You are on page 1of 10

About Microfinance

We're glad you'd like to learn more about microfinance.

This page contains information we have gathered from coleagues, friends, and
microfinance organizations we respect to help answer some of your questions.

To go deeper and see a list of other resources - books, websites, and more - please see our
Learn page under Do More.

FAQs about Microfinance
1. What is microfinance?
2. What is an MFI?
3. Why would poor people need financial services?
4. Why don't they just go to a bank?
5. Why don't banks accommodate poor people?
6. Why are microcredit interest rates so high?
7. What are the effects of microfinance?
8. When is microcredit not appropriate?
9. Why do so many MFIs focus on women?
10. Can microfinance be profitable?
11. Is microfinance the solution to poverty?

1. What is microfinance?

"Microfinance is the supply of loans, savings, and other basic financial services to
the poor." (CGAP)

As the financial services of microfinance 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 to take out a $5,000 loan, or be able to open a savings account with an
opening balance of $1,000. Hence – "micro".

2. What is an MFI?

A microfinance institution (MFI) is an organization that provides microfinance
services, ranging 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, microenterprise 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.

An MFI can be broadly defined as any organization—credit union, down-scaled
commercial bank, financial NGO, or credit cooperative—that provides financial
services for the poor." (CGAP)

"The World Bank estimates that there are now over 7000 microfinance
institutions, serving some 16 million poor people in developing countries. The
total cash turnover of MFIs world-wide is estimated at US$2.5 billion and the
potential for new growth is outstanding." - Data Snapshots on Microfinance - The
Virtual Library on Microcredit

3. Why would poor people need financial services?

"The great challenge before us is to address the constraints that exclude people
from full participation in the financial sector... Together, we can and must build
inclusive financial sectors that help people improve their lives."

- Kofi Annan, UN Secretary General

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."- (CGAP)

4. Why don't they just go to a bank?

"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." (CGAP)

Why is this? For a moment pretend that you are a poor goatherder walking into a
bank:

o You don't have any money to open a savings account with
o You don't have any collateral to secure a loan with
o You don't have a credit record as you have never been formally employed
and you've never taken out a loan before
o You might even be unable to complete the necessary paperwork as you are
illiterate.

Formal financial institutions were not designed to help those who don't already
have financial assets – they were designed to help those who do. Imagine trying to
get a loan in the United States without any savings, an employer or a credit report.

So what do poor people do?

"Credit is available from informal commercial and non-commerical 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." (CGAP)
"Poverty is not created by the poor. It is created by the structures of society and
the policies pursued by society. Change the structure as we are doing in
Bangladesh, and you will see that the poor change their own lives. Grameen's
experience demonstrates that, given the support of financial capital, however
small, the poor are fully capable of improving their lives." - Banker to the Poor

- Muhammad Yunus, Grameen Bank, Founder

5. Why don't banks accommodate poor people?

Some do. 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.

6. Why are microcredit interest rates so high?

The nature of microcredit – small loans – is such that interest rates need to be high
to return the cost of the loan.

"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." (CGAP)

7. What are the effects of microfinance?

"Several years ago two friends of mine were speaking with
a group of 40 clients at a micro-bank in South Asia.
Through the translator, they asked the 40 women what
impact the bank had had on the husbands of the non-
borrowers; not their husbands, but the husbands of women
who are not with the bank. The clients said, 'Before we
took our loans, our husbands were day-labourers, working
for others whenever they could find work. When we took
our loans our husbands stopped being day-labourers and worked with us - bicycle
rickshaw, husking rice, growing garlic on leased land. This caused a shortage of
day-labourers in this area, so the husbands of the non-borrowers who were day-
laborers-their wages went up.' That was the impact of this bank on the husbands
of the non-borrowers."

- Sam Daley-Harris, Microcredit Summit Campaign, Director

"Comprehensive impact studies have demonstrated that:

o Microfinance helps very poor households meet basic needs and protect
against risks;
o The use of financial services by low-income households is associated with
improvements in household economic welfare and enterprise stability or
growth;
o By supporting women's economic participation, microfinance helps to
empower women, thus promoting gender-equity and improving household
well-being;
o For almost all significant impacts, the magnitude of impact is positively
related to the length of time that clients have been in the programme."
(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." (CGAP)

"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.

o 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.
o In El Salvador, the weekly income of FINCA clients increased on average
by 145%.
o In India, half of SHARE clients graduated out of poverty.
o In Ghana, 80% of clients of Freedom from Hunger had secondary income
sources, compared to 50% for non-clients.
o In Lombok, Indonesia,
the average income of
Bank Rakyat Indonesia
(BRI) borrowers
increased by 112%,
and 90% of households
graduated out of
poverty.
o In Vietnam, Save the
Children clients
reduced food deficits
from three months to
one month." (CGAP)

8. When is microcredit not appropriate?

"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 programmes
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." (International
Year of Microcredit)

9. Why do so many MFIs focus on women?

"Today I'm a very respected women 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." (CGAP)

10. Can microfinance be profitable?

Yes.

"The November 2001 issue of the MicroBanking Bulletin includes data from 62
self-sufficient MFIs. The average return on assets for this group is 5.5%, which
compares favorably to commercial-bank returns. Indeed, there are grounds for
hope that microfinance can become attractive to mainstream retail bankers.

At the same time, 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 can not 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." (CGAP)

11. Is microfinance
the solution to
poverty?

"My own view is that we
have to approach extreme
poverty a little like the
way in which a doctor
might approach a patient.
By that I mean do a
diagnosis and understand
what is it that is really
ailing the particular
country, the particular region. Sometimes its terrible governance and the question
is how to improve the governance and the hope for the kind of change that is
needed. In other places it's the terrible burden of disease that may be addressable
by good public health measures. In other places it is to show how to grow more
food. In other places its how to get business going and microfinance has proven to
be an incredibly powerful tool.

Once the basics are in place, the people are eating and can survive, then
microfinance can play a huge role in helping a poor community find ways through
the market to get new opportunities, to earn new income, to start saving, making
investments and start the process of climbing the ladder of economic development
in your children, in your business or your farm and continuing up the process of
improving skills, specialisation, new business ventures and so on. We've learnt
that microfinance can be a wonderful tool for that."

- Jeffrey Sachs, The Earth Institute at Columbia University, Director

No. 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.

Microcredit 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).

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 microenterprise 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." (CGAP)