I. Overview

What is microfinance?

Kiva Borrower
Florinda Agustina Garcia Lopez sells aprons in Guatemala. She takes out microloans to grow her business and hopes to provide improved living conditions for her children.
Microfinance is the supply of loans, savings, and other basic financial services to the poor. (http://cgap.org)
 
As these financial services usually involve small amounts of money - small loans, small savings, etc. - the term "microfinance" helps to differentiate 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 or be able to take out a $50,000 loan, or be able to open a savings account with an opening balance of $1,000.
 
It's easy to imagine poor people don't need financial services, but when you think about it they are using these services already, although they might look a little 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 harvest to sell at a later date. They bury cash in the garden or stash it under the mattress. 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 pot as well. The poor also give their money to neighbors to hold or pay local cash 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 needs a small amount of cash. In-kind savings are subject to fluctuations in commodity prices, destruction by insects, fire, thieves, or illness (in the case of livestock). Informal rotating savings groups tend to be small and rotate limited amounts 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. Perhaps most importantly, the poor are more likely to lose their money through fraud or mismanagement in informal savings arrangements than are depositors in formal financial institutions. (http://cgap.org)
 
The poor rarely access services through the formal financial sector. They address their need for financial services through a variety of financial relationships, mostly informal. (http://cgap.org

The history of modern microfinance

Percentage of population living on less than a dollar a day
Percentage of Population living on less than $1 a day (http://wikipedia.org)
Credit unions and lending cooperatives have been around hundreds of years. However, the pioneering of modern microfinance is often credited to Dr. Mohammad Yunus, who began experimenting with lending to poor women in the village of Jobra, Bangladesh during his tenure as a professor of economics at Chittagong University in the 1970s. He would go on to found Grameen Bank in 1983 and win the Nobel Peace Prize in 2006. (http://globalenvision.org)
 
Since then, innovation in microfinance has continued and providers of financial services to the poor continue to evolve. Today, the world bank estimates that about 160 million people in developing countries are served by microfinance. (http://web.worldbank.org)
 

II. Microfinance providers

Microfinance Institutions

A microfinance institution (MFI) is an organization that provides microfinance services. MFIs range from small non-profit organizations to large commercial banks.
 
Historical context can help explain how specialized MFIs developed over the last few decades. Between the 1950s and 1970s, governments and donors focused on providing subsidized agricultural credit to small and marginal farmers, in hopes of raising productivity and incomes. During the 1980s, micro-enterprise credit concentrated on providing loans to poor women to invest in tiny businesses, enabling them to accumulate assets and raise household income and welfare. These experiments resulted in the emergence of nongovernmental organizations (NGOs) that provided 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." (http://cgap.org

Why don't banks serve poor people?

Population With Access to Finance

World population with access to finance (http://worldbank.org)

Formal financial institutions were not designed to help those who don't already have financial assets - they were designed to help those who do. So what do poor people do?
 
Credit is available from informal commercial and non-commercial money-lenders but usually at a very high cost to borrowers. Savings services are available through 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." (http://www.cgap.org/about/faq)
 
Some banks do provide these services, however. 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 microfinance 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 financial services to those who already have money.

III. Costs, interest rates and sustainability

Interest rates (they're high)

Kiva Borrower
Sikiratou Salami is from Togo, she took a loan out to purchase supplies for her cosmetics business and plans to use part of her profits to finance the schooling of her three children.
There are three kinds of costs the MFI has to cover when it makes microloans. The 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 lent, 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 lent. The transaction cost of the $500 loan is not much different from the transaction cost of the $100 loan. Both loans require roughly the same amount of staff time for meeting with the borrower to appraise the loan, processing the loan disbursement 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 represents an annual interest rate of 16%. To break even on the $100 loan, the MFI would need to collect interest of $10 + 1 + $25 = $36, which is an interest rate of 36%. At first glance, a rate this high looks abusive to many people, especially 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 larger because these costs can't be cut below certain minimums. (http://www.cgap.org/about/faq)

Profitability and sustainability of MFIs

Some worry that an excessive concern for profit in microfinance will lead MFIs away from poor clients to serve better-off clients who want larger 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 managers' objectives than an inherent conflict between serving the very poor and profitability. MFIs serving the very poor are showing rapid financial improvement. Microfinance programs like Bangladesh Rural Advancement Committee and ASA in Bangladesh have already demonstrated that very poor clients can be reached profitably: both institutions had profits of more than 4% of assets in 2000.
 
There are cases where microfinance cannot be made profitable, for example, where potential clients are extremely poor and risk-averse or live in remote areas with very low population density. In such settings, microfinance may require continuing subsidies. Whether microfinance is the best use of these subsidies will depend on evidence about its impact on the lives of these clients." (http://www.cgap.org/about/faq)

IV. Microfinance impact and outcomes

Evidence that microfinance works

Kiva Borrower
"Gun Keshari has become a regular borrower of [an MFI] and over time, with the support of small, low-interest loans, Gun Keshari has seen a dramatic improvement in the living standards of her family." - Polly Banks Kiva Fellow, Nepal
According to CGAP, "Comprehensive impact studies have demonstrated that:  Microfinance helps very poor households meet basic needs and protect against risks; The use of financial services by low-income households is associated with improvements in household economic welfare and enterprise stability or growth; By supporting women's economic participation, microfinance helps to empower women, thus promoting gender-equity and improving household well-being; For almost all significant impacts, the magnitude of impact is positively related to the length of time that clients have been in the program." (UNCDF Microfinance)

Poor people, with access to savings, credit, insurance, and other financial services, are more resilient and better able to cope with the everyday crises they face. Even the most rigorous econometric studies have proven that microfinance can smooth consumption levels and significantly reduce the need to sell assets to meet basic needs. With access to microinsurance, poor people can cope with sudden 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 planning and expanding business activities. Many studies show that clients who join and stay in programs have better economic conditions than non-clients, suggesting that programs contribute to these improvements. A few studies have also shown that over a long period of time many clients do actually graduate out of poverty.
 
By reducing vulnerability and increasing earnings and savings, financial services 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 for 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 when needed, rather than go without or wait until their health seriously deteriorates. (http://www.cgap.org/about/faq)
 
Empirical evidence shows that, among the poor, those participating in microfinance programs who had access to financial services were able to improve their well-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, compared to 50% for non-clients.
 
In Lombok, Indonesia, the average income of Bank Rakyat Indonesia (BRI) borrowers increased by 112%, and 90% of households graduated out of poverty.
 
In Vietnam, Save the Children clients reduced food deficits from three months to one month." (http://cgap.org)
Microcredit may be inappropriate where conditions pose severe challenges to loan repayment. For example, populations that are geographically dispersed or have a high incidence of disease may not be suitable microfinance clients. In these cases, grants, infrastructure improvements or education and training programs are 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. (http://yearofmicrocredit.org)
 
 

Microfinance: a good tool for empowering women

Kiva Entrepreneur
"Today I'm a very respected woman 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 to financial services only through women-making women responsible for loans, ensuring 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 financial 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 mobility 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 play a stronger role in decision making.
 
In some programs that have been active over many years, there are even reports of declining levels of violence against women. (http://www.cgap.org/about/faq)

Microfinance is not a silver bullet

Microfinance is but one strategy battling an immense problem.
 
In the last two decades, substantial progress has been made in developing techniques to deliver financial services to the poor on a sustainable basis. Most donor interventions have concentrated on one of these services, microcredit. For microcredit 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 sounds obvious, but microcredit is viewed by some as "one size fits all." Instead, microcredit should be carefully evaluated against the alternatives when choosing the most appropriate intervention tool for a specific situation.

Microfinance PyramidMicrocredit may be inappropriate where conditions pose severe challenges to standard microcredit methodologies. Populations that are geographically dispersed or nomadic may not be suitable microfinance candidates. Microfinance may not be appropriate 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 presence of hyperinflation, or absence of law and order may stress the ability of microfinance to operate. Microcredit is also much more difficult when laws and regulations create significant barriers to the sustainability of microfinance providers (for example, by mandating interest-rate caps). (http://www.cgap.org/about/faq)
 
While microfinance can not reach all economic segments of society, it has been shown to reach segments previously un-serviced by other financial markets.

Examples of some alternative strategies

Grants can be used to help overcome the social isolation, lack of productive skills, and low self-confidence of the extreme poor, and to prepare them for eventual use of microcredit. Small grants and other financial entitlements can work well as first steps to "graduate" the poor from vulnerability to economic self-sufficiency. A successful example is the BRAC Income Generation for Vulnerable Groups Development program in Bangladesh. This program has graduated more than 660,000 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, provide a foundation for economic activities. Community-level investments in commercial or productive infrastructure (such as market centers or small-scale irrigation 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 donors.
 
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 access to market opportunities stimulates - and depends on - securing credit to cover the costs (product design, transport, etc.) of taking advantage of those opportunities.
 
Legal and institutional reforms can create incentives for microfinance by improving the operating environment for both microfinance providers and their clients. For example, streamlining micro-enterprise registration, abolishing caps on interest rates, loosening regulations governing non-mortgage collateral, strengthening the judicial system, and reducing the cost and time of property and asset registration can foster a supportive climate for microfinance. (http://cgap.org)


V. How can I learn more?

Additional resources

For more information about microfinance, check out our Learn page.

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