Micro-finance Explained : A Sneak Peek into the World of Micro-finance

Micro-finance has become a buzzword in the social sector and viewed as a silver bullet for eradicating poverty. This column is designed to help you gain some basic knowledge on micro-finance, it’s role in poverty alleviation and the current happenings in this space.

What is Micro-finance?

Micro-finance refers to providing financial services – credit and savings ‐ to the poor who are running small businesses or would like to start one and are in need of capital. Small loans for small businesses, with focus on providing credit is the way the industry has evolved over the past 30 years. In our world it’s relatively easy to obtain credit, we have banks who are more than eager to give loans however on the other hand banks are reluctant to service the poor as they often do not have the required collateral and are considered high-risk by any self respecting bank. With the banking system out of their realm, the poor (earning less than $2 a day) often fall prey to private moneylenders who loan at high interest rates and subsequently becoming debtors for life and forever remaining in the clutches of poverty.

With the coming of age of micro-finance institutions (MFIs) in the 1970s, financial services were made available to the poor to provide them loans to run small businesses, build assets, ease consumption, and manage risks. In addition they offered freedom from loan sharks.

How Micro-finance works on the ground

In rural areas and urban slums, small groups of family members and friends are created. These groups mostly comprise of women as they are considered more responsible when it comes to managing money. These groups are overseen by MFI officers who create rules around savings and lending amongst group members. As per general practice, after a few members of the group are accepted for a loan, the rest have to wait for that initial loan to be re-paid before they can obtain their own loans. Peer pressure from group members to repay the initial loan helps maintain a high rate of loan repayments.

How MFIs can help the poor

With access to financial services, the poor are able to obtain small loans at nominal interest to expand or start new businesses. This generates income to improve their living conditions. By starting small micro enterprises such as tailoring, masonry, they are able to create employment for themselves and others. Further facilities for depositing savings with MFIs makes savings a habit.

High repayment rates due to solidarity group lending (in which every member of a group guarantees the repayment of all members) and nominal interest rates helps MFIs to achieve economic sustainability and to scale and grow their financial services for the poor.

Muhammad Yunus, the pioneer of micro-finance first came across the idea of micro-credit while studying the lives of poor entrepreneurs in his native Bangladesh during the famine of 1974. He began by loaning to groups of women, and his program soon proved that small loans could not only quickly improve lives but were paid back with interest and on time. He founded the famous Grameen Bank and won the 2006 noble prize for pioneering and evangelizing the concept of micro-finance

Current State of Micro-Finance within the Sector

Since the early experiments of micro-finance in 1970s which proved poor to be credit worthy, micro-finance institutions has blossomed all across in the developing world. 3,552 micro finance institutions world over provided loans to 155 million clients as per the findings of State of Micro-credit Summit Campaign report 2009. Given the high repayment rates even the commercial banks have jumped in to provide loans and make profit from this segment that they had earlier dismissed as “unbankable”. The profitability from lending to the poor has led micro-finance institutions to raise money from commercial investors such as banks, private-equity firms and in 2007 a large MFI in Mexico, BANCO Compartomos went public.

In recent years the industry has dramatically shifted from its original goal of social maximization to profit maximization. Due to the interplay with commercial investors, high profits are being generated off the poor by charging non transparent prices. High interest rates, multiple lending and tremendous group pressure from non-repayment has led to a string of suicides in the state of Andhra Pradesh, India and many say this is just the beginning.

Micro-finance is currently faced with new challenges and criticism due to the commercialization trends. Further questions are also being raised whether the premise on which the loans are made (i.e for starting micro enterprises) are valid, since borrowers often lack business acumen to grow and sustain the business and often fail.

Micro-finance has definitely helped extend financial services to a market which was totally ignored by the mainstream banks and exploited by loan sharks – however the industry would require higher transparency and tighter regulation to keep true to its original intent of helping the poor.