Module One

© 2012 Frankfurt School of Finance & Management
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in Microfinance
Module 1: Microfinance - International
Trends and Best Practice
Symbols:
Initial Scenario
Definition
Example
Remember
Further Reading
4. edition 02/2012
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Content
1 Financial system ................................................... 1
2 Problems of the poor ............................................ 7
3 Problems of financial intermediaries.....................11
4 The household economy ..................................... 15
5 Surplus and deficit .............................................. 19
6 Financial services demanded by the poor............ 21
7 Financial institutions ........................................... 27
8 The history of microfinance ................................. 39
9 Principles of microfinance ................................... 45
10 The role of regulation in microfinance ................. 51
11 Supervision of MFIs ............................................ 57
12 International trends and new technologies .......... 61
13 Exercise results .................................................. 69

1 Financial system
2004-05_HongKong_0002 by Hajo Schatz
National and international economies cannot function without financial

systems. Financial systems are crucial to the allocation of resources in
a modern economy. They channel household savings to the corporate
sector and allocate investment funds among firms; they allow smoothing
of consumption by households and expenditures by firms; and they
enable households and firms to share risks.
Financial system
A financial system comprises a set of complex and closely

interconnected financial institutions, markets, instruments, services,
practices, and transactions. Its main function is to intermediate money
between savers and borrowers.
Research from the 1960s and 1970s by Raymond Goldsmith, John

Gurley, Edward Shaw, Ronald McKinnon and others demonstrated that
the financial sectors in developed economies were generally
proportionately larger relative to the total economy than the financial
sectors in developing economies. In the latter countries deposits were
not efficiently intermediated for investment outside the financial sector
and money could not play its full economic role because holding it was
not a sufficiently attractive alternative, and the evaluation and sharing of
risks was suboptimal from a welfare perspective. The financial system in
many developing countries was considered to be repressed by low
interest rate ceilings, lack of competition in banking, high required
reserves and directed credit programs and credit quotas. As a response
to these research findings, the financial systems approach to
© 2012 Frankfurt School of Finance & Management 1

development finance gained popularity from the 1970s onwards. This
approach consists of liberalization or selective deregulation of
financial markets, creating a more or less free market for financial
services and transactions. It replaced earlier emphasis on targeting
credit use, creating specialized government-owned lenders, and keeping
interest rates low. In so doing modern microfinance which depends on
relatively high interest rates could develop.
Pischke, J.D. (1998): The Financial Systems Approach to

Development Finance and Reflections on Its Implementation
In later years, the financial system development approach was further

refined (see later chapters in this module), but remained rooted in the
“free market credo”:
Essentially, financial markets operate according to the same principles

and mechanisms as every other market. The determinants are supply
and demand for a certain good as well as the price that strikes a
balance between the two. The product traded on a financial market is
money. The price for the product 'money' is called interest.
The suppliers of monetary capital on the one side are primarily private
households that do not consume all their income at a certain point in
time and instead save a certain portion for future, frequently unforeseen
expenditure. This is why they are called savers or financial surplus
units. Those demanding money on the other side are companies facing
a basic problem: the investment required for production and the outlay
of funds entailed precedes the influx of funds from the sale of their
products. By the nature of their activity, they require capital and are
termed financial deficit units or investors.
If there were no banks, supply and demand for funds would reach
equilibrium in direct contact between financial surplus and deficit units.
This equilibrium does not, however, come about in reality, because fund
providers (savers) and those demanding funds (investors) usually
cannot meet each other in person – imagine a businessman who needs
a loan of 1 million Rupees, he would have to search hundreds of small
savers. Direct contact between savers and borrowers would cause
enormous efforts and high costs for both parties involved. The likelihood
of finding just the right person is very small.
Moreover, the capital provider is exposed to a high degree of

uncertainty as to the willingness and ability of the borrower to repay.
Fund providers generally look for investments with lower risk than those
usually proffered by investors/borrowers seeking capital. Due to
fundamental information and confidence problems, direct financial
relationships are very rare.
All savers can do, therefore, is simply keep their savings themselves or
invest them themselves. In general, though, it is safe to assume that
savers or surplus units do not necessarily want to invest or cannot
invest efficiently. Savers prefer high liquidity and have an interest in
© 2012Frankfurt School of Finance & Management 2

safe ways of depositing their money and at least retaining its value.
From the economic vantage point, the resultant investment behaviour,
i.e. saving in the form of cash and physical assets with comparatively
low profitability, means a very inefficient allocation of resources. Savers
are thus unable to play a role as prospective capital providers.
Without suppliers of capital, i.e. savers, investors in turn are left to their
own resources, i.e. self-finance. The problem here is that not every
prospective investor has the funds required at his disposal. Investment
opportunities are thus restricted by the investor's own capital resources.
As a result, full use is not made of investment opportunities,
investments are only made after a certain saving-up phase or they are
not made at all.
Due to basic information and confidence problems, direct financial

relationships between savers and investors are only found within social
groups, e.g. in village communities or amongst families and friends,
where the individual members know each other personally and a large
degree of mutual confidence exists.
Direct financial relationships afford decisive advantages for both parties.

A prospective investor can make investments that exceed his personal
resources; capital formation becomes more flexible and thus efficient.
As a rule, for the savers it is more convenient to assign their savings
temporarily to an investor than look for investment opportunities
themselves. This affords them a type of investment that combines
liquidity and yield as they require, since they can negotiate maturity and
interest rates with the borrower.
Even if the information and confidence problems are mitigated or

remedied there are structural obstacles to direct financial relationships
stemming from differing preferences of savers and investors regarding
the mode of finance. A financial relationship therefore presupposes
broad agreement on amount, term, risk and expected return between
the borrower and the lender. However, these points give rise to
considerable conflicts of interest:
Amounts differ: private households and individuals save up in

small, sometimes tiny amounts, while investments as a rule require
large sums. An investor must therefore seek several capital providers
to finance a larger-scale investment project.
Due to their high liquidity preference, savers general favour short
maturities, whereas borrowers tend to need medium-term to long-
term periods to finance an investment.
Savers are averse to risk and demand maximum security for their
financial investment. Investors, in contrast, cannot as a rule
guarantee the funds invested without the risk of loss entailed in any
business venture.
Savers are looking for a maximum return on investment, while
investors seek to minimize finance costs.

Due to these contrary interests, direct financial relationships between
surplus and deficit units are difficult. Even when capital providers and
borrowers meet, the odds in favour of completing a contract are low due
to differing preferences. Direct exchange between savers and investors
is confined to small sums, is laborious and time-consuming and only
possible where both parties are prepared to make concessions and
compromises. Also, the prolonged mutual search for capital market
players hampers the implementation of larger investment projects.
Therefore, specialized financial intermediation makes perfect
economic sense.
Financial intermediation
A financial institution uses borrowed funds and own equity capital to

invest them in financial assets, such as loans. Thus, financial
institutions intermediate between savers and borrowers.
The role of financial institutions within the financial system is primarily to

intermediate between those that provide funds and those that need
funds, and typically involves transforming and managing risk.
Particularly for a deposit-taker (bank), this risk arises from its role in
maturity transformation, where liabilities are typically short term, while
loans have a longer maturity.
Financial institutions play a key role as financial intermediaries. They

provide a market where savers and borrowers can ‘meet’ without
meeting in person. Savers and borrowers enter into a mutually
independent relationship with the financial institution. So - unlike
direct financial relationships - the capital provider and borrower do not
need to know each other personally; instead the transaction is largely
anonymous. This considerably reduces search and information costs for
both parties.
The relationship between savers, borrowers / investors and the

financial intermediary is depicted in the figure 1 which reminds us of a
heart and two lungs. The financial institution (intermediary) takes up
savings and channels these deposits to the borrowers / investors. The
triangles in the lower part of the picture represent the relationship of
demand (D), supply (S) and interest rate (i): the interest rate paid by
the financial institution to the savers depends on the supply of funds and
the demand for funds; similarly, the interest rate charged by the
financial institution from the borrowers depends on the demand for loans
and the supply of funds. The difference between both interest rates is
the margin earned by the intermediary.

Figure 1: Financial intermediation (“The Lung”)
General macroeconomic and legal conditions
Saving Lending
Financial institutions
S D S D
N
i i
In an advanced financial system, financial intermediaries perform the

following tasks and functions:
Mediating between those who supply and those who demand funds
Transforming mostly small deposits into larger loans
Appraising, selecting and monitoring borrowers
Handling and managing payments transactions and securities
trading
Creating money, e.g. by creating bank deposit money
Financial intermediaries provide three important transformation
services: size, term, risk.
Financial transformation
Financial institutions transform small and short term deposits into

larger and longer term loans and thereby take over the lending risk
from the saver.
Through transformation of size, financial intermediaries perform a

quantitative transformation with a view to the various quantities of
monetary capital available and in demand. Unit transformation involves
pooling small savings deposits and transforming them into larger loans.

A large number of deposits stemming mostly from private households
are set off against a comparatively low number of loans, primarily to
enterprises. The average deposit amount is well below the average loan
amount. Thus banks relieve the single borrower from the task of seeking
fund providers with sufficient investment capital and enable small savers
to provide their money indirectly to large borrowers.
Through transformation of term, financial intermediaries can match a

large part of the various term requirements of capital providers and
borrowers. It is done by taking largely short-term savings deposits and
transforming these funds into medium-term and long-term loans. This is
possible because some of the depositors, e.g. with savings deposits
with legally-binding periods of notice, formally reserve the right to
withdraw at any time but in fact rarely make use of that option. The
effective deposit period of part of the savings averages some years.
This deposit base can therefore be lent out as medium-term to long-
term credit. When transforming maturities, however, the financial
intermediary incurs liquidity and interest rate risks.
Transformation of risk is one of the most important processing

functions in financial intermediation. It strikes a balance between the
various anticipated risks of capital providers and borrowers. As distinct
from the situation in direct financial relationships, the capital provider no
longer needs to bear the direct risk of a borrower’s investment. The dual
task of credit institutions is to safeguard deposits while bearing the
inevitable risk of loan loss in lending. Thanks to professional risk
management the financial institutions are able to limit the various risks
entailed in lending.
Financial intermediation is crucial for a functioning economy. People

who have no access to financial intermediation have difficulties to get
loans and face a higher risk of losing their savings. They often miss
out on good investment opportunities and usually have to pay very
high interest rates on loans while receiving no interest on their
savings.
Exercise for Chapter 1
The advantage of financial institutions towards money lenders is that

they can use their size to create financial intermediation.
Estimate the level of interest rates a borrower would have to pay in
the following two scenarios, assuming the bank deposit rate would be
20% p.a.:
1. A money lender has USD 10,000 and there are 1000 people who
want a loan of USD 100 each.
2. A bank has USD 1 million in deposits and there are 1000 people
who want a loan of USD 1000 each.
Solutions: Please refer to chapter 13.

2 Problems of the poor
Luigi Guarino - Fabric shop
Initial scenario
Julia runs a small shop in the outskirts of a large city. She has been
doing good business during the last three years and invested most of
her savings in stock for the shop. Now, Julia has the idea to make her
shop larger and also sell home-made foods. She asks family members,
friends and neighbours for a loan to make her dream come true.
However, nobody can help her. Therefore, for the first time in her life,
Julia decides to go to a bank to ask for a loan. She is very nervous
when she enters the big bank building and feels lost in the main hall;
then, she asks one of the customers where to get credit from. He points
her to a small office where a long queue of people is waiting. Julia waits
for almost one hour, finally it is her turn. She explains her case to the
credit officer who tells her to make it short since he is very busy. After
one minute he cuts her off and hands her a list of things she has to
provide if she wants to apply for a loan:
1. Proof that the shop and the land belongs to her;

2. Financial records of the last two years;
3. Business license.
The credit officer also explains that one has to pay a USD 5 loan
application fee and that Julia would have to pledge her land as collateral
since she is a new customer. Julia leaves the bank and goes to the
money-lender who lives around the corner. He charges three times more
interest than the bank but Julia gets a loan within one hour.

Access to financial intermediation is a key to economic development.
However, many people don’t have access to formal financial institutions
and instead rely on informal financial intermediaries, such as money-
lenders who handle small amounts of money and therefore lack
economies of scale and transformation capacity. There are many
reasons why poor people do not have access to formal financial
institutions, for example:
Poor people rarely have regular incomes

They lack equity capital (reserves)
They lack assets which they could use as loan collateral
Irregular incomes and low equity capital forces poor people to have
short-term planning horizons
Due to the above aspects bankers usually consider poor people not
creditworthy
Many bankers also assume that poor people have low repayment
discipline
Poor people often are risk-averse, they fear indebtedness and are
uncertain about their repayment ability
Poor people often lack self-confidence and are wary of embarking
on something new
Poor people have a lack of information about financing and
business opportunities
Poor people often lack confidence in the financial system or in
certain financial institutions
How do the poor handle their money matters? Generally, they save in
kind (animals, jewellery, gold) or keep cash at home. In many countries
the poor form small groups whose members lend to each other. Other
sources of credit are family members, neighbours, friends, traders,
shop-keepers, or so-called moneylenders (often small business people
who lend to others who they know personally and therefore can control
easily). The interest rates money-lenders charge may seem very high
(100% p.a. and more) but they may well be the best option for a poor
person because:
The loan is given immediately, whereas a bank would take weeks to

process a loan application; poor people often borrow in emergency!
There is no paperwork, no red tape, no travelling involved; money-
lenders usually live near-by and loan agreements are made orally
The money-lender requires no collateral or takes securities which a
bank would not accept, such as jewellery or farm products
The borrower may be allowed to repay whenever s/he can, whereas
a bank has fixed repayment schedules

World Bank (2007): Finance for All? Policies and Pitfalls in
Expanding Access
Microfinance providers should learn from informal financial

intermediation when designing their approach: simple products, fast
processing and convenient services. In addition, microfinance
providers can beat informal financial intermediation in terms of pricing
(interest rate) and in terms of security.
Read the example at the beginning of this chapter and find typical
characteristics and problems of poor people in Julia's story!

3 Problems of financial
intermediaries
Moneychangers by neajjean
Initial scenario (continued)
James is a loan officer in a medium size bank in the outskirts of the big
city where also Julia lives. He is a very busy man, handling more than
200 customers. Every day dozens of people are queuing outside his
office, asking for a loan. James knows that most people don’t tell the
truth when they talk about their business - for example, this woman
called Julia who dropped into his office the other day. She said that she
had been running a shop for the last three years and that the land where
the shop is located belongs to her. She also said that business was
going well and that she now plans to make the shop larger and also sell
home-made foods. However, she had no business records, no land title,
no bank account and no cash savings. And besides, James had never
heard of her shop nor knew any of the shop customers. He gave the
woman a list of papers she had to provide but she never came back –
she probably was another liar.
There are many reasons why formal financial intermediaries usually

consider poor people not bankable. First of all, the banking
regulations in a country may be averse to lending to the poor, for
instance due to interest rate caps. Secondly, poor people lack

securities and dependable income streams and dealing with them is
considered to be not profitable (high administrative costs relative to low
revenues), high risk and burdensome. Assets of poor are usually
movable assets. In developed countries, these might be accepted by
some banks as securities, but in developing countries with less reliable
legal systems, this is often seen as too risky. There are also many
information problems, for example because poor people don’t have
business records or a banking history. Physical and social distance
between bankers and the poor also play an important role. Poor people
often mistrust banks and moral hazard is very likely. Finally, non-
deposit taking institutions may find it difficult to get refinance for
unsecured lending to the poor.
Conning, Jonathan; Kevane, and Michael (2003): Why isn’t there

more Financial Intermediation in Developing Countries?
Security
Banks and other financial institutions usually ask borrowers to provide
securities for a loan. The value of a loan security is often higher than
the loan amount. The most common security is collateral, i.e. any item
that belongs to the borrower and can legally be pledged to the lender;
in case of loan default the lender becomes owner of the collateral.
Another common form of security is the personal guarantee where a
third party guarantees a loan and has to pay the outstanding loan
amount in case of loan default.
Moral Hazard
Moral hazard occurs when the party with more information about its
actions or intentions behaves inappropriately from the perspective of
the party with less information – for example, a borrower may take a
business loan but actually use the money for another purpose.
The ultimate purpose of microfinance is not to give poor people

access to credit, but to have sustainable institutions offer a full range
of financial services to the poor, foremost savings services, but also
credit, insurances and money transfer services.

Exercises for Chapter 3
Which of the following statements are wrong?
1. Poor people save in kind because they expect higher returns on

material investments compared to savings deposits.
2. Banks usually don’t give loans to poor people because the
administrative cost is too high compared to the expected interest
revenue.
3. Poor people are bad credit customers. They don’t pay back loans
on time.
4. Poor people are too poor to save.
5. Without proper business records it is difficult for a normal bank to
grant a small business loan.
6. In many countries banks legally have to put 100% capital against
unsecured loans in their balance sheet. This reduces their capital
leverage.

4 The household economy
Money Lender, Mumbai, India.JPG by gruntzooki
Julia runs a small shop in the outskirts of a big city. When she asked for
a bank loan, James, the loan officer, didn’t trust her. Therefore, Julia
took a loan from the local money-lender. He trusts Julia. Why? Well, he
knew what James did not know: that Julia’s husband is working on a
near-by construction site and is earning a regular salary; that Julia’s
eldest daughter has a cleaning job in another state and sends home
money once in a while; that Julia’s shop is very popular with the local
people because it is very clean and located near a busy bus stand; and
most of all that Julia is a honest person and has been running the shop
successfully during the last three years.
The target groups of microfinance are members of poorer sections of

the population in both urban and rural areas. Microfinance is most
successful with the economically active poor, e.g. farmers, the self-
employed, micro-entrepreneurs. The poor in developing countries share
a number of common features that have a bearing on their financial
needs:
As a rule, poorer households are not paid employees: They operate

as household or family enterprises (self-employed).
Their activity is mostly informal, i.e. they are not registered as
companies. They usually do not maintain books and business
accounts.
Poor households frequently pursue several economic activities
simultaneously and therefore draw on multiple sources of income.

Poorer family enterprises usually have few assets and frequently
operate with inadequate fixed and current assets. They rely on
labour instead of capital.
Informal household enterprises operate in a climate of great
uncertainty. That is why risk minimization is given precedence over
the usual business goal of maximizing income.
In family enterprises it is impossible to draw a clear dividing line
between consumption and production. For example, the living
quarters are also the production centre, workshop, stockroom, sales
room, etc. A particular problem is the fungibility of funds since it is
difficult for a lender to determine what a loan paid in cash is actually
used for.
Fungibility
Money is inter-changeable or highly fungible as the household budget

shifts between consumption and investment in response to changing
needs and opportunities. The divide between business and personal
assets is often not clear.
Household economy
Poor families do not strictly separate business and private life. Any
cash that they earn is pooled together and all private and business
expenses are paid out of this pool.
The household economy of the poor is best described in the allegory

of a bathtub. Cash inflows from various sources are pooled in the tub
and this pool of money is used to pay for all kinds of expenses,
consumptive and productive ones. Every household has its own priority
in terms of expenses: for example, if the cash inflow is decreasing, a
household could decide to reduce food expenses but maintain the
expenses for running a shop, or vice versa. A lender should understand
the typical household economy of his clients in order to make suitable
loan decisions.

Figure 2: Household economy (“The bathtub”)
Income from Daughter’s Husband’s

shop sales remittances salary
Expenses for food Expenses for

and housing running the shop
Cash flow
The cash flow of a business or household consists of the inflow of

cash (revenues) and the outflow of cash (expenses) during a certain
period of time. Businesses or households that cannot maintain
positive cash flows are considered bankrupt.
Important: do not confuse cash flow with profit; the latter refers to a
“book value”, not to real cash transactions (for example, a shop can
be profitable but bankrupt if customers buy goods on credit but do not
pay in cash and therefore the shop owner does not have sufficient
cash to pay his suppliers)
Collins, Daryl et al. (2009): Portfolios of the Poor – How the World’s
Poor Live on $2 a Day
Microfinance institutions need to understand the household economy

of their customers when designing approach and financial services.
For example, many poor families save fixed amounts of money every
day or week despite fluctuating incomes – a good opportunity for
savings products. With regard to micro-loans, it is important to
understand that money is fungible and that loan repayment depends
on the total cash flow situation of a household and its expense
priorities. Loan products should be flexible in terms of amount,
purpose, duration and repayment schedule.

Which items belong to the household economy of a family?
1. The weekly salary of the husband
2. The pension the husband will get when he retires in three years.
3. The money the daughter pays every day for food at university.
4. The gold earrings of the wife.
5. The ten chicken in the family backyard.
6. The cake given to the next door neighbour on her birthday

5 Surplus and deficit
Diwali candles by San Sharma
Julia, the shop-keeper, has finally managed to make her shop larger
and sell home-made foods. In the first month business is going very well
but then suddenly sales drop sharply for several weeks, and slightly
increase again thereafter. What happened? Before and during the
holiday season, people were spending lots of money on food. But once
the holidays were over, people were short of cash and reduced
spending; later they returned to normal spending patterns. This is a
normal business cycle and Julia is well aware of it. Therefore, she has
prepared for it by saving up surplus income from the holiday season.
Thus, Julia managed to pay her daily bills even during the weeks after
holidays when revenues were lower than expenses.
A fundamental problem for poor people is that income and expenditure

do not usually coincide. There are times when expenses are greater
than income. For such time periods, poor people prepare by saving up
in kind or cash. Sometimes, they also need to borrow to bridge over
lean times. Another discrepancy results from the life cycle. Young
people earn a surplus in income, while older people spend more than
they earn.
Surplus & deficit
When cash revenues are greater than cash expenses the household
economy has a cash surplus. When cash expenses are greater than
cash revenues the household economy experiences a cash deficit.

Figure 3: Income surplus and shortfall
Net +
cashflow surplus
0
deficit
–
time
The phenomenon of income surplus and shortfall is the main reason

why people need financial services, essentially to balance cash flows for
the following purposes:
Retaining income scheduled for subsequent expenditure

Financing expenditure covered by subsequent income
Microfinance institutions should help their customers to manage their

household cash flow, i.e. offer savings services to store cash
surpluses and loans for periods of cash deficits.
Calculate monthly cash deficit or surplus for this family and the final
cash position at the end of March!
1. January: USD 40 monthly salary of the husband; USD 30

expenses for food etc.
2. February: USD 40 monthly salary of the husband; USD 30

expenses for food etc.; USD 10 for cooking gas.
3. March: USD 40 monthly salary of the husband; USD 30 expenses

for food etc.; USD 20 for school fees; USD 6 for selling chicken.

6 Financial services demanded by
the poor
IMG_0181 by IICD
Julia, the shop-keeper, has a simple method to manage her finances.

Every day – no matter how good or bad the business was - she puts
USD 2 into a secret lock-box at her home; this is her “core reserve” for
emergencies. Moreover, on days when she has surplus revenues in the
shop she hides the extra cash in another lock-box at her house. From
this box she pays daily expenses. As soon as she has accumulated
USD 50 she also buys durable stock, such as canned foods, at the
value of USD 40; USD 10 she puts aside for shop maintenance. This
method allows her to have full shop shelves even during times when the
revenues drop and she would not be able to spend money on new
stocks. Julia never had to borrow money, except once when her father
got very ill and she had to pay the doctors.
The poor need a way to preserve the value of surplus income for
various reasons:
To prepare for emergencies and unforeseen expenditures

To balance normal cash flow fluctuations
To save up for larger expenditures
To save for old-age

A host of empirical studies in many countries have shown that the poor
have a high propensity to save. In fact, access to savings services is
more important to the poor than access to credit. For the poor, the
decision to save is not an income surplus function, but rather a reserve
planned prior to consumption, i.e. poor people tend to save fixed
amounts of money regardless of income, but they vary their
consumptive expenses according to the income situation. In economic
terms, poor people do not save according to the equation:
Savings = Income – Fixed Consumption
but according to the equation:
Consumption = Income – Fixed Savings
Poor people keep their savings in many ways, for example as “cash
under the pillow”, or even in the form of commodities such as animals,
raw material, but also gold and jewellery. A major informal savings
institution are the so-called rotating savings and credit associations
(ROSCA) and the accumulating savings and credit associations (ASCA),
which are widespread and can be found in almost all countries (see next
chapter).
The poor demand four main features of savings services:
Security is the highest priority

Liquidity of deposits: there is a need for both, liquid and illiquid
deposits, e.g. passbook savings, fixed deposits, and accumulating
target deposits such as a pension fund
Convenience: this includes various aspects such paperwork,
distances and opening hours of places where money can be
deposited or withdrawn, etc.
Return: interest earned on savings versus inflation, transaction costs
and fees

The following figure compares some examples of different savings
options:
Figure 4: Comparison of different savings options
Security Liquidity Convenience Return
Gold High (if Medium Medium Depending

earrings worn on (option to (pawnbrokers) on gold
the body) pawn) price
Cash Low High High Negative

(inflation)
Passbook High Medium Low (bank) Low

Savings
Account
Fixed High Low Low (bank) High

Deposit
Account
Contrary to common perception, borrowing is only the second most

important financial need of the poor. They borrow small amounts of
money or goods on short-term basis to bridge emergencies and to
finance productive inputs. Quick and easy access is very important in
this respect. Interest rates are generally high in order to cover high
transaction costs. Medium and long-term loans are required less
frequently, for example to finance larger investments (house, vehicles,
large animals).
Apart from savings and credit services the poor may also need money
transfer services, for example to pay bills or to send / receive
remittances from family members working away from home.
The poor also need insurance services, foremost to cover the risk of
death of the main income earner (life insurance). Informal funeral
societies, for example, cover the funeral expenses of their members.
Other important, but more complex insurance services are health
insurance, accident insurance, disaster insurance and agriculture
insurance (esp. weather index insurance).
While all of the above services are focused on individuals, metafinance

is the financing of community infrastructure needs, for such basic
necessities as potable water supply, waste water removal, street paving,
and garbage collection and disposal. Metafinance occupies the
intermediary space between individual finance and large-scale
municipal finance. Most metafinance initiatives fall into two main
categories, either loans to community-based groups or pooled savings.
As an example of the latter type, SEWA Bank in India and the SEWA
union have entered into a partnership with the Ahmedabad Municipal
Corporation to implement the “Parivartan” housing program, designed to

upgrade the slums in the city. SEWA mobilizes women slum dwellers to
form a residents' association. Every household deposits 2,100 rupees
with the municipal corporation, which entitles them to a toilet, a sewage
system, water supply, and electricity in their new house. The women
may borrow the amount from SEWA Bank if they are unable to pay with
savings. The title to the house is issued in the SEWA member's name,
and it is entered into the official municipal record (for more information:
www.sewabank.com/parivartan).
Cohen, Monique (MicroSave Briefing Note # 25): The Emerging

Market-Led Microfinance Agenda
Graham A.N. Wright, Graham A.N. (MicroSave, 2010): Designing

Savings and Loan Products
Churchill, Craig (ILO, 2007): Protecting the Poor: A Microinsurance

Compendium
Walker, Melanie; Daphnis, Franck (microfinance.org; undated):

Towards Metafinance - Slum Dwellers around the World Need
Financing Options beyond What Microfinance and Traditional
Banking Can Offer: Metafinance Shows the Way Forward
Rhyne, Elisabeth (Huffpost World, 2012/02/10): Microfinance in

Bangladesh: It's Not What You Thought
http://www.huffingtonpost.com/elisabeth-rhyne/microfinance-in-
banglades_b_1266759.html
Microfinance institutions should offer at least two types of savings

products and two types of credit products:
a liquid savings option (e.g., passbook savings) and

an illiquid savings option (fixed deposit; target savings);
a short term loan product and
a longer term investment loan product.
Poor people are usually looking for high security of deposits and
convenient (quick, easy, cheap) services. Interest rates on deposits
and loans are not as essential. In addition to savings and credit
services, MFIs should also consider offering insurance and money
transfer services.

Which of the following statements are correct?
1. Poor people are usually very concerned about the security of

their savings.
2. Poor people generally need access to loan services more

urgently than access to savings services.
3. The only savings product that is relevant for the poor is the liquid
passbook savings.
4. Micro-loans have higher interest rates than larger loans to cover

the relatively higher transaction costs.

7 Financial institutions
IMG_1213 by IICD
Julia, the shop-keeper, had made a bad experience when asking for a
bank loan: the credit officer was rather rude and lots of paperwork was
required to apply for the loan. The money-lender, on the other hand,
charged very high interest. Therefore, Julia was looking for alternatives
and found out that there is a small group of shopkeepers who meet once
a week to pool money which is then lent to a group member. However,
since Julia did not know anybody in the group she could not join. A few
weeks later, Julia read a newspaper article about a cooperative bank in
a neighbouring suburb. The cooperative has more than 2000 members,
mostly small businesses owners. On further enquiry, however, Julia
learned that the cooperative leadership was dominated by one powerful
businessman who also runs for a seat in parliament. This made Julia
suspicious and she decided not to join the cooperative. Finally, a
customer told Julia about a new NGO in town which started a group
scheme. Julia went to the NGO office and asked for more details. A
friendly woman explained that Julia would have to find four other women
to form a group. Each group member would get a small loan from the
NGO and the members would have to guarantee each others’ loan
repayment.

In theory, financial institutions intermediate between savers and
borrowers (see chapter 1). In reality however, there is a wide range of
financial institutions which do not always intermediate directly between
savers and borrowers. In fact, many financial institutions are specialized
on one or few financial products, for example deposits, credit, leasing,
insurance, money transfer, capital market transactions, etc.
Nevertheless, the national and international networks of all financial
institutions create perfect intermediation.
There is a wide range of financial institutions, for example: banks,

leasing companies, insurance companies, cooperative banks, money
transfer agents, savings and credit groups, mutual funds, etc. In the
world of microfinance there is also a wide range of financial institutions
which have their own specific advantages and disadvantages, as shown
in the table below.
Formal financial institutions (banks and non-bank financial

institutions) are regulated organizations which tend to serve wealthier
clients. Cooperative financial institutions (cooperative banks, savings
and credit organizations, credit unions) are member-owned
organizations which offer credit and savings services to their members.
NGO-MFIs are usually non-regulated organizations which exclusively
target poor clients, primarily with micro-credit services. Community-
based financial organizations (village banks, self-help groups) are
more or less formal, unregulated, flexible and low-cost institutions which
tend to operate in rural areas. Traditional providers of microfinance
services include Rotating Savings and Credit Association (ROSCA),
Accumulating Savings and Credit Association (ASCA) and money
lenders.
Bank
A bank is a private or public institution, licensed legally to provide

banking services. There are many different types of banks. Central
banks are usually government owned banks, often charged with
quasi-regulatory responsibilities, e.g. supervising commercial banks,
or controlling the cash interest rate. They generally provide liquidity to
the banking system and act as lender of last resort in event of a
crisis. Commercial banks are focused on profitability, development
banks on social, economic or ecological development. Universal
banks engage in all kinds of banking activities. Non-bank financial
institutions provide special financial services, e.g. leasing or
insurance. Corporate banking is directed at large business entities.
Business banks provide services to mid-market business. Private
banking is providing wealth management services to high net worth
individuals and families. Offshore banks are located in jurisdictions
with low taxation and regulation. Investment banks underwrite
transactions on the capital markets and advise corporations on capital
markets activities such as mergers and acquisitions. Merchant banks
were traditionally engaged in trade financing and often provide capital
to firms in the form of shares rather than loans. Unlike venture

capital firms, they tend not to invest in new companies. Retail banks
provide services to private households and small enterprises.
Savings banks provide easily accessible savings products to all
strata of the population and usually act like retail banks with a
decentralised distribution network. Postal savings banks are savings
banks associated with national postal systems. Building societies
conduct retail banking with a focus on housing finance. Microfinance
banks can be considered retail banks for low-income households and
micro-entrepreneurs. Community banks are locally operated non-
profit institutions that empower employees to make local decisions to
serve their customers and the partners. Community development
banks are regulated banks that provide financial services and credit
to undeserved markets or populations. Ethical banks make only what
they consider to be socially or environmentally responsible
investments.
Leasing
Leasing is a financial product which uses the leased item as a

security. The leased asset remains legally a property of the lessor
until the lease agreement is terminated. There are two basic leasing
types:
1. A finance lease (= hire purchase) allows a firm to finance the

purchase of an asset. Usually, the asset becomes legal property of
the lessee at the end of the lease period. The lessee has the full
benefits and risks of asset ownership.
2. An operating lease is a lease whose term is short compared to the

useful life of the leased asset, for example a vehicle. The lessor
leases the vehicle to the lessee for a fixed regular payment and also
assumes the residual value risk of the vehicle.
In micro-leasing the value of the leased assets is very small, for

example leasing of water pumps or bicycles.
The leasing industry requires a special legal framework and an active
market for second hand assets.
Insurance
Insurance is a contract (insurance policy) that provides compensation

for specific losses (insurance claim) in exchange for a periodic
payment (insurance premium). Insurance companies deal with
insurance products, e.g. life insurance, health insurance, accident
insurance, asset insurance, etc.
Money Transfer Service
Certain financial institutions are licensed to transfer money on behalf

of their clients. There are different money transfer systems, foremost
electronic transfer and cheque or account transfer. Money Transfer

Operators (MTO) are specialised financial institutions which only
transfer money. Informal money transfer systems have a long
tradition. A range of informal systems exist which include the migrants
carrying money themselves or sending it with relatives or friends.
There are also a number of informal services, typically operating as a
side business to an import-export operation, retail shop, or currency
dealership. Most of them operate on the basis of no or very little
paper or electronic documentation. The transaction is communicated
by phone, fax, or email to the counterpart who will be paying out.
Cooperative versus mutual
Cooperatives are institutions with following principles: voluntary and

open membership; democratic member control; member economic
participation; autonomy and independence; education, training, and
information; cooperation among cooperatives; concern for community.
The purpose of cooperatives can differ widely, e.g. workers
cooperatives, production cooperatives, marketing cooperatives, multi-
purpose cooperatives, financial cooperatives.
A mutual, such as a building society or a mutual insurance, is an
organization based on the principle of mutuality. Unlike a true
cooperative, members usually do not contribute to the capital of the
company by direct investment, but derive their right to profits and
votes through their customer relationship. A mutual exists with the
purpose of raising funds from its membership which can then be used
to provide common services to all members of the organization. A
mutual is therefore owned by and run for the benefit of its members. It
has no external shareholders to pay in the form of dividends, and as
such does not usually seek to maximize and make large profits or
capital gains.
ROSCA versus ASCA
ROSCAs (Rotating Savings and Credit Associations) are informal

groups of poor people who meet regularly to save a fixed amount
every week or month. Members then take turns receiving the amount
collected as loans. The order in which members receive loans can be
by lottery, auction or mutual agreement. Traditional ROSCAs are
common all around the world, for example tontines in West Africa or
chit in India.
ASCAs (Accumulating Savings and Credit Associations) are informal
groups that resemble ROSCAs but are slightly more complex. Some
members save and borrow, while others are savers only. Borrowers
may borrow different amounts on different dates for different periods.
Savers receive interest according to their actual savings balance.

Overview of microfinance providers
Type Features Advantages Disadvantages
1. Formal financial institutions (FFIs)
1a. Usually has Able to offer clients Usually not interested

Private corporate a wide variety of in serving low-income
commercial shareholding financial services, people
bank structure including savings, Even if interested,
Regulated and credit, insurance, difficult to reorient
supervised and payments staff and systems for
service provision to
the poor
1b. May be commercial May have large Often not profitable so

State-owned bank, agricultural branch network, must be heavily
bank bank, or including secondary subsidized to stay in
development bank towns not served business
Regulated and by private banks Usually has greater
supervised outreach than
commercial banks but
often does not serve
the poor
1c. Usually has Has “double Clientele often not as

Microfinance corporate bottom-line”; that diversified as a
bank shareholding is, profitability and commercial bank, thus
structure services to lower potentially more risky
Principal clientele income clients than a bank serving a
includes small and May be able to wide range of
micro-enterprises offer the full range customers
Often has been of services to
transformed from clients
NGO structure
Regulated and
supervised
1d. Includes many Finance and Usually not allowed to

Non-bank different types of leasing companies: offer a full range of
financial organizations; for focused on a small services, including
institution example, finance set of specialized savings
companies, leasing products that may Not diversified, thus
companies, and not be available potentially more risky
MFIs that have from banks than an entity serving
transformed from MFIs: focused on a wide range of
NGO structure but the provision of customers with a
have not become services to people diverse set of products
full-fledged banks who cannot get and services
Often regulated and bank access
supervised Minimum capital
requirement lower
than for banks

2. Cooperative financial institutions (CFIs)
CFIs range Member owned Member-owned Governments have

from FFIs Usually one person, structure can often used
(cooperative one vote create a strong cooperatives for their
banks) to May be closed bond sense of ownership own purposes, leading
semiformal
(for example, all to low sense of
village-based
members have same ownership by
savings and
credit employer or members
organizations profession) or open May be used by
(SACCOs) bond (open to all) government to channel
subsidized services to
a clientele favoured by
government
2a. Multi- Often set up with Multiple services Tend to have input
purpose government support under one roof supply and marketing
cooperative Main activity may be expertise rather than
with input supply or financial expertise
financial
marketing Supervision often
services
Often supervised weak
through government Systems may not be
ministry or adequate for
department that accountability and
lacks financial transparency of
supervision skills financial transactions
Sometimes federated
2b. Financial Primary focus is on Savings-first External finance (for

cooperative, financial services orientation can example, credit lines)
including Often supervised create incentives may lead to borrower
credit through government for strong domination
unions
ministry or management and Supervision often
department that internal controls weak
lacks supervision Federated structure Board and managers
skills or could provide may lack necessary
accountability access to services skills, especially
Sometimes federated that primary financial skills
cooperative cannot Systems may not be
afford (TA, external adequate for
audit etc) accountability and
transparency

3. Nongovernmental Organisations–Microfinance Institutions (NGO-MFIs)
3a. May be established Multiple services Difficult to operate

Multipurpose by local or foreign under one roof microfinance using a
NGO organisation Focus on the poor business approach
Usually registered as when other services
a non-profit society, have a social welfare
trust, or association approach
Diversified set of
services such as
health, education,
agriculture
3b. May be established Enables the NGO Difficult to acquire

Multipurpose by local or foreign to retain both social expertise in many
NGO with organization and financial diverse subject areas
microfinance Usually registered as services but Usually not allowed to
services
a non-profit society, develop offer savings services
separated
trust, or association microfinance using other than “forced”
from other
services May be a separate a sustainable savings
department or business model
separate legal entity Clients less likely
Principal product is to get mixed
credit messages
3c. May be established Specialization Usually not allowed to

Microfinance by makes it easier to offer savings services
NGO local or foreign operate a business other than “forced”
organisation aimed at long-term savings
Usually registered as sustainability Difficult to finance
a non-profit society, growth because it has
trust, or association little access to
Principal product is commercial refinance
credit and no shareholder
capital
3d. New entity is often a Able to increase Product mix more

Microfinance shareholding capital and finance limited than a
NGO trans- company growth by seeking commercial bank
formed NGO is usually one outside investors NGO less able to
into a bank
of many Easier to obtain ensure continued
or NBFI
shareholders in this commercial focus on poor, as it
(see 1.)
new entity refinance only owns a company
Usually regulated Often allowed to share
and supervised offer more Mixed ownership
services, such as structure can
savings complicate governance

4. Community-Based Financial Organizations (CBFOs)
4a. Includes Member based Varies according to Varies according to

variety of Village based the model - see the model - see
village based May not be registered examples below examples below
entities with Small savings
names such
collected and
as village
intermediated
bank and self-
help groups
Example 1: Same features as Members obtain Long-term donor

CVECAs - above access to finance for commitment needed
West Links with farmers agricultural (as well because of long
Africa associations that as other) activities time frame and high
assist with credit Network is able to cost to set up
appraisal cover costs, the system
Village units clustered especially on-lending Members’ desire to
into unions that obtain from savings (see hold down interest
refinance from disadvantages for 1a. rates has made it
development bank and and 1b.) difficult to cover
manage overall Agricultural bank that costs for on-lending
finances in the past failed to from bank credit
TA provided by funnel funds profitably lines and has
independent group to rural farmers is now discouraged
financed from margins able to do so member savings
on bank loans
Example 2: Similar to ASCA (see More flexible than Savings cannot be

Self-Help 5.), but intends to be ASCA withdrawn unless a
Groups permanent Savings sometimes member leaves
(SHG) - India External funds: SHGs leverage external SHG
borrow from banks and funding (banks, May be difficult to
on-lend to members MFIs), enabling larger achieve bank links
Sometimes federated loans without support
from the
government
Example 3: “Upgraded” ASCA Low cost Amounts saved

VS&LA Model model with capacity More flexible than generally small
- building for group basic ASCA Loans generally not
Africa development, High returns to suitable for large
governance, internal savings investments;
rules, cash control Can work without however, members
Impermanent (payout written records can schedule
at end of time period) Credit available when annual distributions
yet permanent (groups needed without at a time when most
restart after payout) complex procedures members need
No external funding Members can have large lump sums
access to their
savings at any time

5. Traditional Providers
5a. Unregistered Works well in Amounts saved

Rotating Time-bound remote generally small
Savings and Members deposit a rural communities Inflexible: cannot
Credit fixed amount each Well-known in deposit or withdraw
Association
period many countries funds as needed, so
(ROSCA)
Each period, one Simple, easy to generally not available
member receives all manage system for emergencies
funds No written records No lending
Rotates until Enables people to Savings tied up until
everyone has obtain usefully member’s turn to
received funds large sums collect
No external funding
5b. Unregistered Same advantages Amounts saved

Accumulating Time-bound as for ROSCAs generally small
Savings and Usually a fixed More flexibility than Loans generally not
Credit amount deposited ROSCAs for people suitable for large
Association
each period who want loans investments, because
(ASCA)
Funds lent to Members receive a of small loan size and
members with return on their risk
interest investment Savings tied up for the
No external funding cycle
5c. Fast, easy access Available Interest rates generally

Money- High interest rates everywhere too high for investment
lender No external funding Simple and in business
accessible Poor can end up in
Loans usually debt trap and lose
available when critical livelihood
people need them assets, such as land
(may be liquidity Usually do not offer
constraints during other financial services
certain seasons) such as savings and
payments
Note:
ASCA = accumulating savings and credit association; CBFO = community-based financial
organization; CFI = cooperative financial institution; CVECA = caisses villageoises d’epargne
et de crédit autogérées; FFI = formal financial institution; MFI = microfinance institution; NBFI
= non-bank financial institution; NGO = nongovernmental organization; ROSCA = rotating
savings and credit association; SACCO = savings and credit organization; SHG = self-help
group; TA = technical assistance; VS&LA = village savings and loan association.
Source: Ritchie, Anne: Community-based Financial Organizations: A Solution to Access in
Remote Rural Areas? - Agriculture and Rural Development Discussion Paper 34. The
International Bank for Reconstruction and Development / The World Bank, Washington, DC,
2007.

Although there seem to be many differences between conventional
financial institutions and microfinance institutions, the borderline is
getting more and more blurred, as an increasing number of banks or
insurance companies are moving into the microfinance market.
Therefore, it is probably fair to say that the only real difference between
conventional financial institutions and microfinance institutions are their
missions: conventional financial institutions pursue profitability
(shareholder value!), while real microfinance institutions pursue a so
called double bottom line, i.e. profitability as well as social
performance (e.g. poverty alleviation); some MFIs also have
environmental goals (triple bottom line).
Double / triple bottom line

Financial institutions or companies which aim at financial performance
(profits) as well as social performance (e.g. poverty alleviation) are
pursuing a double bottom line. Organisations which, in addition, have
environmental goals are pursuing a triple bottom line.
Contrary to common perception, modern microfinance is mostly supplied

by very large organizations. According to industry data
(www.mixmarket.org) the “average microcredit client” in 2009 was
served by an institution with 2.2 million borrowers, 9,000 employees,
and 730 million USD in assets. Why is this so? Because large
institutions reach economies of scale which help them solve the key
business problem of microfinance: how to provide financial services for
the poor without losing money. - However, smaller MFIs often perform
better than larger ones with regard to reaching out to the poorest of the
poor (measured by average outstanding loan size).
Wright, Graham A.N. (MicroSave India Focus Note 8): What Does
Competition Mean For Indian MFIs?
CGAP Occasional Paper No. 8 (2004): Financial Institutions with a

“double bottom line”: Implications for the future of microfinance
Roodman, David (Center for Global Development, 2011): Due

Diligence: An Impertinent Inquiry into Microfinance
There is no single best institutional solution for microfinance. Banks,

regulated non-bank financial institutions, cooperatives, NGO-MFIs,
community-based financial organizations and traditional providers of
microfinance, they all have a role to play in offering financial services
to the poor – as long as they take their social mission as serious as
their financial objectives.

1. There is no difference between a mutual and a cooperative bank.

2. Leasing is a financial product which uses the leased item as a
security.
3. ROSCAs are more complex than ASCAs because some
members save and borrow, while others are savers only.
4. The main differences between conventional NGO-MFIs and
transformed NGO-MFIs lie in ownership and supervision.
5. Group schemes like Grameen are the best microfinance
approach.

8 The history of microfinance
Bamari and Bedi, SHG treasurer and president by Find Your Feet
Julia, the shop-keeper, was looking for various alternatives to banks and
money-lenders. After looking at the advantages and disadvantages of all
options, she decided to form her own ROSCA. Julia invited ten of her
best friends and neighbours to join the group. They decided that each
member has to contribute USD 10 per week to the ROSCA. Then they
discussed how to distribute the weekly fund (USD 100) Julia proposed
to give the money to the eldest member first, then in the next week to
second eldest and so forth until the cycle starts again from the
beginning. Julia’s best friend, Anna, suggested to put small slips with
each member’s name written on it in a box and draw one slip at each
weekly meeting to decide who gets the chit fund, until all slips have
been drawn and the cycle begins again. Julia’s neighbour, Carolin, had
another idea. She suggested that the group conducts an auction so that
the member who needs the money most urgently would get it first. All
members can engage in reverse bidding to get money from the fund. For
example, after a period of bidding the lowest bid may be USD 90. The
winning bidder then gets USD 90 from the fund and the remaining USD
10 are divided amongst the nine other members, bringing the discount

per person to approximately USD 1,10. After long discussion, the group
decided to go for the paper slip system.
Microfinance
Microfinance is the provision of financial services to the poor. It is

more than just micro-credit! Informal microfinance providers are not
licensed, regulated or supervised. A Microfinance Institution (MFI) is a
licensed organisation that is involved in the provision of financial
services to the poor and has at least 80% of its total portfolio in loans
of amounts less than the country’s GDP per capita.
Microfinance is not a new thing. Informal microfinance has been

around for hundreds of years. In almost every corner of the world people
have long been forming groups to pool their savings and give loans to
their group members, be it for business, weddings, funerals or anything
else - for example. the 'chit' funds in India, 'hui' in China, the 'arisan' in
Indonesia or the 'paluwagan' in the Philippines, to name but a few.
Pawning is another form of microfinance which has been in use for
centuries.
The birth of microfinance in Europe dates back to the 16th and 17th
century. The so-called Irish loan funds emerged in the 1720s as
charities, initially financed from donated resources and providing
interest-free loans, but soon replaced by financial intermediation
between savers and borrowers. Loans were short-term and instalments
weekly. Peer monitoring was used to enforce repayment.
Today’s microfinance traces to Germany’s credit cooperative

movement, which began in response to famine in the 1850s. Farmer
cooperatives established by Raiffeisen and the Volksbanken founded by
Schulze-Delitzsch are examples which still exist today. The Sparkassen
(savings banks) were established by the German state to mobilize and
protect small deposits of the public. In Germany, these former
microfinance institutions now account for around 50% of banking assets;
outreach is to around 90% of the population.
In 1903, the British introduced cooperative credit groups into colonial

India, including what is today Bangladesh, home to the Grameen Bank,
the world’s best-known microfinance institution.
After World War II many countries engaged in development finance,

directed and subsidised credit to specific target groups. However, many
of these projects and banks failed. In 1976 the Grameen banking
approach was developed in Bangladesh. This was the beginning of
“modern” microfinance. Its basic credo: the poor are bankable and
microfinance is financially viable. Many institutions followed the group
based microfinance example of Grameen. In similar manner village
banking was developed in Latin America by a NGO called FINCA.

Another important MF success story is Bank Rakyat Indonesia (BRI).
Until 1983, interest rates in Indonesia were regulated, the financial
sector was dominated by state banks, and the establishment of new
banks and branches was restricted. The century-old Bank Rakyat
Indonesia (BRI) was the main provider of subsidised agricultural credit.
In the absence of incentives for small farmers to repay and for BRI staff
to enforce credit discipline, repayment rates lingered around 40-50%.
After the interest rate deregulation in June 1983, the new management
of BRI decided to commercialise the units into self-sustaining profit
centres. Since then the new Microbanking Division has been generating
huge profits each year and savings mobilized have continuously
exceeded loans outstanding. BRI is the show-case for the successful
reform and downscaling of a commercial bank.
Another hallmark in the history of MF is the establishment of BancoSol

in the year 1992. For the first time ever, a MF-NGO was transformed
into a licensed bank, allowed to take public deposits. Many other NGOs
followed this path of transformation.
A new wave of MFIs started in the 1990s in the former communist

countries. Here, the greenfield approach is prominent - i.e.,
microfinance banks are created from scratch. ProCredit bank is
probably the best known example of this approach.
In 1995, the Consultative Group to Assist the Poor (CGAP -

www.cgap.org; www. microfinancegateway.org) was established under
the auspices of the World Bank; it is an international think tank and
service provider for the microfinance industry, with a focus on
commercial microfinance. In 2002, the internet platform Microfinance
Information Exchange (www.mixmarket.org) was established by CGAP
to increase the transparency of the microfinance industry. It provides
instant access to financial and social performance information covering
approximately 2,000 MFIs around the world. Publications of MIX include
MicroBanking Bulletin and MIX Microfinance World.
Since the 1990s, the microfinance industry copied many features of the
traditional banking sector. The first venture capital fund dedicated to
microfinance, ProFund, was founded in 1995. Other funds followed
soon. In 1996, MicroRate, the first rating agency of the microfinance
industry was established. Microfinance Investment Vehicles (MIVs),
investing in MFIs, mushroomed. MicroRate estimated the total MIV
assets as of December 31, 2010 to be 7 billion USD - with a steady
growth despite the global financial crisis and economic recession.
Another important landmark in the history of microfinance was the initial

public offering (IPO) of the Mexican Banco Compartamos in April 2007.
The IPO of its stock was 13 times oversubscribed and raised 467 million
USD for the microfinance bank. The huge demand was fuelled by the
exceptional growth and profitability of Banco Compartamos. Mainstream
international fund managers and other truly commercial investors - not
socially responsible investors - bought most of the shares. However, the
Compartamos case raised serious concerns in the microfinance

industry, in view of the huge profits it produced for Compartamos
shareholders, amongst them social investors such as ACCION
International.
In 2010, another IPO caused heated discussions. The Indian

microfinance institution SKS raised over 100 million USD on the share
market, while at the same time a scandal emerged in the Indian state of
Andrah Pradesh where several borrowers of MFIs committed suicide -
allegedly because they could not pay back their loans.
The recent events in India and other countries where MFIs made huge
profits while customer over-indebtedness increased dramatically put the
issue of mission drift into the limelight. Moreover, some experts claim
that there is no evidence that micro-credit really helps the poor to get
out of poverty, others criticize the high interest rates charged from the
poor. These critics request more government control of the microfinance
sector. The heated discussion around mission drift and microfinance
impact has re-focused the microfinance industry on the issues of
responsible finance, customer protection and social performance
management, with three prominent initiatives established since then: the
Social Performance Task Force (http://sptf.info), the Smart Campaign
(www.smartcampaign.org) and Microfinance Transparency
(www.mftransparency.org).
While the hot debate about mission drift is going on, interesting
innovations have been developed in the microfinance industry - one of
the most promising being mobile phone banking. In Kenya, the mobile
phone payment service M-PESA was launched in March 2003. As of
November 2011, M-PESA has over 14 million subscribers and well over
28,000 agents across the country. The services has already expanded
into other countries.
Seibel, H.D. (2007): Does History Matter? The Old and the New
World of Microfinance in Europe and Asia
Roodman, David (Center for Global Development; Jan. 2012): Due

Diligence: An Impertinent Inquiry into Microfinance
MicroRate (2011): The State of Microfinance Investment 2011
Microfinance Podcast (2010): 8 part interview series about

Compartamos’ IPO
http://www.microfinancepodcast.com/category/institutions/compart
amos/
The history of microfinance shows that local financial institutions may

evolve from very small informal beginnings to becoming part of the
banking sector. Committed leadership, a conducive legal framework,
appropriate regulation and effective supervision are important
ingredients for success.

Read the paper written by H.D. Seibel (Does History Matter? The Old
and the New World of Microfinance in Europe and Asia) and answer
the following questions:
1. Why did the Irish loan funds boom from the 1823 onwards, and
then decline after 1843?
2. In Germany, what was the main difference between Schultze-

Delitzsch and Raiffeisen before 1864?
3. What are the three main strands of indigenous finance in India?
4. Why are Indian chit funds regulated by law?
5. Where do you see the main difference between the Indian and
the European cooperative system?.

9 Principles of microfinance
India - Colori by Religione 2.0
Julia, the shop-keeper, started her own ROSCA. After one year of
successful operation, a young lady from a local Microfinance Institution
called Finance For All approached the group and asked the members
whether they would like to join a microfinance group scheme. The group
members agreed to join the scheme because Finance For All offered
them two distinct advantages compared to the fund: they can put their
individual savings into a secure state bank account intermediated by
Finance For All, and they could get larger loans by borrowing funds from
Finance For All
One year later: Julia and two other group members are doing really well,
they have taken gradually increasing short term loans and invested
them in their small business. Now, they are pondering whether to leave
the group and join Finance For All individual loan programme because
they need larger and longer term loans than the group scheme can
offer, and because they don’t want to guarantee other, less successful
group members’ loans any longer - two of the poorest group members
repeatedly had problems to repay their loans and the better-off group
members had to jump in for them in order to remain eligible for the next
group loan.

Although microfinance is an international success story there are also
many failures. What makes the difference between success and failure?
The Washington based international organization CGAP (Consultative
Group to Assist the Poor; www.cgap.org) has come up with the following
eleven principles of good practice in microfinance.
1. The poor need a variety of financial services, not just loans. Just
like everyone else, poor people need a wide range of financial services
that are convenient, flexible, and reasonably priced. Depending on their
circumstances, poor people need not only credit, but also savings, cash
transfers, and insurance.
2. Microfinance is a powerful instrument against poverty. Access to

sustainable financial services enables the poor to increase incomes,
build assets, and reduce their vulnerability to external shocks.
Microfinance allows poor households to move from everyday survival to
planning for the future, investing in better nutrition, improved living
conditions, and children’s health and education.
3. Microfinance means building financial systems that serve the poor.

Poor people constitute the vast majority of the population in most
developing countries. Yet, an overwhelming number of the poor
continue to lack access to basic financial services. In many countries,
microfinance continues to be seen as a marginal sector and primarily a
development concern for donors, governments, and socially-responsible
investors. In order to achieve its full potential of reaching a large
number of the poor, microfinance should become an integral part of the
financial sector.
4. Financial sustainability is necessary to reach significant numbers of

poor people. Most poor people are not able to access financial services
because of the lack of strong retail financial intermediaries. Building
financially sustainable institutions is not an end in itself. It is the only
way to reach significant scale and impact far beyond what donor
agencies can fund. Sustainability is the ability of a microfinance provider
to cover all of its costs. It allows the continued operation of the
microfinance provider and the ongoing provision of financial services to
the poor. Achieving financial sustainability means reducing transaction
costs, offering better products and services that meet client needs, and
finding new ways to reach the unbanked poor.
5. Microfinance is about building permanent local financial

institutions. Building financial systems for the poor means building
sound domestic financial intermediaries that can provide financial
services to poor people on a permanent basis. Such institutions should
be able to mobilize and recycle domestic savings, extend credit, and
provide a range of services. Dependence on funding from donors and
governments - including government-financed development banks - will
gradually diminish as local financial institutions and private capital
markets mature.

6. Microcredit is not always the answer. Microcredit is not appropriate
for everyone or every situation. The destitute and hungry who have no
income or means of repayment need other forms of support before they
can make use of loans. In many cases, small grants, infrastructure
improvements, employment and training programs, and other non-
financial services may be more appropriate tools for poverty alleviation.
Wherever possible, such non-financial services should be coupled with
building savings.
7. Interest rate ceilings can damage poor people’s access to financial

services. 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, and their growth
and sustainability will be limited by the scarce and uncertain supply of
subsidized funding. When governments regulate interest rates, they
usually set them at levels too low to permit sustainable microcredit. At
the same time, microlenders should not pass on operational
inefficiencies to clients in the form of prices (interest rates and other
fees) that are far higher than they need to be.
8. The government’s role is as an enabler, not as a direct provider of

financial services. National governments play an important role in
setting a supportive policy environment that stimulates the development
of financial services while protecting poor people’s savings. The key
things that a government can do for microfinance are to maintain
macroeconomic stability, avoid interest-rate caps, and refrain from
distorting the market with unsustainable subsidized, high-delinquency
loan programs. Governments can also support financial services for the
poor by improving the business environment for entrepreneurs,
clamping down on corruption, and improving access to markets and
infrastructure. In special situations, government funding for sound and
independent microfinance institutions may be warranted when other
funds are lacking.
9. Donor subsidies should complement, not compete with private

sector capital. Donors should use appropriate grant, loan, and equity
instruments on a temporary basis to build the institutional capacity of
financial providers, develop supporting infrastructure (like rating
agencies, credit bureaus, audit capacity, etc.), and support experimental
services and products. In some cases, longer-term donor subsidies may
be required to reach sparsely populated and otherwise difficult-to-reach
populations. To be effective, donor funding must seek to integrate
financial services for the poor into local financial markets; apply
specialist expertise to the design and implementation of projects;
require that financial institutions and other partners meet minimum
performance standards as a condition for continued support; and plan
for exit from the outset.
10. The lack of institutional and human capacity is the key constraint.
Microfinance is a specialized field that combines banking with social
goals, and capacity needs to be built at all levels, from financial
institutions through the regulatory and supervisory bodies and

information systems, to government development entities and donor
agencies. Most investments in the sector, both public and private,
should focus on this capacity building.
11. The importance of financial and outreach transparency.

Accurate, standardized, and comparable information on the financial
and social performance of financial institutions providing services to the
poor is imperative. Bank supervisors and regulators, donors, investors,
and more importantly, the poor who are clients of microfinance need this
information to adequately assess risk and returns.
Sustainable Microfinance
The concept of sustainability is at the core of the modern microfinance

approach. Sustainability refers to both, financial and social dimensions.
MFIs are expected to charge loan interest rates high enough to at least
cover their real costs and to eventually become independent from
subsidies. In other words: MFIs must become profitable. This policy will
best insure the permanence and expansion of microfinance services. At
the same time, MFIs are also expected to pursue their social objectives
and help their clients to sustainably get out of poverty.
Financial sustainability
Financial sustainability is the ability of a microfinance provider to

cover all of its costs, without dependence on subsidies.
Social sustainability
Social sustainability is the ability of a microfinance provider to put its

social mission into practice.
Subsidy
Donor organizations and governments often subsidise microfinance

institutions in the form of non-monetary grants (equipment, personnel,
technical assistance, etc.), equity funds or concessional loans.
Subsidies to microfinance customers may come in the form of loan
interest rates that are kept below cost-covering. - MFIs should be
transparent about all subsidies they received, in order to make
performance indicators meaningful.
There are three kinds of costs an MFI has to cover when it makes
micro-loans. The first two, the cost of funding that it lends and the cost
of loan defaults, are proportional to the amount lent. The third type of
cost, transaction costs, however is not proportional to the amount lent.
Regardless of their size, loans granted by MFIs 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. The transaction cost of a $500 loan, for example, is

therefore not much different from the transaction cost of a $100 loan.
Suppose that the transaction cost is $25 per loan and that the loans
provided by an MFI are for one year. Its cost of money is 10% and its
provisioning for loan defaults lies at 1% of loan amount. To break even
on the $500 loan, the MFI would need to collect interest of $50 (cost of
money) + $5 (loan provisioning) + $25 (transaction cost) = $80, which
represents an annual interest rate of 16 percent. 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 percent.
The above example clearly illustrates the logic behind the "micro-loan
paradox", i.e. poor people who take very small loans pay much higher
interest rates than better-off people who take large loans. Because of
this paradox micro-credit has often been criticized by outsiders that the
poor are being exploited.
Are high interest rates exploiting the poor? This issue is being
discussed controversially. We may conclude that MFIs have to charge
rates that are higher than normal banking rates to cover their costs and
keep their services available – but at the same time, MFIs with a social
mission should always aim at reducing their interest rates by cutting
costs as much as possible (i.e., by becoming more efficient). Despite
regrettable exceptions, worldwide the microfinance industry is actually
getting better at achieving their social and financial missions. CGAP's
global research found in 2008/9:
MFI interest rates averaged about 28 percent in 2006, declining by

2.3 percent a year since 2003.
MFI rates are lower than consumer and credit card rates in most
countries, and usually far lower than rates charged by informal
money-lenders.
Operating costs are the largest single contributor to interest rates, at
an average 12.7 percent of loan portfolio in 2006, but declining by
one percentage point per year since 2003.
CGAP Occasional Paper No. 15 (2009): The New Moneylenders: Are

the Poor Being Exploited by High Microcredit Interest Rates?
CGAP Focus Note No. 5 (1996): Financial Sustainability, Targeting

the Poorest, and Income Impact: Are There Trade-offs for
Microfinance Institutions?
Morduch, Jonathan (2010): Targeting the Ultra Poor
Bateman. Milford (Overseas Development Institute, Mar. 2011):

Microfinance as a development and poverty reduction policy: is it
everything it’s cracked up to be?

Microfinance institutions must aim at financial and social sustainability
without relying on long-term subsidies. Therefore, MFIs have to
charge relatively high loan interest rates and pay low deposit rates.
However, MFIs also need to continuously increase their efficiency and
improve their social performance.
Which of the following two MFIs would you consider more

sustainable?
Year 2009: MFI A MFI B

Borrowed funds $1,000,000 $2,000,000
Concessional rate of interest 2% 3%
paid by the MFI for borrowed
funds
Market interest rate for 10% 10%
borrowing funds
Profit at the end of the year $70,000 $70,000

10 The role of regulation in micro-
finance
India - Colours of India - 011a - Pots for sale by mckaysavage
Julia, the shop-keeper, and two of her friends have finally left the group
scheme of the MFI Finance For All. Now they are in the Finance For All
individual loan programme where they can get larger and longer term
loans. The responsible loan officer has given Julia an information leaflet
which explains the loan conditions, for example the maximum loan
amount, the acceptable loan purposes, the effective annual interest
rate, penalty fees applicable on late repayment, etc. The loan officer
also explained that Julia’s savings would be 100% safe because
Finance For All has recently received a government license to collect
savings from its loan clients. The central bank has strict rules on what
Finance For All is allowed to do with the collected savings. Moreover,
Finance For All has to send monthly financial reports to the central bank
and a supervisor of the central bank visits the institution once in a while.
Julia was relieved when she learned that her savings will be safe, since
there were rumours of other MFIs in the country that have gone
bankrupt and did not pay out all of the collected savings.
The financial sector is different to any other economic sector because of

the high inherent systemic risk, which stems from the fact that money
handled in the financial sector keeps all other sectors running. As we
have seen in the recent past, but also many times before in various
countries, an entire financial system can collapse and cause a cascade
of business and state failures. In order to avoid such catastrophes
financial sector regulation has to be stricter than the regulation of any
other sector.

Common instruments of regulation are licensing of financial
institutions, minimum capital requirements, obligation to publicly
disclose financial and other information, reserve requirements to ensure
bank liquidity, corporate governance requirements, reporting
requirements, rating requirement and restrictions on large exposures
and related party exposures. Regulations may also interfere with the
investment decisions of financial institutions, for example in India and
Nepal where banks have to invest a certain percentage of their assets in
so called priority sectors.
Regulation is called "prudential" when it is aimed specifically at

protecting the financial system as a whole, as well as protecting the
safety of small deposits in individual institutions. When a deposit-taking
institution becomes insolvent, it cannot repay its depositors. If it is a
large institution, its failure can undermine confidence enough so that the
banking system suffers a run on deposits. Therefore, prudential
regulation involves the government in attempting to protect the financial
soundness of the regulated institutions. Prudential regulation is
relatively difficult, intrusive, and expensive because it involves
understanding and protecting the core health of an institution.
"Non-prudential" regulations do not have the ultimate aim of protecting

the entire financial system but rather the interests of certain groups
such as investors and borrowers. These rules tend to be easier to
administer because government authorities do not have to take
responsibility for the financial soundness of the organizations. These
issues include, among others, the formation and operation of
microlending institutions; consumer protection; fraud and financial
crimes prevention; credit information services; interest rate policies;
limitations on foreign ownership, management, and sources of capital;
tax and accounting issues; and a variety of cross-cutting issues
surrounding transformations from one institutional type to another.
Prudential versus non-prudential regulation
Regulation is the creation and enforcement of a set of rules and

standards for financial institutions, including regulated MFIs and
microfinance banks. These rules are usually set by a country's central
bank or any other legal authority.
Prudential regulation is defined as a regulatory system where the
financial authority assumes responsibility for the soundness of
financial institutions. It aims at stability of the financial system and
protection of small deposits. Key aspects of prudential regulation are
requirements regarding capital and corporate governance.
Non-prudential regulations do not have the ultimate aim of
protecting the entire financial system; they primarily serve the
interests of customers and investors, for example by setting reporting
standards or consumer information rules.

Since the supervision of financial institutions under prudential regulation
is expensive, it is not meaningful to cover all financial institutions in a
country with prudential regulations. Instead, it is better to focus
prudential regulation on those institutions that pose a systemic risk due
to their size (“too big to fail”) and/or that collect deposits from the public.
It is the role of the government to protect small depositors because
they cannot be expected to have sufficient knowledge and information to
decide which financial institution is sound and trustworthy. Licences and
supervision through the state create trust and stabilise the financial
system.
It is important that regulations in particular for deposit-taking institutions

– are very strict in order to reduce the number of market entries so that
the authorities can ensure the effective supervision of licensed
financial institutions.
Prudential regulation can also be enabling and promoting

microfinance. In Indonesia for example, the issuance of the rural bank
law and related regulations in 1988 led to the creation of over 1,500
small rural banks in less than a decade. A survey among regulated MFIs
in Latin America (Elizabeth Rhyne, 2002) identified a number of
advantages, including:
better access to commercial and non-commercial sources of funds

for equity and debt;
better way to achieve growth and outreach goals;
improved standards of control and reporting;
improved ability to offer products beyond microcredit, such as
savings and transfers;
enhanced legitimacy in the financial sector and with clients.
The regulatory framework generally consists of the primary and the

secondary legislation. The primary legislation comprises a Law or Act
adopted by a legislative body, e.g. the parliament. The Law or Act
defines the broad framework and sets the standards. The secondary or
subordinate legislation comprises the Regulations adopted by an
executive body, e.g. the Ministry of Finance, the Reserve Bank or the
Supervisory Agency. The Regulations define the rules based on the
general standards. Example: The Law sets the standard: Capital of
microfinance institutions must be maintained at an adequate level at all
times. The Regulations set the rule: A capital adequacy ratio of 20
percent is to be applied by all MFIs.
Microfinance needs a different regulatory treatment than normal

banking because of two major characteristics: (I) the small sizes of
deposits and loans and the resulting high transaction costs, and (II) the
lack of conventional loan collateral. Areas of regulation that typically
require adjustment include unsecured lending limits, capital-adequacy
ratios, loan loss provisioning rules and minimum capital requirements.

Capital adequacy versus minimum capital
Capital adequacy refers to the equity capital, which a financial
institution must have to cover the risk of its assets (mostly the loan
portfolio in the case of MFIs). The regulator in each country defines
equity capital and risk-weighted assets (micro-loans are usually
considered 100% risk because there is no collateral as security). The
Capital Adequacy Ratio (CAR) is then calculated as the total value of
Equity capital divided by the total value of risk-weighted assets. The
minimum CAR required in countries that are committed to the "Basel
II Accord" is 8%..
Minimum capital, on the other hand, refers to the legally required
equity to establish a financial institution. The regulations regarding
minimum capital differ widely from country to country.
Loan loss provisioning

Loan loss provisioning is a provision set aside to cover potential
future loan losses. The regulator defines for which asset classes
provisions have to be made; for unsecured loans which are one
payment in arrears, for example, the required provision may be 25%
of the outstanding loan amount. The provision is a book expense for
the financial institution and therefore lowers its profit.
Although MFIs that do not take voluntary deposits do not need

prudential regulation and supervision, they usually have to meet certain
regulatory conditions as lenders, for example a special license and
minimum capital requirements. In some countries interest-rate caps
are enforced on all financial institutions which may dissuade them from
serving typical microfinance markets. On the other hand, regulations
that promote competition, such as transparent loan cost disclosure,
permit customers to choose the best offer and thus help to weed out
inefficient operators.
Meagher, Patrick; et al. (2006): Microfinance Regulation in Seven

Countries: A Comparative Study
Prudential regulation should only be applied to large financial

institutions and to deposit-taking institutions. Non-prudential
regulation can help to promote microfinance and protect clients.
However, regulation without supervision is a toothless paper tiger.

Which of the following regulations do you consider prudential?
1. The equity capital required to set up a non-bank financial

institution is 200,000 USD.
2. The interest rates on loans must be made public as “effective

annual interest rate” which is calculated on a declining balance
method and includes all direct financial costs of a loan (interest,
fees and other obligatory costs) to be paid by the client.
3. Financial institutions are not allowed to have liabilities in excess

of 10 times their own risk weighted equity capital.
4. Deposit-taking institutions must keep 10% of their total deposit

base with the central bank.
5. Banks must invest at least 20% of their assets into the small
industry sector.

11 Supervision of MFIs
Um Hampi by qiv
Julia, the shop-keeper, is a proud customer of the Finance For All

individual loan programme and she also saves regularly. Things are
going well for Julia and also for Finance For All. One day, however,
when Julia happened to be in the Finance For All head office, she could
sense excitement in the air. All staff members’ heads turned to the back
door where a small middle aged man in a grey suit entered the office.
Julia heard one bank clerk say to another one: “This is him, the guy
from the central bank!” Julia did not understand what he meant, so she
asked one of the loan officers who she knew. The loan officer explained:
“Once in while we are visited by an official from the central bank. He
goes through our accounts and filing system, checks whether everything
is entered according to government regulations and interviews some of
the staff members; sometimes he even visits clients to cross-check the
information in our files. If there is any irregularity the central bank will
send an official letter to our big bosses and they will then put pressure
on us to make sure the mistakes are corrected immediately.” Now, Julia
understood why everyone was so nervous, but she felt relieved that the
government controls Finance For All – after all, she entrusted all her
savings to this organization.

Regulation and supervision belong together. Regulation without
supervision is useless, and supervision without regulations would be
arbitrary. The proper supervision of microfinance institutions requires
specialised skills to identify and address the distinctive risks faced by
these institutions.
Supervision
Supervision is the external oversight of financial institutions aimed at

enforcing compliance with regulations. Supervision is done by an
independent authority, for example the central bank.
On-site supervision should focus on examining the MFI’s credit

methodology, information systems, internal controls and the quality of
their human resources. Portfolio evaluations should be conducted using
stratified samples, amid the large number of borrowers that MFIs usually
have. On-site supervision is usually conducted once a year, lasting
between 2-14 days, depending on the size of the institution.
Off-site supervision should provide data and analyses to support the

planning and execution of future on-site inspections. The supervisory
agency should require essentially the same data from MFIs as it does
from commercial banks. The supervisory agency should set the
standards for the proper recording of transactions by MFIs, fit within the
context of the overall accounting standards adopted by the country.
Specifically, the standards imposed by the supervisory agency should
require the timely recognition of past due loans, the recording of
restructured loans, the creation of adequate loan loss reserves and the
recording of subsidies received in the form of funding at below-market
interest rates.
In principle, the supervisory agency should hold MFIs to the same

standards as other financial institutions with respect to the preparation,
presentation and disclosure of financial information. This applies to
information to the public (including depositors), the financial markets
(creditors and investors) and the supervisory agency itself. However,
small MFIs and those operating in rural areas could be allowed to have
less frequent reporting of information on their liabilities (e.g. Reserve
requirements and deposits). Disclosure and reporting on the assets side
of the balance sheet (including loan portfolio quality) should be done
with the same level of detail and at the same frequency as for other
financial institutions.
A major constraint to microfinance industry supervision is the fact that

the supervisory capacity in most developing countries is limited.
Therefore, the number of MFIs that can be supervised effectively is
rather small and must be focused on the largest institutions and on
deposit-taking organizations.
A second constraint is the cost of supervision. In relation to their

assets, MFIs are much more expensive to supervise than commercial

banks. Experience has shown that supervising MFIs was about 30 times
as expensive as the supervision of commercial banks. In some countries
the supervision cost is covered entirely by the government and in others
it is paid for at least partially by the supervised financial institutions.
Both constraints – limited supervisory capacity and high supervision

cost – have led supervisory agencies to decide against providing direct
oversight of large numbers of MFIs and instead pursue arrangements of
delegated supervision and/or of self-supervision.
Delegated supervision refers to an arrangement where the supervisory

agency delegates direct supervision to a third party, but retains control
over it. This seems to have worked in some cases where the
supervisory agency closely monitored the quality of the delegated
supervisor’s work (although it is not clear whether this model has
reduced total supervision costs). For delegated supervision to work, the
following conditions must be met: (i) the duties and responsibilities of
the bank supervisory agency and the delegated supervisor must be
clearly defined; (ii) the delegated supervisor must have the requisite
technical capacity and resources; and (iii) the delegated supervisor
must be reasonably independent of the institutions it supervises.
Self-regulation and self-supervision of financial intermediaries in

developing countries have been tried many times, and are virtually
never effective in protecting the soundness of the regulated
organisations. Hence, self-supervision is widely regarded as a weak
form of supervision since there are few incentives for institutions to
impose constraints and sanctions on themselves, as well as a lack of
legal backing to enforce compliance with given standards and the power
to close insolvent institutions.
The effectiveness of supervision of microfinance institutions can be

greatly enhanced by complementary institutions. A credit bureau, for
instance, allows the supervisor to identify over-indebted borrowers
which pose high risks to the financial system. External audit firms can
be contracted by the supervisory agency to provide reliable information
on financial institutions. The supervisory agency may also request that
all deposit-taking financial institutions undergo at least one rating per
year. However, the supervisory authority should never delegate its full
responsibility to audit firms or rating agencies. Their work can only be
complementary.
To be effective supervision must be linked to possible sanctions for

non-compliance with regulations. Sanctions may range from penalties to
loss of operational license.
Christen, R.P.; et al. (2003): Microfinance Consensus Guidelines:

Guiding Principles on Regulation and Supervision of Microfinance

Supervision ensures compliance with regulations. Due to capacity and
cost constraints not all MFIs can be supervised to the same extent;
focus should be on larger and deposit-taking MFIs. Delegated
supervision and self-supervision works best when the supervising
authority retains final responsibility.
1. Supervision ensures compliance with regulations.
2. If supervision is too expensive, the supervisory authority can also

use the results of rating agencies
3. Supervision should only be done on-site.
4. Supervision must be linked to possible sanctions for non-

compliance with regulations.
5. Financial institutions should hire an audit firm to prepare the

accounts for on-site supervision.

12 International trends and new
technologies
SEND Farmers Aug 2009 (9) by IICD
Julia, the shop-keeper, has been customer of Finance For All MFI for
the last three years. Things have been going extremely well for her and
Julia is grateful to Finance For All. One day, however, Julia learned
about a new MFI which started operations in her suburb. This MFI was
called 21st Century Microfinance Ltd. and had a completely different
approach. Apart from normal loans they offered mobile phone operated
bank accounts, access to ATMs, leasing and life insurance - services
which Julia never heard of before but which she was curious about. The
mobile phone service, in particular, seemed very interesting to Julia: she
would be able to send and receive money through her mobile phone and
in her booming shop she could even become an agent in this scheme.
Access to ATMs was offered by 21st Century Microfinance Ltd. through
two partner banks, this would allow Julia to withdraw money at any time
of the day, seven days a week, something very useful when running a
shop. Leasing also seemed luring to Julia, as she would be able to buy
a generator for her shop so that she could have electricity during the
frequent power cuts. And what about life insurance? It never crossed
Julia’s mind what would happen to her husband and children if she died
unexpectedly. They probably would find it very difficult to pay for the
funeral and to make ends meet thereafter. Yes, a life insurance would
not be such a bad idea.
Julia was pondering whether to contact 21st Century Microfinance Ltd...

The growth of the microfinance industry depends on the general
framework in a specific country, primarily on the political situation, on
population growth and migration patterns, on general economic
development and on regulations governing the financial sector.
Obviously, there are huge differences between countries. Large,
emerging markets like Brazil, Russia, India and China may take a
different path compared to least developed countries. Some basic global
trends and industry challenges to be considered for the future
development of microfinance are:
The population in many developing countries is becoming younger,

more urban, more educated and better connected.
Wireless technology is spreading fast; mobile phones and internet is
reaching even remote areas.
Against the background of the global economic recession and the
increasing problems in the microfinance sector (esp. customer over-
indebtedness), people and governments in many countries are
asking for more state control of the financial sector.
Financial flows from developed to developing countries and
between developing countries are changing fast; private investments
and migrants' remittances have already become much more
important than development aid.
An increasing number of international regulations may affect
financial systems in developing countries, for example anti-money
laundering regulations.
Environmental problems are increasing globally, and so do
environmental technologies such as solar energy.
Critics of microfinance have pointed out that there is no hard
evidence that micro-credit really helps the poor to get out of poverty.
There is a lack of scientific research in the field of social impact.
MFIs should consider the above trends and challenges as business

opportunities. Possible responses may include the following:
Develop new and better financial services for the poor -

Urbanisation, migration, education and connectivity will change
traditional social systems on which rural and group-based MFIs are
built, but these phenomena may also create new business
opportunities for MFIs, for instance money transfer services,
business start-up finance, housing finance, education loans, leasing
and insurances. As people become more educated and better
connected they may also become more demanding with regard to
service quality and financial product diversity. MFIs will have to
become more customer-oriented and innovative.
Expand into branchless banking - Outreach to the poor is one of
the main challenges of microfinance. Many potential microfinance
clients live in remote areas that are difficult to reach from urban

centres, or they are so poor that even conventional MFIs may find it
difficult to serve them. In the recent past, the use of new
technologies and branchless banking has also commenced to
revolutionize microfinance, increasing outreach and cutting down on
transaction costs. Mobile phone banking, Point of Sale (POS)
payment systems, Automated Teller Machines (ATM), credit and
debit cards, mobile bank outlets, internet banking and similar
innovations are prominent examples how microfinance services can
be delivered to people who have not been reached yet.
Invest into "green economy" - New investment opportunities
emerge in the “green economy”, for example in solar energy, biogas
production and energy efficiency technologies. Moreover, climate
change adaptation may be a field where microfinance providers can
get involved, for example agriculture and disaster insurance.
Commit to "responsible finance" - More state control and
international regulations may impede MFIs, but it could also lead to
better supervision, less fraud and less institutional failures, thus to
more public trust. MFIs should tackle this challenge pro-actively by
putting the principles of responsible finance into action - for example
through transparent and fair pricing, or by controlling customer over-
indebtedness.
Access new sources of funding - New refinancing possibilities for
MFIs have been emerging in the last years. Most MFIs started by
using grants or soft loans from donors, but increasingly Microfinance
Investment Vehicles (MIV), social investors and even commercial
investors get interested. Therefore, rating agencies and industry
standards will become more important in future. At the same time
measuring social performance gets increasing attention because
social investors want to know what social impact their money has. In
future, MFIs that can prove the social impact of their work will find it
easier to attract investors and clients.
Microfinance investment vehicle (MIV)
Any intermediary that mobilizes funds from investors to invest into

microfinance institutions is a MIV. CGAP distinguishes six categories:
Registered mutual funds targeting primarily retail investors and

seeking near a money market returns from primarily fixed-income
investment;
Commercial fixed-income investment funds targeting public and
private institutional investors and seeking close to a market return;
Structured finance vehicles offering a range of asset-backed
securities with different risk and return profiles to microfinance
investors;
Blended-value funds offering below-market returns to socially
focused investors and providing a mix of debt and equity finance

to MFIs;
Holding companies of microfinance banks providing mainly equity
finance and technical assistance to start-up microfinance banks;
Private equity funds seeking a market return.
Outreach
In microfinance, outreach refers to reaching the poor with financial

services. One can distinguish between outreach depth and outreach
breadth. Depth refers to the poverty level of clients, breadth to the
number of poor clients. The aim of microfinance is to reach as many
poor people as possible, and also the poorest of the poor.
Arguably, new technologies will become the main driver of

innovation and efficiency gains in the microfinance industry. Hundred
millions of mobile phone users worldwide are already using or will soon
be able to use their phones for financial transactions. The most
significant amount of growth is in Asia. New technologies are at the core
of e-banking, m-banking and branchless banking – three terms which
are often used interchangeably although they are not quite the same
(see next box).
M-banking, e-banking, branchless banking
Branchless banking is the delivery of financial services without using

bank branches, thereby cutting down transaction costs. Many
approaches of branchless banking are based on new technologies
such as mobile phones and internet; however, branchless banking
can also be achieved by business partnerships, for example using
post offices instead of bank branches to deliver financial services. –
e-banking (electronic banking) is one aspect of branchless banking; it
refers to the delivery of financial services through electronic media
such as internet, automated teller machines (ATM), point-of-sale
machines (POS) and mobile phones. M-banking (mobile banking) is
part of e-banking and refers to the delivery of financial services
through mobile phones.
Branchless banking is facing a number of advantages and challenges:
Branchless banking can dramatically reduce the cost of delivering

financial services to poor people. CGAP estimates that it can offer
basic banking services to customers at a cost of at least 50 percent
less than what it would cost to serve them through traditional
channels.
However, CGAP estimates that less than 10 percent of all branchless
banking customers are poor, new to banking, and are using these
channels for financial services (or activities other than making bill

payments, purchasing airtime, or withdrawing government cash
benefits). Much advertising and marketing is needed.
So far, most MFI-led branchless banking initiatives have been small
pilots or have had only limited success. The broad experience so
far is that while many banks are deploying mobile banking
capabilities to make banking more convenient for existing customers,
those ventures that have attempted to reach new client segments
have usually been done in partnership with, if not been led by, a
mobile operator or technology company. Many MFIs have neither the
customer scale or back-office systems to be attractive enough to link
into mobile solutions.
Also, several client adjustment issues need to be addressed:
apprehension with technology, security fears (will money be safe
on the phone?), phone requirements, and a lack of coverage in
the most remote and poor areas.
Branchless banking, in particular e-banking is still at its infant stage in

the world of microfinance. Indeed there are many failures worldwide.
Successful implementation of an e-banking solution is not so much
dependent on technology but rather on understanding three key factors
(based on MicroSave India Focus Note 4, 2008): customer value for
the end users (concentrate on areas where cash is inconvenient and the
e-banking solution can do things that cash cannot); business case for
the collaborating companies (all partners involved in the service delivery
must benefit); frame conditions (for example existing e-banking
infrastructure, financial literacy of potential customers and government
regulations).
As MFIs try to diversify and improve their products, services and

delivery channels, the importance of partnerships increases rapidly.
There are many obstacles to launching new financial services or
expanding outreach, e.g. restrictions due to government regulations,
high up-front costs, lack of technical expertise or infrastructure.
Partnerships with other institutions can be a solution to these
obstacles. Here are some examples:
Partnerships with banks to offer account services to MFI clients, esp.

savings account and money transfer services.
Partnerships with insurance companies to offer insurances to MFI
clients.
Partnerships with leasing companies to offer leasing services to MFI
clients.
Partnerships with traders to offer loans or leasing for equipment, raw
materials and new technologies to MFI clients.
Partnerships with mobile phone companies, postal offices or retail
shops to offer money transfers and cash withdrawal services to MFI
clients.

Partnerships with housing development companies to offer housing
loans.
The success of business partnerships depends on two key factors:

mutual trust and shared benefits. Trust between businesses is built on
compatible corporate cultures (shared values) and personal contacts,
and the partnership must adequately benefit all partners involved, which
is a great challenge when drafting the partnership contract.
Furthermore, in some cases legal and technical issues can be a
problem: for example, conventional insurance contracts and insurance
claim procedures will have to be simplified to fit the needs of the poor;
or, information campaigns will be necessary to explain insurance or
leasing services to the poor.
Apart from new technologies and partnerships, there is also a trend in

microfinance to develop new financial products such as micro-
insurance, micro-leasing or specialized loan products. For instance,
micro-lending can improve poor people’s access to modern energy
services (biogas, micro hydropower, wind, solar, or liquefied petroleum
gas). The market potential for energy lending by MFIs is huge, since the
electrification rate among poor and rural consumers is still low in most
developing countries. However, MFIs (or their partners) will need to
develop the market for new energy technologies beforehand because
poor people may not be familiar with the benefits and the operation of
such technologies. Furthermore, lending must be scaled up to achieve a
critical mass. Since larger loans with longer terms mean higher credit
risk, MFIs will have to off-set this risk through various methods, such as
careful client selection and portfolio diversification. Other specialized
loan products with similar characteristics are facility loans - for example,
loans to improve household sanitation and water supply.
In the field of micro-insurance many innovations have been launched

in recent years. Although life insurance is still the most popular
insurance product for poor households, there are promising experiments
with health insurance, as well as crop and livestock insurance. Index
insurance in agriculture has been successfully tested in India and other
countries. The basic idea of index insurance is to simplify insurance
claims by defining an objective indicator which automatically triggers an
insurance payout; for instance, crop insurance payouts are triggered by
rainfall data, i.e. the farmers will get money from the insurance company
if the total rainfall in the critical months is below a certain amount which
is scientifically considered necessary for the crop to produce.
Micro-leasing is another attractive product for MFIs. The typical client

of micro-leasing is in the “middle to upper strata” of microbusinesses.
Equipment and machinery leases are granted upon the cash flow
generated by the leased items, rather than by the credit history of the
lessee. By retaining ownership of the asset, the lessor has collateral
which can be repossessed in the event of a client payment default.
However, considering the lower grade technology in the informal sector,
lessors targeting this market must be able to accurately estimate the

equipment’s residual value and participate in the re-leasing or selling to
the secondary market.
MicroSave India Focus Note 4 (2008): Electronic Banking: The Next

Revolution in Financial Access?
CGAP Focus Note No. 38 (2006): Use of Agents in Branchless

Banking for the Poor: Rewards, Risks, and Regulation
CGAP Focus Note No. 39 (2006): Financial Inclusion 2015: Four

Scenarios for the Future of Microfinance
CGAP Focus Note No. 44 (2008): Foreign Capital Investment in

Microfinance - Balancing Social and Financial Returns
CGAP Focus Note No. 48 (2008): Banking on Mobiles: Why, How,

for Whom?
CGAP Focus Note No. 57 (2009): Scenarios for Branchless Banking

in 2020
CGAP (2009): Microfinance Funder Survey - Global Results
Hess, Ulrich (World Bank, 2003): Innovative Financial Services for

Rural India. Monsoon-Indexed Lending and Insurance for Small-
holders
Mas, Ignacio (CGAP Microfinance Blog, 2012): The Great Financial

Inclusion Juggling Act
http://microfinance.cgap.org/2012/01/03/the-great-financial-
inclusion-juggling-act/
CGAP Focus Note No. 61 (2010): Growth and Vulnerabilities in

Microfinance
Rhyne, Beth (Center for Financial Inclusion; 2012): Financial

Inclusion by 2020? Five Global Trends That Will Shape the Answer
http://centerforfinancialinclusionblog.wordpress.com/2012/01/09/fin
ancial-inclusion-by-2020-five-global-trends-that-will-shape-the-
answer/
Ehrbeck, Tilman (CGAP Microfinance Blog, 2012): Financial

Services for the Poor: Reflections on 2011
http://microfinance.cgap.org/2012/01/08/financial-services-for-the-
poor-reflections-on-2011/
Global trends, such as urbanisation, migration, mass education and

new technologies, are business opportunities for MFIs which are
prepared to offer innovative financial products and low-cost delivery
systems, for example branchless banking, mobile banking, micro-
leasing, micro-insurances and remittance transfer services.

Read CGAP Focus Note No. 39 and briefly describe in your own
words the four scenarios proposed by the authors!

13 Exercise results
Estimate the level of interest rates a borrower would have to pay in

the following two scenarios, assuming the bank deposit rate would be
20% p.a.:
1. A money lender has USD 10,000 and there are 1000 people who
want a loan of USD 100 each.
2. A bank has USD 1 million in deposits and there are 1000 people
who want a loan of USD 1000 each.
Solutions: In the first scenario demand for funds is much greater than
supply; therefore the interest rate would be much higher than 20%
which is the alternative investment opportunity for the money-lender.
In the second scenario, supply of funds is equal to demand, therefore
the interest rate would be slightly higher than 20% which is the cost of
funds for the bank.
Read the example at the beginning of this chapter and find typical
characteristics and problems of poor people in Julia’s story!
Solutions: Julia invested savings in kind; she asked family members,

friends and neighbours for a loan; she was very nervous when she
entered the big bank building; the loan officer treated her not well;
bank’s requirements are very cumbersome; Julia goes to the money-
lender.

1. Poor people save in kind because they expect higher returns on

material investments compared to savings deposits.
2. Banks usually don’t give loans to poor people because the

administrative cost is too high compared to the expected interest
revenue.
3. Poor people are bad credit customers. They don’t pay back loans
on time.
4. Poor people are too poor to save.

5. Without proper business records it is difficult for a normal bank to
grant a small business loan.
6. In many countries banks legally have to put 100% capital against

unsecured loans in their balance sheet. This reduces their capital
leverage.
Solutions: 1, 3, 4
Which items belong to the household economy of a family?
1. The weekly salary of the husband
2. The pension the husband will get when he retires in three years.
3. The money the daughter pays every day for food at university.
4. The gold earrings of the wife.
5. The ten chickens in the family backyard.
6. The cake given to the next door neighbour on her birthday
Solutions: 1, 3, 4, 5

Calculate monthly cash deficit or surplus for this family and the final
cash position at the end of March!
January: USD 40 monthly salary of the husband; USD 30 expenses

for food etc.
February: USD 40 monthly salary of the husband; USD 30 expenses

for food etc.; USD 10 for cooking gas.
March: USD 40 monthly salary of the husband; USD 30 expenses for

food etc.; USD 20 for school fees; USD 6 for selling chicken.
Solutions: Jan +10 (surplus); Feb 0 (no surplus, no deficit); March

-4 (deficit); final cash position = +6 (surplus)
Which of the following statements are correct?
1. Poor people are usually very concerned about the security of

their savings.
2. Poor people generally need access to loan services more

urgently than access to savings services.
3. The only savings product that is relevant for the poor is the liquid
passbook savings.
4. Micro-loans have higher interest rates than larger loans to cover

the relatively higher transaction costs.
Solutions: 1, 4.

1. There is no difference between a mutual and a cooperative bank.
2. Leasing is a financial product which uses the leased item as a

security.
3. ROSCAs are more complex than ASCAs because some

members save and borrow, while others are savers only.
4. The main differences between conventional NGO-MFIs and

transformed NGO-MFIs lie in ownership and supervision.
5. Group schemes like Grameen are the best microfinance

approach.
Solutions: 1. (members of a mutual usually do not contribute to the

capital of the company by direct investment); 3. (ASCAs are more
complex than ROSCAs); 5. (there is no single best approach for
microfinance; in fact, many clients of group schemes want to join
individual schemes if given the option).
Read the paper written by H.D. Seibel (Does History Matter? The Old
and the New World of Microfinance in Europe and Asia) and answer
the following questions:
1. Why did the Irish loan funds boom from the 1823 onwards, and
then decline after 1843?
2. In Germany, what was the main difference between Schultze-
Delitzsch and Raiffeisen before 1864?
3. What are the three main strands of indigenous finance in India?
4. Why are Indian chit funds regulated by law?
5. Where do you see the main difference between the Indian and
the European cooperative system?
Solutions: (1) Due to changing legal frame conditions: in 1823 funds

were allowed to collect interest-bearing deposits and to charge
interest on loans; in 1843 a cap on interest rates was declared. (2)
Raiffeisen believed in charity, while Schultze-Delitzsch insisted on a
self-help approach, which Raiffeisen copied in 1864. (3) Moneylen-
ders, chit funds and merchant bankers. (4) Risk of fraudulent pyramid
schemes. (5) The role of government: in India the government tends
to intervene directly in cooperative management, in Europe the
governments set the legal framework for cooperatives without
interference on management level.

Which of the following two MFIs would you consider more

sustainable?
Year 2009: MFI A MFI B

Borrowed funds $1,000,000 $2,000,000
Concessional rate of interest 2% 3%
paid by the MFI for borrowed
funds
Market interest rate for 10% 10%
borrowing funds
Profit at the end of the year $70,000 $70,000
Solutions: MFI A has received 8% subsidy on borrowed funds (10% -

2%). This equals $80,000 subsidy ($1,000,000*8%) which is 1.14
times higher than profit. MFI B received 7% subsidy on borrowed
funds. This equals $140,000 subsidy which is 2 times higher than
profit. – Hence, MFI A can be considered more sustainable than MFI
B.
Which of the following regulations do you consider prudential?
1. The equity capital required to set up a non-bank financial

institution is 200,000 USD.
2. The interest rates on loans must be made public as “effective

annual interest rate” which is calculated on a declining balance
method and includes all direct financial costs of a loan (interest,
fees and other obligatory costs) to be paid by the client.
3. Financial institutions are not allowed to have liabilities in excess

of 10 times their own risk weighted equity capital.
4. Deposit-taking institutions must keep 10% of their total deposit

base with the central bank.
5. Banks must invest at least 20% of their assets into the small
industry sector.
Solutions: 1, 3, 4

1. Supervision ensures compliance with regulations.
2. If supervision is too expensive, the supervisory authority can also

use the results of rating agencies
3. Supervision should only be done on-site.
4. Supervision must be linked to possible sanctions for non-

compliance with regulations.
5. Financial institutions should hire an audit firm to prepare the

accounts for on-site supervision.
Solutions: 2 (ratings can never replace supervision, they can only

complement); 3 (on-site and off-site supervision should be combined);
5 (audit firms are hired to audit financial reports required by the
supervisor, the accounts of an institution are maintained internally)
Read CGAP Focus Note No. 39 and briefly describe in your own
words the four scenarios proposed by the authors!
Solutions:
(1) The use of new technologies could result in widespread access to
financial services or exacerbate the digital divide.
(2) The states could play a supportive role for microfinance or they
could harm it.
(3) New international players could bring microfinance forward or
cause mission drift and client over-indebtedness
(4) International financial sector regulations could increase access to
financial services or hamper it.

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© 2012 Frankfurt School of Finance & Management

© 2012 Frankfurt School of Finance & Management

1 Financial system ................................................... 1

2 Problems of the poor ............................................ 7

3 Problems of financial intermediaries.....................11

4 The household economy ..................................... 15

5 Surplus and deficit .............................................. 19

6 Financial services demanded by the poor............ 21

7 Financial institutions ........................................... 27

8 The history of microfinance ................................. 39

9 Principles of microfinance ................................... 45

10 The role of regulation in microfinance ................. 51

11 Supervision of MFIs ............................................ 57

12 International trends and new technologies .......... 61

13 Exercise results .................................................. 69

© 2012 Frankfurt School of Finance & Management

2004-05_HongKong_0002 by Hajo Schatz

National and international economies cannot function without financial

A financial system comprises a set of complex and closely

Research from the 1960s and 1970s by Raymond Goldsmith, John

© 2012 Frankfurt School of Finance & Management 1

Pischke, J.D. (1998): The Financial Systems Approach to

In later years, the financial system development approach was further

Essentially, financial markets operate according to the same principles

Moreover, the capital provider is exposed to a high degree of

© 2012Frankfurt School of Finance & Management 2

Due to basic information and confidence problems, direct financial

Direct financial relationships afford decisive advantages for both parties.

Even if the information and confidence problems are mitigated or

 Amounts differ: private households and individuals save up in

© 2012 Frankfurt School of Finance & Management 3

A financial institution uses borrowed funds and own equity capital to

The role of financial institutions within the financial system is primarily to

Financial institutions play a key role as financial intermediaries. They

The relationship between savers, borrowers / investors and the

© 2012Frankfurt School of Finance & Management 4

General macroeconomic and legal conditions

In an advanced financial system, financial intermediaries perform the

Financial institutions transform small and short term deposits into

Through transformation of size, financial intermediaries perform a

© 2012 Frankfurt School of Finance & Management 5

Through transformation of term, financial intermediaries can match a

Transformation of risk is one of the most important processing

Financial intermediation is crucial for a functioning economy. People

Exercise for Chapter 1

The advantage of financial institutions towards money lenders is that

Solutions: Please refer to chapter 13.

© 2012Frankfurt School of Finance & Management 6

Luigi Guarino - Fabric shop

1. Proof that the shop and the land belongs to her;

© 2012 Frankfurt School of Finance & Management 7

 Poor people rarely have regular incomes

 The loan is given immediately, whereas a bank would take weeks to

© 2012Frankfurt School of Finance & Management 8

Microfinance providers should learn from informal financial

Exercise for Chapter 2

Solutions: Please refer to chapter 13.

© 2012 Frankfurt School of Finance & Management 9

Initial scenario (continued)

There are many reasons why formal financial intermediaries usually

© 2012 Frankfurt School of Finance & Management 11

Conning, Jonathan; Kevane, and Michael (2003): Why isn’t there

The ultimate purpose of microfinance is not to give poor people

© 2012Frankfurt School of Finance & Management 12

Amounts differ: private households and individuals save up in

Poor people rarely have regular incomes

The loan is given immediately, whereas a bank would take weeks to

As a rule, poorer households are not paid employees: They operate

Retaining income scheduled for subsequent expenditure

To prepare for emergencies and unforeseen expenditures

Security is the highest priority

a liquid savings option (e.g., passbook savings) and