Lending in the informal and unorganized sector of the economy

Author: Kevin Henderson
Kevin Henderson
Kevin Henderson
Private Equity | Corporate Finance

Kevin is currently the Head of Execution and a Vice President at Ion Pacific, a merchant bank and asset manager based Hong Kong that invests in the technology sector globally. Prior to joining Ion Pacific, Kevin was a Vice President at Accordion Partners, a consulting firm that works with management teams at portfolio companies of leading private equity firms.

Previously, he was an Associate in the Power, Energy, and Infrastructure Investment Banking group at Lazard in New York where he completed numerous M&A transactions and advised corporate clients on a range of financial and strategic issues. Kevin began his career in corporate finance roles at Enbridge Inc. in Canada. During his time at Enbridge Kevin worked across the finance function gaining experience in treasury, corporate planning, and investor relations.

Kevin holds an MBA from Harvard Business School, a Bachelor of Commerce Degree from Queen's University and is a CFA Charterholder.

Reviewed By: Manu Lakshmanan
Manu Lakshmanan
Manu Lakshmanan
Management Consulting | Strategy & Operations

Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects.

Manu holds a PHD in Biomedical Engineering from Duke University and a BA in Physics from Cornell University.

Last Updated:November 22, 2023

What is Microcredit?

Microcredit is lending in the informal and unorganized sector of the economy. The purpose of microloans or microlending is to create financial inclusion in society.

The Microcredit, microfinance, or microbanking financial services sector act as a means of offering intermediary financial services. 

As the name suggests, it offers small amounts of loans as microcredit services. This functions with low collateral and minimal interest rates. It is provided to poorer clients, especially impoverished people in rural or underdeveloped areas.

Grameen Bank's model (lit. "rural bank" in Bengali), developed by Muhammud Yunus in Bangladesh, laid the groundwork for the microfinance system. 

Microfinance revolves around providing banking, monetary, and financial services to marginalized people who lack access to banking and financial assistance due to loose financial footholds. These people lack access to banking and financial services due to economic poverty. 

The term actually refers to the borrowing and lending aspects of microfinance. Microlending can range from as little as $5 to an amount exceeding $3000. The range of microlending available depends on the society's geographical, financial, and social constraints. 

It lends itself to various aspects of microfinance. It is involved in expanding businesses, uplifting the poor, and creating financial services in the rural areas of developing countries. 

The microfinance industry's estimated value stands at $178.84 billion in 2020. The projections forecast its estimated value to reach $496.90 billion by 2030. Thus, its value will grow at around 10 % annually until 2030. 

But what is Microfinance?

  • It focuses on providing small funding through financial services to individuals or groups. 

  • Its origins trace to Yunus' conceptualization of the rural banks in Bangladesh. 

  • The industry aims to realize the financial potential of the marginalized section of society.

Microfinance's Mission

Poor households often lack fundamental access to services and knowledge, i.e., financial literacy and awareness, insurance, savings, and loans. This creates a socio-economic and financial gap between different classes. 

The scope is limited to small-scale entrepreneurs engaged in so-called "cottage industries." These businesses turned to microfinance primarily because of a lack of collateral and little access to banking and financial services. 

The initial offerings tap into the poor's resources by bridging the service gap and creating financial inclusion. 

Microfinance offers various intermediary services to promote financial inclusion. These service offerings were developed to address developing economies' needs and economic constraints. 

Its background is in offering loans in varying amounts. Sometimes, clients can access loans without collateral through peer-to-peer network financing. 

Microcredit institutions can also offer low or no interest rates. 

Providing financial services to the poor boosts the economy and leads to economic development. Overall, it leads to skill development in the marginalized sections of society. In addition, it creates sustainability by reducing reliance on other means of living. 

Microfinance adopted the framework of the banking and financial sector to fit the poor's needs, with lower interest rates than the traditional banking sector and low or no collateral requirements. 

When microfinance first became available, it largely served the following industries: 

  1. Processing and Manufacturing 

  2. Agriculture and Foresting 

  3. Shopkeeping

The Business Model 

Microfinance targets small entrepreneurs or business owners. However, they also aim to help low-income households or entrepreneurs just starting.

During its initial conception, it focused on offering credit to the marginalized sections of society in developing economies. 

These services further expanded to the insurance and banking service sectors. In addition, the microfinance industry's goals developed to provide better customer support by offering financial literacy information. 

Microfinance doesn't generate most of its revenues through interest rates. Instead, it charges minimal rates and offers low payments with more periodic installments. 

The industry relies on group collateral requirements or peer-to-peer financing networks to generate revenues. The wide variety of networks helps the system offer different services, depending on their resources.

Relevance of Microfinance

The following are the relevant:

1. Economic Impact

The relevance of microfinance lies in its impact on the economy. 

Microfinance was developed to provide credit to low-income households. Families outside the conventional system had nowhere to turn in underdeveloped or developing economies. 

The lasting impact on the financial system brought about a financial empowerment revolution. Thus, it has led to revenue and employment growth. 

Moreover, female empowerment resulting from the availability of such credit has reduced overall debts and less dependence on the market for profits. 

These credit services allow many underprivileged people to contribute to the economy by starting and expanding businesses, buying homes, etc., when they otherwise couldn't have.

2. bUplifting and Empowering the Poor 

The contemporary relevance of micro-financial services is attributed to Muhammud Yunus. The economist saw potential in an untapped and underserved financial market.

In the 1970s, Grameen bank revolutionized the banking and changed the trajectory of the finance sector to include empowering the less fortunate. It established itself and grew while focusing on empowering women and serving cottage industries.

3. Revitalizing Business 

It saw the emergence of group financing and finance systems with the peer-to-peer network structure. Later, it developed into a credit structure that provided small amounts of funding to entrepreneurs for buying initial capital. 

Currently, there is a wide range of loan programs available where clients can borrow from a few dollars to a few thousand dollars. 

Also, specific requirements for clients to be approved to receive credit vary from those in the traditional banking system. 

How does Microcredit Work?

The Grameen bank, or the "Bank for the Poor," is a microfinance institution developed in Bangladesh to promote community development. It was founded in 1983 by Muhammud Yunus and is headquartered in Dhaka, Bangladesh. 

The Grameen Bank's method of action varies from those of traditional banks. For example, when creating a branch, the bank proceeds in the following manner: 

  1. The process starts with the identification of the core issues in an area. Then, it works on a solution-based model with information from a survey on background social issues. 

  2. They take steps to progress toward development-based goals and have adopted long-term processes that use the aspirations of various economic agents to their advantage. 

  3. The credit system's framework dictates that it provides services in regions lacking them to ensure the financial inclusion of all members of society.

  4. The service offerings focus on the targeted issues, identifying needy demographics. This is to serve poverty-stricken people and others who require credit and financial services but can't access them.

Policymakers are working on methods of eliminating poverty. Entrepreneurship has helped many communities develop and escape the hardships of extreme poverty. Seeing this, researchers became curious about the action of the microfinance mechanism and overall outcomes.

Microcredit works to create access to fundamental banking and financial services for those often left out of society. These key services include credits, savings, and insurance products & services. 

Case study: Microfinance Outcomes 

According to  The Latif Jameel Poverty Action Lab, the Microfinance-based approach brings varying outcomes.

Case study: Microfinance Outcomes
Outcome India Mexico Philipines
Ownership Indifferent  Indifferent Indifferent
Revenue  Indifferent Positive difference  Indifferent
Assets  Positive difference No data  Indifferent
Costs  Positive difference  Positive difference  Negative difference 
Profits Indifferent Indifferent Indifferent
Income Indifferent  Indifferent Indifferent
Consumption Indifferent Negative difference  Indifferent
Wellbeing Indifferent Positive difference  Negative difference 

The expansion of microfinance services led to the rise of businesses and the expansion of industrial and economic activities. 

Economic outcomes after the introduction of microfinance have been evaluated on the parameters given above and assessed as indifferent, positively different, and negatively different. 

Critiques of Microfinance

Some of the critiques are:

  1. Financial intermediaries often fail to provide microfinance services to the poor.

  2. The capital investment did not increase significantly, and financial intermediaries failed to empower the poor.

  3. Financial institutions failed to meet set standards and bring in clientele. 

Microcredit FAQs

Researched and Authored by Anannya Sahani 

Reviewed and Edited by Sara De Meyer | LinkedIn

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