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What is 'Microfinance'
A type of banking service that is provided to unemployed or low-income
individuals or groups who would otherwise have no other means of gaining
financial services. Ultimately, the goal of microfinance is to give low income
people an opportunity to become self-sufficient by providing a means of saving
money, borrowing money and insurance.

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BREAKING DOWN 'Microfinance'

Microfinancing is not a new concept. Small microcredit operations have existed
since the mid 1700s. Although most modern microfinance institutions operate in
developing countries, the rate of payment default for loans is surprisingly low more than 90% of loans are repaid.
Like conventional banking operations, microfinance institutions must charge
their lendersinterests on loans. While these interest rates are generally lower than
those offered by normal banks, some opponents of this concept condemn
microfinance operations for making profits off of the poor.

The World Bank estimates that there are more than 500 million people who have
directly or indirectly benefited from microfinance-related operations.

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About Microfinance

Microfinance is a general term to describe financial services to low-income individuals or to those

who do not have access to typical banking services.
Microfinance is also the idea that low-income individuals are capable of lifting themselves out of
poverty if given access to financial services. While some studies indicate that microfinance can play
a role in the battle against poverty, it is also recognized that is not always the appropriate method,
and that it should never be seen as the only tool for ending poverty.
Table of Contents
Overview
I.
What is microfinance?
II.
The history of modern microfinance
II.
Microfinance providers
I.
Microfinance Institutions
II.
Why don't banks serve poor people?
III.
Costs, interest rates and sustainability
I.
Interest rates (they're high)
II.
Profitability and sustainability of MFIs
IV.
Microfinance impact and outcomes
I.
Evidence that microfinance works
II.
Microfinance: a good tool for empowering women
III.
Microfinance is not a silver bullet
IV.
Examples of some alternative strategies
V.
How can I learn more?
I.
Additional resources
II.
Become a Kiva lender
I.

I. Overview
What is microfinance?

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 $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)

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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?

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.

back to top

III. Costs, interest rates and sustainability

Interest rates (they're high)

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)

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IV. Microfinance impact and outcomes

Evidence that microfinance works

"Gun Keshari has become a regular

borrower of [an MFI] and over time,
with the support of small, lowinterest 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 nonclients, 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

"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 womenmicrofinance 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.

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). (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 selfconfidence 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 nonmortgage 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)

back to top

V. How can I learn more?

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

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