Microfinance: Text and Cases
PART I
Text
MARCO ELIA
SESSION 1
What is microfinance?
To respond to a demand of financial services for low income people located mostly in
developing countries, in the 70’s new products and methodologies started to be
developed in an industry known as microfinance. In developing countries, where these
services are more needed, they are often underdeveloped or even absent. Microfinance
aims at filling this gap and give access to financial services such as savings, credit,
insurance and money transfer to people that otherwise would remain unserved.
It is generally accepted that microfinance is a powerful economic development tool.
Microfinance institutions (MFIs) deliver basic financial services to poor and low
income people, or microentrepeneurs, with little or no access to the formal financial
system. MFIs developed specific products and methodologies to overcome the
shortfall of collaterals of clients and therefore make them eligible to get loans and
other financial services.
Microentrepreneurs, or economically active poor, are business people who through
microfinance take advantage of economic opportunities that otherwise would remain
unmatched due to financial constraints. What makes microfinance different from other
anti-poverty tools is the idea of improving the living conditions of the poor through
their own efforts. Credit is given to support “microbusinesses”, allowing low-income
people to respond to economic opportunities. For them the main constraint is a small
investment in working capital, and microcredit allows to overcome this obstacle.
It is important to make clear from the beginning the importance and at the same
time the limits of microfinance. It is an economic development tool among many and
alone it is not the definitive answer to poverty alleviation. Its effectiveness has been
tested and demonstrated but it should be used in conjunction with other tools; the
poorest of the poor, for instance, need other forms of support before being able to
make use of loans. These limitations give the exact background in which microfinance
should be placed as an extraordinary powerful instrument against a particular portion
of poverty.
1.1 Microcredit
A microcredit is a small credit given to a client by a bank or another institution.
Microcredit can be offered, often without collateral, to an individual or through group
lending. Group lending is a mechanism that allows a number of individuals to obtain a
loan through a group scheme. The incentive to repay is based on peer pressure; if one
person in the group defaults, the other group members must make up the payment.
Microfinance: Text and Cases - PART I
amount. Individual lending, in contrast, focuses on one client and does not require the
formation of groups (see session 3 “Methodologies”).
A microfinance institution (MFI) is then a financial institution which can be a non
profit organization, a regulated financial institution or a commercial bank that provides
microfinancial products and services to low-income clients or microentrepreneurs. The
purpose of these organizations is the provision of financial services to those who
would otherwise be excluded from the formal financial system.
The definition of microenterprise varies from country to country but according to
the general definition given by ACCION International, a network of microfinance
institutions (see box 2.1), a microenterprise is “a small-scale business in the informal
sector. Microenterprises often employ less than 5 people, can be based out of the home
and are often the sole source of family income but can also act as a supplement to
other forms of income. Examples of microenterprises include small retail kiosks,
sewing workshops, carpentry shops and market stalls”.
Microcredit has been proven an effective tool against poverty, enabling those
without access to the formal financial system to borrow the small amount of funds they
need and start or develop small businesses.
1.2 Microcredit and microfinance
The use of the terms microcredit and microfinance, mainly for historical reasons, is
sometimes incorrect. The lack of clarity in their use, even in the sector of
development, is the reason why these two ideas must be clearly differentiated from the
beginning.
Microcredit is a part of the field of microfinance. Microcredit is the provision of
credit services to low-income entrepreneurs, while microfinance includes credit,
savings and increasingly additional financial services such as insurance and money
transfer. The evidence showed that for the very poor saving is as important as borrowing: this is indicative of the importance of microfinance as a combination of
different financial services.
The recent shift in terms from microcredit to microfinance reflects the
acknowledgement that saving services, and not just loans, improve the well-being of
the poor and together with insurance, help poor people to stabilize income and to
protect against risks. Money transfer is then another critical service: according to the
World Bank the business of remittances, i.e. the money that emigrants send home to
relatives, is growing strongly and is often managed by informal arrangements with
high charges and high risks.
Clients’ training, provided by some MFIs, is classified as a non-financial service
and is a tool of the broader category of microenterprise development. The correct
definition of microfinance includes only financial services and this is why, even if it is
often provided by MFIs, training is not classified under the term microfinance. See the
figure below.
Figure 1.2 Microenterprise development, microfinance and microcredit
MICROFINANCE NON FINANCIAL
SERVICES
MICROENTERPRISE DEVELOPMENT
• TRAINING
• CONSULTING
• MICROCREDIT
• MICROSAVINGS
• MICROINSURANCE
• MONEY TRANSFER
(REMITTANCES)
The poor need a different range of financial instruments to be able to build assets,
stabilize consumption and protect themselves against risks. The broadening of the
concept of microfinance comes from this basic assumption.
The current practice of using the terms microcredit and microfinance synonymously
needs to be discontinued in order to better understand their different roles in the
industry. The source of confusion is likely to be historical and can be traced back to
the late 1990’s when the term microfinance was first introduced as an extension of the
already well known idea of microcredit. The introduction of the term microfinance
followed the success of many microcredit programmes around the world and in 1997,
during the first Microcredit Summit, 2,900 delegates from 137 countries representing
around 1,500 organisations gathered in Washington, D.C. During that occasion the
birth of the global industry of microfinance was officially recognized. Since then the
focus started to change and move from the predominant welfarist idea, where only the
provision of credit was considered to be important, to the need of becoming financially
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Microfinance: Text and Cases - PART I
sustainable through the provision of a complete range of financial products and to
reach more people.
The “first generation” of institutions, predominantly NGOs, delivered only credit in
almost thirty years starting from the seventies. This added confusion to the use of the
terms and even today serious difficulties still exist in looking at microfinance as a set
of financial products that can be delivered on a sustainable basis. But why did these
institutions provide only credit? They assumed that poor people were unable to save
and that they only needed loans. However it was proved to be untrue; in 1984 when
Bank Rakyat Indonesia (BRI), the biggest MFI in the world (see box below), offered
savings accounts to poor people with no minimum deposit, it achieved extraordinary
success. In December 2003 the microbanking division of BRI recorded 3.1 millions
loan accounts and 29.9 millions savings accounts with an average loan disbursed of
US$542 and average saving balance per account of US$118.
1.3 Who are the clients of microfinance
The clients of microfinance are the “economically active poor” or low-income persons
that do not have access to formal financial institutions. The clients must have
economic opportunities and entrepreneurial skills as the money they receive must not
be used for consumption but for productive purposes. This is the reason why the
poorest of the poor, or the destitute, are generally excluded from the circle of
microfinance and targeted by other development programmes. In figure 1.3 is shown
that most microfinance clients today are around the poverty line. The extreme poor are
rarely reached by microfinance while the microfinancial services are not appropriate
for the destitute and they are better targeted by other social programs.
1.4 Microfinance and moneylenders
Moneylenders are the more direct competitors of MFIs. Poor people, excluded from
the formal financial system, most of the time have the only alternative of this kind of
informal sources of funds. The interests charged almost always far exceed what is
charged by MFIs and borrowers do not have any kind of protection from abusive
behaviours, e.g. abusive lending or unfair loan collection practices.
Once the negative aspects of moneylenders are highlighted it is important to learn
from their positive features that make them close to the poor people and able to
respond to their needs. Such features are simple procedures, clear terms, timely
disbursement and loans backed by the borrowers’ character rather than collaterals. The
innovation of microfinance has been the combination of these positive features into
more formal financial institutions.
1.5 Financial sustainability
To carry on business, financial institutions and in general all corporations, need the
necessary funds. These can be raised in several different ways: they can issue shares
(what is technically called equity) or access what is called debt financing which is
typically in the form of bonds and loans from other financial institutions. Banks can
then collect savings from their clients. Additional resources can come from donations,
grants or soft loans (loans at a below-market rates).
The relative importance of the different sources differs between different financial
institutions. Financial NGOs typically rely on donor subsidies and are not allowed to
collect savings, while commercial banks rely on their own sources of funds, deposits
of the clients (savings) and equity capital. Collecting savings is generally forbidden to
NGOs as a special banking license is needed in order to protect savers in case of the
institution’s default. At present, the main sources of funds for MFIs are charities,
governments and international organizations. Most MFIs rely heavily on donor support
and are not financially viable.
Financial sustainability is the ability of a microfinance provider to cover all of its
costs on an unsubsidized basis. According to the United Nations sustainability is
necessary to reach a larger number of people on an ongoing basis. If MFIs remain
dependent on limited donor funding they will be able to reach only a limited number
of people. Financial sustainability is not an end in itself but is the only way to reach
significant scale.
1.6 Future perspectives
We defined microfinance as the provision of financial services to low income people
that otherwise would be excluded from the formal financial system. I hope that this
definition will become outdated as soon as possible after the commercialization of the
provision of these kind of services and their inclusion into the formal financial
system1. By that time microfinance, accessing the limitless resources available in the
capital market, would reach much more clients and would hopefully fill the present
gap between supply and demand. The risks obtaining this goal are many but there are
plenty of reasons for hope. The most important is the evidence of the progress that the
industry, at an increasing speed, made in the past 30 years.
SESSION 2
Microfinance practices:
the institutionist and welfarist approach
Microfinance, as presented in the first session, is a powerful economic development
tool, with its main feature being the new way it combines banking with social goals.
The traditional image of this industry has, mainly for historical reasons, often been
closer to aid than to business: many microfinance institutions (MFIs), have been nonprofit
organizations separated from the wider formal financial system. It was only in
the 90’s, when the international community started to recognize the importance of
focusing on the institution and its sustainability, that this situation started to change. It
was at that time that the debate between the institutionist and welfarist approach
became of crucial importance.
This session will give a brief overview of the two positions. The scope of this
chapter is to draw a general picture of the problem in order to understand the main
differences that exist within the world of microfinance. It is important to understand
what lies behind the word microfinance when completely different types of institutions
(NGOs vs. commercial banks) deliver similar services and where their commitment to
serve the poor comes from. Furthermore the institutionist idea of delivering
microfinance services through self sufficient institutions is actually supported by the
mainstream international community even though there are many concerns that can
arise from this approach and these will also be discussed.
2.1 The institutionists
The institutionists believe that in order to effectively fight the problem of poverty, it is
necessary to build a microfinance industry able to reach a large number of people.
According to estimates made by the Grameen Foundation USA the actual supply of
microfinance services show a market gap between the potential demand and market
supply of 70%. This means that the majority of people who need these financial
services lack access to them.
In order to reach a large number of people a huge amount of financial resources that
donors cannot provide is necessary. The institutionists start from the basic and evident
assumption that donors cannot subsidize enough MFIs to let them provide financial
services to all of the potential microfinance clients. They state that the only way to
Microfinance: Text and Cases - PART I
overcome this constraint is to attract private sources of capital and this in turn requires
MFIs to be sustainable and profitable.
According to this position sustainable financial institutions that provide financial
services to the poor are necessary if the main goal is a substantial poverty reduction.
The emphasis must be put on breadth of outreach (number of clients reached) rather
than on depth of outreach (level of poverty of clients). If the system is not able to
increase the number of clients reached, it would fail the target of poverty reduction.
Furthermore, institutionists believe that if the approach of building sustainable MFIs is
used the poorest will also benefit from it, while the other way around of targeting the
poorest with highly subsidized programs will have a low overall impact due to the
limited and unstable donor funding.
The institutionist position has clearly obtained success within the microfinance
community. Bank Rakyat Indonesia (BRI), Banco Solidario (BancoSol) in Bolivia, the
Consultative Group to Assist the Poor (CGAP), USAID, The Grameen Foundation,
ACCION International and the World Bank are just some examples of MFIs,
international institutions and networks that clearly accept and follow this approach.
Moreover, most of the literature in the field of microfinance follows the institutionist
position.
2.2 The welfarists
The welfarist approach focuses on depth (number of clients reached) over breadth of
outreach (poverty level of clients) and accept subsidies on an ongoing basis.
Welfarists accept subsidies as they believe that if sustainability is considered as a
necessary requirement, the accomplishment of the social mission of microfinance is at
risk. Microfinance combines banking with social goals and while the institutionists put
much emphasis on the former, welfarists look primarily at the latter. They recognize
the importance of financial self-sufficiency, but without accepting it as necessary.
The center of attention is now the clients rather than the institution (see table 2.1
below for a summary and a comparison of the two positions). Welfarists argue that
for-profit institutions, even if their operations serve low-income people, will inevitably
switch to the better-off of them and to different target groups. This will substantially
force microfinance institutions to lose their social mission.
2.3 Key principles of microfinance
The following “Key principles of microfinance” have been developed by CGAP and
its 28 member donors (see box 2.3) and then endorsed by the Group of Eight leaders at
the G8 Summit in Sea Island (Georgia) on 10 June 2004. They are almost generally
accepted and represent a point of reference for the whole industry. Practitioners and
microfinance operators also refer at them as “Best Practices Microfinance”. Here is
reported, point by point, the document approved in 2004.
1. Poor people need a variety of financial services, not just loans. Like
everyone else, the poor need a range of financial services that are convenient,
flexible, and affordable. Depending on circumstances, they want not only loans,
but also savings, insurance, and cash transfer services.
2. Microfinance is a powerful tool to fight poverty. When poor people
have access to financial services, they can earn more, build their assets, and
cushion themselves against external shocks. Poor households use microfinance to
move from everyday survival to planning for the future: they invest in better
nutrition, housing, health, and education.
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SESSION 2 Microfinance practices: the institutionist and welfarist approach
3. Microfinance means building financial systems that serve the poor. In
most developing countries, poor people are the majority of the population, yet
they are the least likely to be served by banks. Microfinance is often seen as a
marginal sector—a “development” activity that donors, governments, or social
investors might care about, but not as part of the country’s mainstream financial
system. However, microfinance will reach the maximum number of poor clients
only when it is integrated into the financial sector.
4. Microfinance can pay for itself, and must do so if it is to reach very
large numbers of poor people. Most poor people cannot get good financial
services that meet their needs because there are not enough strong institutions
that provide such services. Strong institutions need to charge enough to cover
their costs. Cost recovery is not an end in itself. Rather, it is the only way to
reach scale and impact beyond the limited levels that donors can fund. A
financially sustainable institution can continue and expand its services over the
long term. Achieving sustainability means lowering transaction costs, offering
services that are more useful to the clients, and finding new ways to reach more
of the unbanked poor.
5. Microfinance is about building permanent local financial institutions.
Finance for the poor requires sound domestic financial institutions that provide
services on a permanent basis. These institutions need to attract domestic
savings, recycle those savings into loans, and provide other services. As local
institutions and capital markets mature, there will be less dependence on funding
from donors and governments, including government development banks.
6. Microcredit is not always the answer. Microcredit is not the best tool
for everyone or every situation. Destitute and hungry people with no income or
means of repayment need other kinds of support before they can make good use
of loans. In many cases, other tools will alleviate poverty better—for instance,
small grants, employment and training programs, or infrastructure
improvements. Where possible, such services should be coupled with building
savings.
7. Interest rate ceilings hurt poor people by making it harder for them
to get credit. It costs much more to make many small loans than a few large
loans. Unless microlenders can charge interest rates that are well above average
bank loan rates, they cannot cover their costs. Their growth will be limited by the
scarce and uncertain supply soft money from donors or governments. When
governments regulate interest rates, they usually set them at levels so low that
microcredit cannot cover its costs, so such regulation should be avoided. At the
same time, a microlender should not use high interest rates to make borrowers
cover the cost of its own inefficiency.
8. The role of government is to enable financial services, not to provide
them directly. National governments should set policies that stimulate financial
services for poor people at the same time as protecting deposits. Governments
need to maintain macroeconomic stability, avoid interest rate caps, and refrain
from distorting markets with subsidized, high-default loan programs that cannot
be sustained. They should also clamp down on corruption and improve the
environment for micro-businesses, including access to markets and
infrastructure. In special cases where other funds are unavailable, government
funding may be warranted for sound and independent microfinance institutions.
9. Donor funds should complement private capital, not compete with it.
Donors provide grants, loans, and equity for microfinance. Such support should
be temporary. It should be used to build the capacity of microfinance providers;
to develop supporting infrastructure like rating agencies, credit bureaus, and
audit capacity; and to support experimentation. In some cases, serving sparse or
difficult-to-reach populations can require longer-term donor support. Donors
should try to integrate microfinance with the rest of the financial system. They
should use experts with a track record of success when designing and
implementing projects. They should set clear performance targets that must be
met before funding is continued. Every project should have a realistic plan for
reaching a point where the donor’s support is no longer needed.
10. The key bottleneck is the shortage of strong institutions and
managers. Microfinance is a specialized field that combines banking with social
goals. Skills and systems need to be built at all levels: managers and information
systems of microfinance institutions, central banks that regulate microfinance,
other government agencies, and donors. Public and private investments in
microfinance should focus on building this capacity, not just moving money.
11. Microfinance works best when it measures—and discloses—its
performance. Accurate, standardized performance information is imperative,
both financial information (e.g., interest rates, loan repayment, and cost
recovery) and social information (e.g., number of clients reached and their
poverty level). Donors, investors, banking supervisors, and customers need this
information to judge their cost, risk, and return.
2.4 Final remarks
This session introduced the debate between the institutionists and the welfarists, which
is currently central in the world of microfinance. These approaches have led to very
different institutions, methodologies and products, and have sometimes created
confusion in the exact definition of microfinance. For instance, NGOs have completely
different institutional structure, delivery systems and objectives if compared to
commercial banks. However both are delivering microfinance.
Several microfinance institutions around the world have shown that sustainable
MFIs can reach poor people; this is why I strongly believe that microfinance should
access commercial sources of funds even if the crucial role of welfarist institutions and
donors must be recognized. The role of donations has been very important for the
development of the industry. Subsidized projects have introduced breakthrough
innovations such as the Grameen group lending scheme (see session 3.2.1 dedicated to
the Grameen model) and donations are often necessary in the start up phase of a
microfinance institution to set up the initial, and very expensive, infrastructure.
However, once illustrated these important remarks in favor of the welfarists, must
be stressed that the institutionist vision has been accepted by the mainstream
international community as the only way to achieve significant scale. Substantial
poverty reduction is then possible only through an industry that can provide
microfinance services to a large number of clients and fill the market gap that actually
exists between supply and demand.
SESSION 3
Methodologies
MFIs worldwide developed different methodologies in order to fit the local
environment with the basic microfinance principles. This session will analyse the two
main lending schemes, individual and group lending, and two successful applications
by Bank Rakyat Indonesia and Grameen Bank. Grameen Bank introduced
breakthrough innovations in group lending while Bank Rakhyat, lending to individuals
without the group mechanism, became the biggest MFI in the world
It is not possible to identify a single best product or methodology. What is
extremely successful in a country could fail in a different environment. The Grameen
model succeeded in rural Bangladesh and became a point of reference in the world of
microfinance but failed in other environments. The Grameen model needs strong
social relationships and social cohesion. It will be analysed in depth in this session
together with another successful model with the purpose of underlining the fact that
MFIs must fit local conditions rather than follow general rules.
3.1 Individual lending
Individual lending methodologies use conventional banking methods that have been
downscaled to reach low income people, the target group of microfinance institutions.
Individual lending uses conventional banking methods, being the main difference the
fact that are often accepted non traditional collaterals. These kinds of collaterals are
called alternative collaterals and can be assets such as a bicycle or a table.
Individual lending relies on detailed assessment of the clients’ financial and
economic information gathered and analysed by the loan officer. Loan decisions are
individually tailored based on the specific needs of each applicant and are usually
made after the visit of a loan officer at the house and workplace of the client.
Loan officers are responsible for tracking each loan through updated reports,
sometimes made on a daily basis. Loans officers play a very important role in every
microfinance credit methodology; they must ensure a good repayment record of each
client through the development of updated information and anticipate potential
problems. They need to have an understanding of the different business activities and
to track market developments that might affect repayment behaviour. Data accuracy is
essential. Individual lending organizations put significant effort and time into
understanding their clients’ characteristics and risks and use the information to design
loans that fit with the cash flows of the microbusiness.
3.2 Group lending
Group lending is the disbursement of loans through groups of customers. Group
lending enabled microfinance institutions to deal with the increased costs of making
many small loans and to solve the problem of the lack of collaterals by the customers.
In group lending some costs, such as the screening of potential customers or part of the
monitoring, are shifted from the bank to the clients who are in a better position to
exclude bad known potential customers and to control the use of the funds by the other
group members. There are different group lending techniques that however share
common basic features.
Group members obtain small short term initial loans with a duration ranging from
one month to one year. The amount disbursed usually follows a stepped lending
approach: larger loans are disbursed when previous amounts are repaid. This approach
gives an incentive to repay and allow the institution to build a credit history for every
group and client.
Group members are generally not chosen by the lending institution but are selfselected
by the customers themselves. The average number of members is from 3 to 10
people joined together to guarantee each others’ loans. Loans are then given to
individuals and the group is the guarantee.
Subsequent larger loans depend on on-time repayments of all members of the
group. If one member is delinquent the group is legally responsible for his/her
payment. Instalments are generally weekly or monthly and repayment is guaranteed
collectively.
3.3 Lending methodologies in the Arab region
According to the regional survey that the United Nations Capital Development Fund
published in 2004, group lending is the major lending methodology used by
microfinance institutions in the Arab area: almost 70% of their clients are members of
groups. However, if Morocco is excluded from the calculation, then individual lending
becomes the most popular. Furthermore, in some countries like Yemen the majority of
the institutions use groups but they only have the purpose of reducing costs: there is
some sort of social pressure but group members do not guarantee each other’s
repayment.
The table below, taken from the survey of the United Nations Capital Development
Fund, shows the situation country by country and as an average.
