What is Micro Finance?

History — Microfinance emerged in the 1970s as social innovators began to offer financial services to the working poor — those who were previously considered “un-bankable” because of their lack of collateral. Once given the opportunity, not only did clients of MFIs expand their businesses and increase their incomes, but their high repayment rates demonstrated that the poor are capable of transforming their own lives given the chance. This model of lending disproved all conventional thinking. Microfinance was born. Since then, microfinance has become one of the most sustainable and effective tools in the fight against global poverty.

How microfinance works ?

The most common microfinance product is a microcredit loan — usually less than $100. These tiny loans are enough for hardworking micro-entrepreneurs to start or expand small businesses such as weaving baskets, raising chickens, or buying wholesale products to sell in a market. Income from these businesses provides better food, housing, health care and education for entire families, and most important, additional income provides hope for a better future.

In addition, the poor, like all of us, need a secure place to save their money and access to insurance for their homes, businesses and health. Microfinance institutions (MFIs) are now innovating to help meet these needs, empowering the world’s poor to improve their own lives.

The global repayment rate for microcredit loans is higher than 95 percent, which allows MFIs to re-lend these funds to even more clients. By giving the world’s poor a hand up, not a handout, microfinance can help break the cycle of poverty in as little as a single generation.

DETAILS ABOUT MICROFINANCE

The traditional banking system requires that a borrower have collateral to receive a loan. The world’s poorest people have no such collateral. Further, traditional banks are not generally interested in issuing small loans — $50 to $150 — as the interest benefits do not exceed the transaction costs. That said, how has microfinance been so successful?Microfinance institutions exist in many forms — credit unions, commercial banks and, most often, non-governmental organizations (NGOs). Many microfinance institutions (MFIs) use social collateral in the form of peer groups to ensure loan repayment. Borrowers take out loans in groups of five to eight individuals. If a borrower defaults on her loan, the entire group typically is penalized and sometimes barred altogether from taking further loans. This peer pressure encourages borrowers to be very selective about their peer group members and to repay loans in full and on time, resulting in the higher than 95 percent repayment rates industry-wide.

Microcredit loan cycles are usually shorter than traditional commercial loans — typically six months to a year with payments plus interest, due weekly. Shorter loan cycles and weekly payments help the borrowers stay current and not become overwhelmed by large payments.

Clearly the transaction-intense nature of weekly payment collections, often in rural areas, is more expensive than running a bank branch that provides large loans to economically secure borrowers in a metropolitan area. As a result, MFIs must charge interest rates that might sound high — the average global rate is about 35 percent annually — to cover their costs.

For a financial institution to scale and remain sustainable, at a bare minimum it has to cover its costs. In the example below, a large bank (big lender) can charge anything over 14 percent to recoup its costs, whereas the MFI has to charge a rate of at least 31 percent to cover its costs. So what about price regulations for microcredit loans in the form of interest rate ceilings or subsidies to help reduce the rates charged to borrowers? Although many types of price regulation might be well-meaning, in reality they can cause a fatal blow to the MFIs that they affect. When MFIs are required to charge a pre-determined interest rate, which is usually much below the cost that the MFI incurs, MFIs are often forced to go out of business. As a result, those who the MFI would have served are left without access to any financial services at all — this type of regulation often is a disservice to the very people it’s meant to protect.

One should note that although MFIs may charge rates of 30 to 70 percent to cover their costs, these interest rates are still significantly lower than the 300 percent to 3,000 percent annual rates that many borrowers were previously paying to money lenders, and are typical of the local credit card interest rates.

IMPACT OF MICROFINANCE

There are many reasons why women have become the primary target of microfinance services. At a macro level, it is because 70 percent of the world’s poor are women. Women have a higher unemployment rate than men in virtually every country and make up the majority of the informal sector of most economies. They constitute the bulk of those who need microfinance services.

Targeting women has also proved to be a successful, efficient economic development tool. Research performed by the United Nations Development Programme (UNDP) and the World Bank, among others, indicates that gender inequalities inhibit overall economic growth and development. A recent World Bank report confirms that societies that discriminate on the basis of gender pay the cost of greater poverty, slower economic growth, weaker governance, and a lower living standard for all people.

Women are usually the primary or sole family caretakers in many developing countries. Helping them gain additional daily income improves the condition of their entire household. Putting extra income in women’s hands is often the most efficient way to affect an entire family, as women typically put their children’s needs before their own. Children are more likely to complete their education and escape the poverty trap than their parents are. Giving women access to microcredit loans therefore generates a multiplier effect that increases the impact of a microfinance institution’s activities, benefiting multiple generations.

Source: Unitus