What Is Microfinance?

Microfinance is a type of banking service provided to unemployed or low-income

individuals or groups who otherwise would have no other access to financial
services.

Key Takeaways/Characteristics
 Microfinance is a banking service provided to unemployed or low-income
individuals or groups who otherwise would have no other access to financial
services. 
 Microfinance allows people to take on reasonable small business loans safely,
and in a manner that is consistent with ethical lending practices. 
  The majority of microfinancing operations occur in developing nations, such as
Uganda, Indonesia, Serbia, and Honduras. 
 Like conventional lenders, micro financiers charge interest on loans and
institute specific repayment plans.
 The World Bank estimates that more than 500 million people have benefited
from microfinance-related operations.

Microcredit Vs Microfinance

Basis for
Microcredit Microfinance
Comparison

Microfinance refers to the number of

Microcredit is the small loan
financial services provided to the
facility provided to the people
Meaning small entrepreneurs and enterprises
with less earning, to motivate
who cannot take shelter of banks for
them to become self-employed.
banking and other services.

What is it? Subset Superset

Includes Credit Activities Credit and non-credit activities

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The significant differences between microcredit and microfinance are provided
below:

1. Microcredit is defined as the loan facility for poor customers. A broad range of
financial services for the poor clients is known as Microfinance.
2. Microcredit is a component of microfinance.
3. Microcredit includes credit activities only, but microfinance includes credit as
well as noncredit activities like savings, pension, insurance, etc.

Understanding Microfinance
Microfinance services are provided to unemployed or low-income individuals
because most of those trapped in poverty, or who have limited financial resources,
do not have enough income to do business with traditional financial institutions.

Role of Microfinance on Economic Development

Financial Stability

One of the largest roles that microfinance has in local economies is helping to
provide low-income and poor families with the means to becoming financially
stable. Small microfinance loans give people the opportunity to generate enough
income to pay for necessities such as food, shelter and basic medical needs. Giving
these families the opportunity for long-term financial stability can help reduce the
number of people on public assistance programs, which benefits local and national
economies.

Job Creation

A business that opens and operates as a result of a microfinance loan does not
create jobs in as large numbers as bigger multi-national corporations. Many
microfinance lenders focus on giving loans to people who live in some of the
poorest areas of the world. The jobs these small businesses create are significant to
these local communities where jobs are scarce. When people in these small
communities are earning more income, the more likely it is that they will spend
their earnings within their community. This helps stimulate local economic growth.

Global Poverty

Microfinance supporters believe that giving low income and poor families the
opportunity for long-term financially stability through these small loans helps

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break the cycle of poverty in the current generation and work toward ending global
poverty for future generations. As more of these communities begin to grow and
the local economies begin to prosper, the world’s gross domestic product begins to
increase and the income gap between the wealthiest and poorest people in the
world will begin to decrease.

Microfinance Supports Educating Entrepreneurs

Microfinancing organizations support a large number of activities that range from

providing the basics—like bank checking and savings accounts—to startup capital
for small business entrepreneurs and educational programs that teach the principles
of investing. These programs can focus on such skills as bookkeeping, cash-flow
management, and technical or professional skills, like accounting.

Role of Microfinance for Developing Countries

1. It allows people to better provide for their families.

Microfinance allows for an added level of resiliency in the developing world. Even
when households are able to work their way out of poverty, it often takes just one
adverse event to send them right back into it. It’s often a health care issue that
causes a return to poverty. By allowing entrepreneurs to become more resilient
through their own efforts at their own business, it gives them the opportunity to
make it through times of economic difficulty.

2. It gives people access to credit.

Muhammad Yunus, who is often credited as the modern father of microfinance,

once gave $27 to women out of his own pocket because he saw how the cycle of
debt affected their work crafting bamboo chairs. Most banks will not extend loans
to someone without credit or collateral because of the risks involved in doing so,
yet those in poverty do not have any credit or collateral.

By extending microfinance opportunities, people have access to small amounts of

credit, which can then stop poverty at a rapid pace. Yunus has always believed that
credit is a fundamental human right. There are certainly some financial institutions
which may disagree with his assessment.

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3. It serves those who are often overlooked in society.

In many developing nations, the primary recipient of microloans tends to be

women. Up to 95% of some loan products are extended by microfinance
institutions are given to women. Those with disabilities, those who are
unemployed, and even those who simply beg to meet their basic needs are also
recipients of microfinance products that can help them take control of their own
lives.

Women are key figures in leadership roles in business, even in the developed
world. Women also develop others more frequently when it comes to
entrepreneurial roles. This comes from coaching, feedback, or investments. Even
in the developed world, women helping women is an economic force that poverty
can’t stop.

4. It offers a better overall loan repayment rate than traditional banking

products.

When people are empowered, they are more likely to avoid defaulting on a loan.
Women are also statistically more likely to repay a loan than men are which is
another reason why women are targeted in the microfinance world. There’s also
the fact that for many who receive a microloan, it is their only real chance to get
themselves out of poverty, so they’re not going to mess things up.

Zenger Folkman published a survey regarding ratings of high integrity and honesty
in leadership roles that was separated by gender. The mean percentile of women
displaying these traits was 55%, while for men, it was just 48%. In business, the
bottom line is this: integrity matters. Microfinance institutions have recognized this
and approached women because of this. As a side effect of this approach, many
developing countries are taking a new look at what role women should play in
society.

5. It provides families with an opportunity to provide an education to their

children.

Children who are living in poverty are more likely to have missed school days or to
not even be enrolled in school at all. This is because the majority of families who
live in poverty are working in the agricultural sector. The families need the
children to be working and productive so their financial needs can be met. By
receiving microfinancing products, there is less of a threat of going without
funding, and that means more opportunities for children to stay in school.

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This is especially important for families with girls. In return, this makes girls more
likely to finish schooling and then either obtain a fair-paying job or go onto a
further educational opportunity.

6. It creates the possibility of future investments.

The problem with poverty is that it is a cycle that perpetuates itself. When there is
a lack of money, there is a lack of food. When there is a lack of clean water, there
is a lack of sanitary living conditions. When people are suffering from
malnutrition, they are less likely to work. A lack of sanitation creates the potential
of illness that prevents working days.

Microfinance changes this by making more money available. When basic needs are
met, families can then invest into better wells, better sanitation, and afford the time
it may take to access the health care they need.

As these basic needs are met, it also means that there are fewer interruptions to the
routine. People can stay more productive. Kids can stay in school more
consistently. Better healthcare can be obtained. This creates a lower average family
size because there are more guarantees of survival in place.

And when that happens, the possibility of future investments will occur because
there is more confidence in being able to meet basic needs.

7. It is a sustainable process.

How much risk is there with a $100 loan? Some investors might pay that for a
decent dinner somewhere. Yet $100 could be enough for an entrepreneur in a
developing country to pull themselves out of poverty. This small level of working
capital is sustainable because it’s essentially a forgettable amount.

If there is a default on that money, the interest and high repayment rates of other
microloans will make up for it. Then repayments are reinvested into communities
so that the benefits of microfinance can be continually enhanced. Each repayment
becomes the foundation of another potential loan.

This is why many microfinance products have relatively high interest rates. Some
institutions may charge the equivalent of a 20% APR, but others have interest rates
which exceed 800%. Although interest is high, recipients are invested into making
these products work because virtually all institutions put repayments back into new
loans that target the most vulnerable households in the developing world.

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8. It can create real jobs.

Microfinance is also able to let entrepreneurs in developing countries be able to

create new employment opportunities for others. With more people able to work
and earn an income, the rest of the local economy also benefits because there are
more revenues available to move through local businesses and service providers.

It’s not just the entrepreneurial level that benefits from job creation through
microfinance. Grameen Bank in Bangladesh employs over 21,000 people and their
primary financial products are related to microfinance. That’s tens of thousands of
jobs that are created by the industry with the sole purpose of being able to drag
people up and out of poverty.

9. It encourages people to save.

Microloans are an important component of microfinance, but so is saving money.

When people have their basic needs met, the natural inclination is for them to save
the leftover earnings for a future emergency. This creates the potential for more
investments and ultimately even more income for those who are in the developing
world.

Some microfinance institutions have seen an extraordinary number of savings

occur when products are extended. The Unit Desai of Bank Rakyat Indonesia
counts 28 million savers to just 3 million microloan borrowers.

Now saving isn’t always seen, especially from borrowers, but this is part of the
expected microfinance process. Small loans make small financial improvements
for households living in poverty. Instead of big improvements, microfinance
allows for small improvements. When enough of those improvements occur, then
there is a safe place for people to store their income thanks to this industry.

10. It reduces stress.

There is a valid argument to be made that some microloans go to cover household

expenses instead of business needs. Some are using these loans to pay bills or
purchase food. It’s true. Yet without this product available, there wouldn’t be an
ability to pay bills or purchase food. So even though it may not always be used for
business purposes, it still serves a purpose by reducing stress.

Stress cannot be underestimated when it comes to poverty. Even in the developing

world, the stresses of poverty can be overwhelming. It causes people to seek out

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coping mechanisms that are not always healthy. And, in some cases, it may even
cause families to break apart.

Sometimes childbirth is a coping mechanism for poverty simply because an extra

set of hands means an extra chance for income. By reducing these stress markers,
households can focus on the job at hand to provide for themselves, even if that
means net income levels for that family may not rise in the near future.

11. It allows people to feel like they matter.

The feeling of receiving a credit product for the first time cannot be ignored. It’s a
feeling like you’ve made it. That you really are somebody because you’ve been
trusted with credit. This feeling applies to everyone, even in the developed world.
When a person feels like they matter, it changes who they are at a core level.
Instead of focusing on how they can just survive, then begin to look for ways to
thrive.

This brings us back to the stress that poverty creates on people. People, when they
are approved for a microloan for the first time, will often have a reaction that is
similar to Steve Martin’s reaction in The Jerk when he discovered his name in the
phone book.

And this is why Yunus feels that credit is a fundamental right. Without credit,
survival is often the best possible outcome. With credit, there is hope that anything
can be possible.

12. It offers significant economic gains even if income levels remain the same.

The gains from participation in a microfinance program including access to better

nutrition, higher levels of consumption, and consumption smoothing. There is also
an unmeasurable effect which occurs when women are empowered to do
something in their society when they might not normally be allowed to do so. As
spending occurs, these benefits also extend outward to those who may not be
participating in the program so that the entire community benefits.

The most important weakness of microfinance is that the effects of raising income
levels for the poor can often be questionable. Although it raises the possibility of
income accumulation and savings, microfinance products also raise the possibility
of creating a further indebtedness that may potentially extend the cycles of poverty
for an infinite period of time.

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Although some may look at consumption in a negative view, those who have gone
without for so long will see improved consumption as a sign that things are getting
better. Consumption smoothing allows an entire community to realize the benefits
that microfinance can provide.

It isn’t always about the money. Sometimes economic success comes from
stability.

Yet if you were to ask the average person who was the recipient of a microloan
how they felt about the experience, you would be told that they were happy the
loan was available. This happiness is reflected in the high repayment rates that are
almost always seen in programs offered within developing countries. That in itself
shows that the benefits of microfinance, at a core level, are almost always leaving a
positive effect.

Microfinance Loan Terms

Like conventional lenders, micro financiers must charge interest on loans, and they
institute specific repayment plans with payments due at regular intervals. Some
lenders require loan recipients to set aside a part of their income in a savings
account, which can be used as insurance if the customer defaults. If the borrower
repays the loan successfully, then they have just accrued extra savings. 

Empowering women in particular, as many microfinance organizations do, may

lead to more stability and prosperity for families. 

Because many applicants cannot offer collateral, microlenders often pool

borrowers together as a buffer. After receiving loans, recipients repay their debts
together. Because the success of the program depends on everyone's contributions,
this creates a form of peer pressure that can help to ensure repayment.

For example, if an individual is having trouble using his or her money to start a
business, that person can seek help from other group members or from the loan
officer. Through repayment, loan recipients start to develop a good credit
history, which allows them to obtain larger loans in the future.

Interestingly, although these borrowers often qualify as very poor, repayment

amounts on microloans are often actually higher than the average repayment rate
on more conventional forms of financing. For example, the microfinancing
institution Opportunity International reported repayment rates of approximately 99
percent in 2019.

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History of Microfinance
Microfinance is not a new concept. Small operations have existed since the 18th
century. The first occurrence of microlending is attributed to the Irish Loan Fund
system, introduced by Jonathan Swift, which sought to improve conditions for
impoverished Irish citizens. In its modern form, microfinancing became popular on
a large scale in the 1970s.

The first organization to receive attention was the Grameen Bank, which was
started in 1976 by Muhammad Yunus in Bangladesh. In addition to providing
loans to its clients, the Grameen Bank also suggests that its customers subscribe to
its "16 Decisions," a basic list of ways that the poor can improve their lives.

The "16 Decisions" touch upon a wide variety of subjects ranging from a request to
stop the practice of issuing dowries upon a couple's marriage, to keeping drinking
water sanitary. In 2006, the Nobel Peace Prize was awarded to both Yunus and the
Grameen Bank for their efforts in developing the microfinance system.

India's SKS Microfinance also serves a large number of poor clients. Formed in
1998, it has grown to become one of the biggest microfinance operations in the
world. SKS works in a similar fashion to the Grameen Bank, pooling all borrowers
into groups of five members who work together to ensure that their loans are
repaid.

Benefits of Microfinance
The World Bank estimates that more than 500 million people have directly or
indirectly benefited from microfinance-related operations. The International
Finance Corporation (IFC), part of the larger World Bank Group, estimates that, as
of 2014, more than 130 million people have directly benefited from microfinance-
related operations. However, these operations are only available to approximately
20% of the three billion people who qualify as among the world’s poor. 

In addition to providing microfinancing options, the IFC has helped establish or

improve credit reporting bureaus in 30 developing nations. It has also advocated
for adding relevant laws in 33 countries that govern financial activities.

The benefits of microfinance extend beyond the direct effects of giving people a
source for capital. Entrepreneurs who create successful businesses, in turn, create
jobs, trade, and overall economic improvement within a community.

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The For-Profit Controversy
Although there are countless heartwarming success stories ranging from micro-
entrepreneurs starting their own water supply business in Tanzania, to a $1,500
loan that allowed a family to open a barbecue restaurant in China, to immigrants in
the U.S. being able to build their own businesses, microfinance has sometimes
fallen under criticism.

While microfinance interest rates are generally lower than conventional banks',
critics have charged that these operations are making money off of the poor.
Especially since the trend in for-profit microfinance institutions, such as BancoSol
in Bolivia and the above-mentioned SKS (which actually began as a nonprofit
organization (NPO) but became for-profit in 2003.)

One of the largest, and most controversial, is Mexico's Compartamos Banco. The

bank was started in 1990 as a nonprofit. However, 10 years later, management
decided to transform the enterprise into a traditional, for-profit company. In 2007,
it went public on the Mexican Stock Exchange, and its initial public offering (IPO)
raised more than $400 million.

Like most other microfinance companies, Compartamos Banco makes relatively

small loans, serves a largely female clientele, and pools borrowers into groups. The
main difference lies in how it uses the funds it nets in interest and repayments.
Like any public company, it distributes them to shareholders. In contrast, nonprofit
institutions take a more philanthropic stance with regard to profits, using them to
expand the number of people they help, or to create more programs. 

Concerns about For-Profit Microfinancing

In addition to Compartamos Banco, many major financial institutions and other
large corporations have launched for-profit microfinance departments,
including CitiGroup, Barclays, and General Electric, for example. Other companies
have created mutual funds that invest primarily in microfinance firms.

Compartamos Banco and its for-profit peers have been criticized by many,

including the grandfather of modern microfinance himself, Muhammad Yunus.
The immediate, pragmatic fear is that, out of a desire to make money,
large microfinance bankers will charge higher interest rates that may create a debt
trap for low-income borrowers.

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But Yunus and others also have a more fundamental concern: that the incentive for
microcredit should be poverty alleviation, not profit. By their very nature—and
their obligation to stockholders—these publicly-traded firms work against the
original mission of microfinance, helping the poor above all else.

In response, Compartamos and other for-profit microfinanciers counter that

commercialization allows them to operate more efficiently, and to attract more
capital by appealing to profit-seeking investors. By becoming a profitable business,
their argument goes, a microfinance bank is able to extend its reach,
providing more money and more loans to low-income applicants. For now, though,
charitable and commercialized microfinanciers do co-exist.

Nonprofit vs. For-Profit Microfinance

In addition to the divide between the nonprofit and for-profit microfinance
enterprises, other criticisms exist. Some say that individual microloans of $100 are
not enough money to provide independence—rather, they keep recipients working
in subsistence-level trades, or just cover basic needs, like food and shelter.

A better approach, these critics maintain, is to create jobs by constructing new

factories and producing new goods. They cite the examples of China and India,
where the development of large industries has led to stable employment and higher
wages, which in turn has helped millions to emerge from the lowest levels of
poverty.

Other critics have said that the presence of interest payments, however low, is still
a burden. Despite the healthy repayment rates, there still are borrowers who
cannot, or do not, repay loans, because of the failure of their ventures, personal
catastrophe, or other reasons. So, this added debt can make recipients of
microcredit even poorer than when they started.

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