Microfinance

Knowledge Center

What is Microfinance? Meaning.

Microfinance is the supply of small loans and other financial services to people with a low income who would otherwise have no access to credit from traditional banks and financial institutions. Microfinance is seen by some as a viable solution to reduce poverty, enabling those at the Bottom of the Pyramid to reshape their destiny.

Microfinance basically consists of offering small loans to poor working people of developing countries, who carrying out their daily business activities, are able to repay their debts at the end of a fixed period, usually a day or a week. The value of the loans generally ranges from 1$ to a maximum of 200$. The money is lent from local organizations, so called Microfinance Institutions (MFI), when certain conditions are met.

The concept of microfinance when applied to insurance services take the name of Microinsurance.

Why Microfinance

Traditionally banks were unable to serve the base of the pyramid, because the fixed costs (assessment of potential borrowers, their repayment prospects and security; administration of outstanding loans, collecting from delinquent borrowers, etc) were too high in the case of small loans. Also poor people typically have few assets to serve as collateral.

On the other hand it was clear that the poor people represented a huge potential market in need for financial services that wasn’t served at all.

What are the Needs of Poor People?

Microfinance experts thus studied patterns and specific needs of a typical base of the pyramid customer. Stuart Rutherford in his recent book "The Poor and Their Money", cited 4 types of needs of the poor (compare: Maslow’s Hierarchy of Needs, Packhard’s Hidden Needs, and McClelland's Theory of Needs):

1. Lifecycle Needs: childbirth, weddings, children education or professional training, funerals, the building of a new house, age of maturity.
2. Personal Emergencies: sickness, injury, unemployment, thefts, harassments or death.
3. Disasters: fires, floods, cyclones and other natural disasters or a war.
4. Investment Opportunities: business growth or stability, land or equipments purchases, house improvement, securing a job, etc.

Origin of Microfinance. History

The history of microfinance goes back to 1974 when Professor of Economics at University of Chittagong, Dr. Muhammad Yunus, with the intent of finding a practical solution to poverty, experienced the first microfinance attempt himself. During a visit to a rural village in Bangladesh, he lent 27$ to a community of 42 people who were otherwise unable to make out a living. The result was that those people were able to invest that amount in their small woodwork business, sell their products, buy food and other basic stuff and give to the money back to the professor with interest. Inspired by his successful experience and after in-depth studies on the topic, he started a professional micro-financial activity and in 1983 he created the Grameen Rural Bank, the first Microfinance Institution that today accounts for 1 billion $ in loans spread to over 7 millions borrowers.

Professor Muhammad Yunus and Grameen Bank were awarded the Nobel Peace Prize 2006 for 'for their efforts to create economic and social development from below'.

During the 80’s and the 90’s, after many researches and experiments proving the business viability and profitability of Yunus' concept, microfinance institutions grew constantly in number till topping 3000 in 2006. Most microfinance institutions started their business as non-profit organizations sustained by grants and subsidies, and have been able to turn into for-profit corporations attracting investors globally.

Major banks, attracted by high growth rates, started instituting funds focused on microfinance that allow investors from all over the world to invest in this new industry, movement or Microfinance Channel, as it has been defined by management scholars.

The Microfinance Concept in More Detail

The concept of microfinance is based on a primary principle holding that most human beings will do their best to be well off, provided they have the required tools. This is one of the reason, combined with a strict selection of borrowers, why microcredit has the highest repayment rate if compared to all other form of loans issued by traditional banks.

Unfortunately, studies demonstrated that microfinance cannot work everywhere and not everybody is a good candidate for microcredit. In order to be useful and successful for the borrower while viable and profitable for an institution, the following microfinance conditions must be met.

1. Developing or third world economies. Microfinance is characterized by low-amount financial services and that is why it finds application in developing or third world economies. Poor people living in industrialized countries cannot leverage 10$ to grow their small business.
2. A socio-economical environment that offers market opportunities for small craft businesses. The vast majority of microcredit is issued to borrowers who have environmental-friendly craftiness of any sort, such as woodworks, sewing, agriculture, etc…that perfectly fit sustainable development of local small communities. Regions with extremely low density, very poor infrastructures, lack of law and order, or having a large portion of the population affected by diseases are better of with grants or investments in infrastructure and education. In some parts of Africa the economic system is so weak that people would have nothing to do with a small amount of money, especially where barter is still the most common form of trade.
3. The mentality to honestly escape poverty. Values and mentality matter: it is fundamental that borrowers are members of a community that commit to honestly escape poverty. Many studies demonstrated that women, who are currently the largest and most preferred category of microcredit clients, are better loans payers than men because of the care they have for their families’ well being. Moreover, community pressure put forth by people living in small local communities, such as in villages located in India or Guatemala, helps borrowers to maintain a high level of commitment to repay their debts. If a borrower couldn’t pay an installment the other villagers would probably help her. If she would be unwilling to meet her obligations the pressure exerted on her from the other villagers (happy with microcredit) would be too high.

Effects of Microfinance

Besides helping to reduce poverty, the following effects were found:

1. The empowerment of women and the promotion of gender-equity. Especially in rural communities where their role is more marginal, women acquire decision power and a more active role in their family development and well being.
2. A boost to growth and stability to local small businesses located in developing countries.
3. The opportunity for low-income individuals to take advantage from favorable economic conditions due to removing a Barrier to Entry.
4. The development of a planning attitude in people who couldn’t satisfy their basic needs. Most microfinance clients have been able to break a closed loop of poverty by acquiring assets, sending their children to school, and improving their living conditions.

Best Practices - Microfinance Here you find the most valuable discussions from the past.   Microfinance Counseling is Necessary My experience with microfinance goes back to projects that I initiated in the mid-90s in Yugoslavia, volunteering with t (...)           History of Microfinance I would like to add that poet Rabindranath Tagore, Nobel laureate for Literature (1913), introduced microcredit over 100 (...)           Recent Microfinance Trends What are the most recent developments in the area of Microfinance? (...)         PROs and CONs of Microfinance: An Overview Microcredit has been seen as the magic bullet that can help the poor to escape poverty, however in recent years the flaw (...)

Resources - Microfinance Here you find powerpoint presentations, micro-learning videos and further information sources. Microfinance in Emerging Economies Microfinance (...)   Microfinance Introduction, Best Practices, Trends Microfinance, Microcredit (...)   Microfinance In-depth Microfinance (...)   Risk Management in Rural Agricultural Lending Agricultural Risk Management, Micro Finance, Bottom of the Pyramid, Agriculture Risk Management (...)

Compare with: Break-Even Point  |  CAPM  |  Cost of Capital  |  Payback Period  |  12 Principles of Network Economy  |  Start-up Company  |  Undercapitalization

Return to Management Hub: Ethics & Responsibility  |  Finance & Investing

More on Management  |  Return to Management Dictionary  | 

This ends our Microfinance summary and forum.