LECTURE TWO

FINANCIAL SYSTEMS AND MICROFINANCE

Expected Learning Outcomes

By the end of this lecture, students should be able to:

1. Identify and explain the levels of financial systems: formal, semi-formal, and informal.

2. Explain the role of different financial institutions in supporting microfinance.

3. Analyze the interaction between financial markets and microfinance in promoting

economic development.

A. Levels of Financial Systems

Financial systems provide mechanisms for mobilizing savings, allocating credit, and facilitating
payments. They can be classified into three main levels:

a) Formal Financial System

✓ Comprises regulated institutions licensed by the central bank or other regulatory

authorities.

✓ Includes commercial banks, microfinance banks, insurance companies, pension funds,

and SACCOs.

Characteristics:

i. Highly regulated by authorities such as Central Bank of Kenya (CBK) or Sacco

Societies Regulatory Authority (SASRA.)

ii. Offer formal savings, loans, and other financial products.

iii. Require collateral and credit history for lending.

Example (Kenya):

❖ KWFT Bank provides small loans to women entrepreneurs.

❖ Equity Bank supports microloans for SMEs and agricultural businesses.

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b) Semi-Formal Financial System

✓ Institutions operate under some regulation but outside the formal banking sector.

✓ Includes NGO-managed MFIs, credit unions, rotating savings and credit associations
(ROSCAs), and some SACCOs not fully licensed.

Characteristics:

i. Offer flexible lending conditions.

ii. Focus on social objectives, e.g., poverty alleviation.

iii. Often target low-income or underserved populations.

Example (Kenya):

❖ Faulu Kenya (NGO microfinance institution) provides loans to informal sector traders.
❖ Local credit cooperatives offering small-scale credit in rural areas.

c) Informal Financial System

✓ Comprises unregulated, community-based financial arrangements.

✓ Includes moneylenders, table banking groups, chit funds, and family savings groups.

Characteristics:

i. No formal regulation or legal protection.

ii. Lending often relies on social trust or group guarantees.

iii. High flexibility but sometimes high interest rates.

Example:

❖ Table banking in Western Kenya: Women contribute daily/weekly funds and take small
loans for business or household needs.
❖ Village moneylenders providing short-term credit in rural communities.

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 B. Role of Financial Institutions in Microfinance

Financial institutions are critical in mobilizing savings, providing credit, and facilitating
financial inclusion:

1. Commercial Banks:

✓ Funding for MFIs: Banks provide term loans or lines of credit to MFIs for working
capital and lending, reducing reliance on donor funds.

✓ Infrastructure & Services Sharing: They offer access to their branch networks,
ATMs, IT systems, and transaction processing for a fee, reducing costs for MFIs.

✓ Direct Microfinance Operations: Some banks create internal units or specialized

small finance banks to directly provide micro-loans and deposits, leveraging their
existing infrastructure, capital, and management expertise.

✓ Financial Inclusion: By partnering or entering the market, banks expand access to

banking services (loans, savings, payments) for the unbanked and underbanked.

✓ Risk Management & Profitability: Banks bring robust governance, efficient

systems, and a focus on profitability, making microfinance sustainable and less
risky.

✓ Investment Vehicles: They can create or participate in microfinance investment

funds, channeling capital to the sector.

Example: Equity Bank partners with MFIs to reach rural farmers.

2. Microfinance Banks (MFBs):

✓ Bridging the Gap: MFBs address the reluctance of traditional banks to lend to the
poor due to perceived high risk and lack of collateral. They bring the financially
excluded population into the formal financial system, thus deepening financial
markets.

✓ Mobilizing Savings: They encourage a banking habit among low-income earners

and rural populations by offering various savings accounts with competitive interest

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 rates and low minimum balance requirements. This also provides a stable funding
source for their lending operations.

✓ Providing Accessible Credit: MFBs offer small, flexible loans, often without
stringent collateral requirements, to enable clients to start or expand small
businesses (e.g., agriculture, trade, small-scale manufacturing).

✓ Poverty Alleviation and Employment Generation: By providing capital and

fostering entrepreneurship, MFBs help clients increase their income levels,
improve their standard of living, and create jobs within their communities.

✓ Supporting SMEs: They are vital for the growth of Small and Medium Enterprises
(SMEs), which are often the engine of economic growth and employment in
developing countries.

✓ Rural Transformation: MFBs are particularly instrumental in rural areas, where

they promote economic activities and help in the overall transformation of the
grassroots economy.

Example: KWFT targets women entrepreneurs with low-interest microloans.

3. SACCOs (Savings and Credit Cooperative Societies):

✓ Mobilize community savings and provide loans to members.

✓ Encourage a culture of savings and self-reliance.

Example: Mwalimu SACCO provides loans to teachers in Kenya at lower rates than
banks.

4. NGO-based MFIs:

✓ Provide microcredit often without strict collateral requirements.

✓ Focus on social development outcomes, such as poverty reduction or women

empowerment.

Example: Faulu Kenya provides microloans for small-scale traders in urban and rural
areas.

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 5. Informal Groups (ROSCAs / Table Banking):

✓ Facilitate access to emergency funds and small business loans.

✓ Foster social cohesion and trust-based lending.

Example: Women groups in Kakamega pooling daily contributions to lend to

members.

C. Interaction Between Financial Markets and Microfinance

Microfinance does not operate in isolation; it interacts with broader financial markets and the
economy:

1. Liquidity and Funding:

o Formal and semi-formal institutions provide liquidity to MFIs through deposits and
interbank lending.

Example: Microfinance banks borrow from commercial banks to scale up lending.

2. Credit Risk Management:

o Participation in financial markets allows MFIs to hedge risks, access insurance

products, and manage default risks.

3. Capital Mobilization:

o Microfinance institutions can issue bonds or attract equity investments to expand

operations.

Example: Equity Bank issues bonds to fund microfinance programs for SMEs.

4. Integration into National Economy:

o Microfinance clients often graduate to formal banking systems as businesses grow.

o Enhances financial deepening and inclusion at the macroeconomic level.

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 Example: Smallholder farmers in Kenya start with table banking but eventually access
bank loans to expand farming.

Assignment Questions

1. Explain the three levels of financial systems and discuss their relevance to microfinance in
Kenya.

2. Discuss the role of financial institutions in supporting microfinance and illustrate your answer
with Kenyan examples.

3. Analyze how microfinance interacts with broader financial markets to promote economic
growth.