 1970s by an economics professor Dr. Mohammed Yunus. While teaching at the University of Chittagong in Bangladesh, he noticed the nearby slum areas and wanted to help the people somehow.
After surveying the area and engaging in fruitful conversations with the villagers, he noticed that these low-income individuals had no access to credit facilities. Above that, they did not have any physical means to visit a conventional bank to secure a loan.
Even if they reached the banks somehow, they were still denied loans due to the absence of credit history and substantial assets that could act as collateral. The only alternative they had was to ask the local money lenders who charged high-interest rates they could not afford.
The poor had a minimal credit history and little to no assets, but Dr. Yunus observed that they were far more financially sensible and trustworthy when managing finances.
During his survey, he noticed that women who made bamboo stools daily for their livelihood were involved in an oppressive debt cycle. They only needed around $27 to break the debt cycle, and no provision was available for a small credit facility with a reasonable interest rate.
In October 1983, 'Grameen Bank' was established. The bank has served thousands of individuals by providing microcredits, and the business model has proved successful in helping the poor loosen the chains of poverty.
Note
Dr. Yunus's work had rung bells in social entrepreneurship, and he was awarded the Nobel Peace Prize in 2006 for his contribution.
Microfinance Institutions in different Countries
It has changed the World for the better. Millions of individuals have benefited from financial inclusivity and access to resources. They now have access to affordable and high-quality services from financial institutions.
Advocates of MFI strongly support the system in becoming a helping hand for economic development and employment by focusing on budding micro-entrepreneurs. It has also helped individuals better manage their finances and protect their belongings from risks.
In 2020, the global microfinance valuation was at $178 billion and will reach $500 billion by 2030. More than 10,000 various MFIs provide financial services to more than 70 million people with a portfolio value of more than $40 billion.
In the US
The success of 'Grameen Bank' has attracted the attention of policymakers and NGOs in the US to uplift the homeless and promote economic development. However, the financial structure in the country is much different than one sees in a developing country.
Even if people here don't have access to one type of loan, they qualify for more than one public assistance, like a home equity loan or unemployment assistance.
Even though it has seen some success in the streets, many loopholes remain to be covered when disbursing microcredits. Read this article by Harvard on the current problems that MFIs are facing in the US.
'Accion Networks' is one of the first MFIs in the US that has laid the groundwork for providing credit to individuals underserved by mainstream banks. Tailoring the terms and conditions of the micro-credit according to the income earned is one of the features.
In Other parts of the World
Let's see the scenarios in some other parts of the world:
1. Bangladesh
The success of 'Grameen Bank' started in 1983 has buzzed the entire World. The bank also had a default rate of 3% when it began and proved the poor worthy of credit. In a way, it has helped thousands of women become self-sufficient and helped the future generation to attain education.
BRAC stands for Bangladesh Rural Advancement Committee and has also agreed to support this institution. It provides migrant loans, small enterprise loans, and loans for agriculture and women, with about $4.5 billion in total loans disbursed.
ASA, which stands for Association for Social Advancement, is also a significant player (NGO) in micro-financing the needs to help the poor.
2. India
SEWA - Self Employment Women Association was the first to start microfinancing in India in a small village near Ahmedabad, Gujarat, in 1974. Currently, 'Bandhan Bank' is the largest distributor of micro-finance with around 4500 outlets.
Many NGOs have chimed in to provide the same services and are helping the nearby areas develop economically.
Most of the loans disbursed here are given in a group with 5-10 members as it ensures saving and payment due to social pressure and outcast from the group if not paid. The majority of the borrowers in this scheme are women.
Pros and Cons of Microfinance
We will examine whether microfinance has been a boon or a curse to the economy.
How has it helped society? Let's see some of its pros below:
- People with small and medium enterprises have been able to harness the power of these institutions and escape poverty traps.
- It is a way to foster financial inclusion and has indirectly improved people's access to health and education, making them well off and providing better for their families.
- One successful venture encourages other entrepreneurs to pursue their trade and creates employment opportunities nearby.
- A close relationship created by the MFIs with their clients has helped them achieve higher repayment rates and crushed the 'unbankable' term from the system.
- Helps and encourages low-income individuals to save as little as possible for future or emergency use of services such as savings accounts.
- It provides people with the possibility of future investments. When striving to meet necessities is out of the picture, they can think about putting the rest of their money in a different area. Economic development gives a better chance of survival and higher living standards.
- It has also helped thousands of women to become self-sufficient through microcredits that have helped them grow their businesses. As a result, women no longer have to depend on their husbands and can easily choose the path of financial independence.
On the other hand, some of the cons are:
- Many argue that the interest loans on these loans are not significantly different than those offered by traditional banks and thus do not greatly alleviate poverty.
- This argument arose when for-profit institutions came into the picture. People felt they were making money from poor people's hard work. This for-profit controversy has diverted attention from the central aspect, social impact.
- One of the most significant constraints in the MFIs is the non-existent regulation of the system and limited human resources to carry out the operation due to less payout.
- People also need to be financially aware before making a good choice in choosing credit that best suits their needs. Therefore, imparting financial education before everything else is more important.
Future of Microfinance
This industry is relatively new. However, with the concept still new and conventional banks still stereotyping the poor as 'unbankable,' it still has to go a long way and overcome various obstacles.
This form of financing seems promising in the years to come. Many MFI institutions that started with just one branch now have outlets in many different nations covering different rural areas.
Many of them are even on the stock exchange listing. For example, SKS - is a microfinance institution in India. As the demand for credit increases for low-income individuals, the products offered by MFI are becoming flexible to suit individuals' needs.
Loans for agriculture, starting a new boutique, opening a beauty parlor, taking education loans, or providing a platform for skill development and imparting financial training, are just some of the services. In addition, the MFI is now adding investment alternatives in the form of debt and equity funds.
However, a more flexible and holistic approach with proper research on what financial services to provide can help create products tailored to needs.
The MFI also has its future in collaborating with network providers as more and more smartphones reach people, and digital financing is becoming a norm. For example, it has proved successful with the M-Pesa, the largest mobile phone-based banking service provider in Kenya.
The developing and poorest countries are the largest market for these institutions. MFI was more rural-based in the past, often providing services in rural areas, but many clients also exist in urban areas.
These are the people who have the need to access credit but are underserved by traditional banking sources. In addition, they come from the unorganized sector and can't provide a definite credit score and collateral.
MFIs tend to face direct competition from traditional banks who already have resources to tap and seek new markets, as well as from new FinTech companies who are on their way to dismantling the conventional business model approach for banking.
A more customer-centric or client-centric approach can help substantially for the success of any MFI. The main reason is the personal connection with the borrowers that instills trust and makes them repay loans. MFIs thus attain only a 3% default rate.
In conclusion, there's a lot to be done. But, it has helped many people live comfortable lives, get an education and a job, and will continue to do so.
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