What is microfinance?
What are the different types of microfinance institutions?
What is “fundamentally new with microcredit”?
When did microfinance get started?
Who are microfinance clients?
How does microfinance help the poor?
When is microfinance not an appropriate solution?
Why do microfinance institutions charge such high interest rates?
But aren’t the poor too poor to save?
So what exactly is a microfinance institution?
Can microfinance be profitable?
What is the role of the government in the development of microfinance?

What is microfinance?

The term microfinance includes multiple financial services needed by disadvantaged individuals : credits, savings, insurance, money transfers... Among these services, microcredit is the leading element. It refers to small loans that typically do not require collateral and are granted to poor families to enable them to improve their living conditions, notably through micro-enterprises.

The services are usually adapted to fit the needs of the those with low revenues - amounts are usually very small and there are various types of services and products to suit different circumstances. The services are also intended to be simple to use and access.

This type of amount is generally too low to interest traditional financial establishments, whereas microfinance institutions have developed specific products adapted for this sector. And thus, those typically excluded from financial services become included.

What are the different types of microfinance institutions?

Many types of organisations are active in microfinance. Three current trends coexist in this movement with each of them having several core variations:

• Credit unions first appeared in the XIXth century: Raiffeisen in Germany and Austria, for example. Loans from credit unions are no longer just ‘micro’, but it has been shown that the poor frequently save more than they borrow.

• The second, notably illustrated by the BRI in Indonesia, consists of commercial banks that open ‘micro’ counters. By tapping into their network of existing offices, and by applying microfinance best practices, they can offer services to the poor at very competitive rates.

• The most widespread model consists of NGOs that add a microcredit element to their other development activities. Once they have become specialists in this domain, they then ‘transform’ into regulated banking institutions oriented towards microfinance.

• Private, profit-making initiatives that practice microfinance must also be added to this list.

It has been demonstrated that the efficiency, the quality of service, and the costs, do not necessarily depend on the type of institution.

What is “fundamentally new with microcredit”?

For Maria Novak, founder of the Association pour le droit à l'initiative économique (France), "the main difference, in relation to traditional credit, is that there is a new target : the poor and the excluded. Microfinance organisations recognise their skills, their needs and their ability to repay loans. Instead of eliminating clientele upstream because the methods, criteria and guarantees are not appropriate for their situation, they create procedures and guarantees that work for them. Instead of dictating how their loans must be used, microfinance professionals listen to their needs. This also allows them to see that people excluded from bank loans are, like everyone else, are endowed with an entrepreneurial spirit, sound judgment and most importantly, they have higher repayment rates than the rich."

When did microfinance get started?

What we today call microfinance really took off in the ‘80s, even though the first efforts began back in the 1970s- particularly in Bangladesh. Compared to credits granted through development programs, especially in rural areas, microcredit places a much higher importance on the repayment of loans, of fixing interest rates that will cover the cost of the services provided, and of targeting clients that typically only have their families or usurers as sources of financial services. To put it simply, microfinance organisations strive to be financially sustainable so that they can continuously serve the poor without having to rely on subsidies, which are often unpredictable.

Who are microfinance clients?

A typical microfinance client is someone with a low income and no access to traditional financial sources because they are unable to meet the requirements (identity papers, collateral, minimum deposits, etc.). They most commonly run small family businesses.

• In rural areas, it is usually small farmers, people that have small plots to produce food products (spices, jams…), artisans or small shopkeepers.

• In urban zones, the clientele is more diversified: small shopkeepers, service providers, artisans, street vendors, seamstresses…

Clients are usually referred to as micro-entrepreneurs and most of them work in the informal or unofficial sectors. Economic definitions of a micro-enterprise (for example, 'less than ten employees') are often inaccurate since they do not reflect all the realities seen in the field.

How does microfinance help the poor?

Being able to access financial services is a sine qua non condition for breaking out of poverty. It allows people to:
• invest in a profit-generating activity
• further develop an existing micro-enterprise in order to make it more sustainable
• overcome the risk associated with poverty.

Accessing loans also serves as a powerful instrument for emancipation which can enable the poor, and particularly women, to become economic agents of change. Therefore, by providing access to financial services, microfinance plays an important role in the fight against various aspects of poverty. For example, if part of the revenues generated by a micro-enterprise is reinvested to further develop the business activity, then this can also serve to improve their nutrition, children’s education, health care…

Being poor means being vulnerable. Sometimes, to pay a debt or even to feed their children, a family is obliged to sell the only material object of value that they own, such as the goat or the cow that brings them an income from the sale of its milk. With a microcredit, the family can face critical situations without having to get rid of the few goods that they own.

According to Michel Lelart (CNRS-Université d’Orléans), member of the Réseau Entrepreneuriat de l'Agence universitaire de la francophonie (AUF) : “Microfinance is based on social ties, and uses them (…) Microfinance is a finance of closeness - geographic closeness of course, because the people know each other and sometimes mutually support one another, but most importantly cultural closeness. It is always adapted to needs, which is why it is always innovating: it includes insurance services (…), it also includes services for transferring money made by migrant workers”.

When is microfinance not an appropriate solution?

It is primarily when certain conditions pose severe challenges to loan repayment that microfinance might not be appropriate. As it is practised today, microcredit, like all other credits, must be repaid. In other words, the borrower must be able to reimburse his or her loan. Since very poor people rarely have an income that is steady enough for them to repay a loan, we are in a vicious circle. Lending to such people risks further indebting them and increasing their precariousness.

Today, it is clear that microfinance cannot solve all the problems of development. There are situations where only hand-outs are helpful, even if those might be accompanied by loans. Victims of natural disasters, refugees fleeing conflicts, recent graduates from professional training, those that are unemployed, and others may include types of individuals in precarious situations where a credit might not be the only help needed. Furthermore, microcredit programmes generally need to be accompanied by government efforts to help and encourage micro-entrepreneurs.

Microcredit is particularly useful for those that have already identified a business activity and mainly need a reliable source of credit to expand such activities and to be able to cope with any sudden expenses. Poor people have shown that they are more than capable of running their businesses with an entrepreneurial spirit and are quite able to repay their loans.

The realm of potential clients increases exponentially if the larger concept of ‘microfinance’ is considered- especially when savings accounts are included. In many countries today, it is difficult to open a simple account in a banking institution without having to meet all of their demands (identity card, minimum deposit which is usually too high for poor people…). Additionally, banks frequently only have counters or offices in the capital or in other major cities which excludes a large part of the population.

Why do microfinance institutions charge such high interest rates?

It is true that microcredit is expensive. One of the main reasons for this is the low amounts of the transactions which is why very few banks expand into this market. For example, for a $100 loan to be processed, it requires the same staff and resources as a $10,000 loan, which means that the transaction costs are far higher.

A typical loan officer from enda inter-arabe has 350 micro-entrepreneurs, but a portfolio of only around 200,000 TND ($150,000). The investigation required before granting someone their first loan requires one or two visits to their neighbourhood and, throughout the duration of the loan, the loan officer keeps in close contact with his or her clients, visiting them several times to follow up and to offer advice. The cost of managing many small loans is therefore rather high and this explains why, in order to remain sustainable, microfinance institutions have to charge interest rates that are higher than those in the banking sector.

Experience also proves that clients can handle these costs. Having permanent access to credit is more important for them than the cost. In fact, the returns on investments using this capital are usually much higher than in larger businesses with higher expenses. Microfinance clients realize that the alternatives- to resort to a usurer or to have no access to credit- are a much bigger problem for them. Just as an example, interest rates on the black market can reach up to 20% per day.

But aren’t the poor too poor to save?

Contrary to what many think, the poor do save money, even if their savings are not always in cash :
• gold jewellery
• livestock
• construction materials…

These savings enable them to face up to unexpected expenditures and to those that they knew about ahead of time :
• costs for schooling
• home improvements
• sickness
• funerals…

However, this type of saving is not in cash and is not easily accessible (unless such assets are desperately sold very cheaply). If they can avoid having to use their savings, of course they will prefer other solutions which might be a microcredit or a savings system offered by a microfinance institution.

Therefore, the poor need savings services that are secure and easily available. They particularly value being able to access their savings in case of emergency or if an opportunity to improve their business arises. Such services must be flexible in order to meet the particular needs of the poor depending on their financial status : typically, the poor do not just suffer from low incomes, but also their irregularity.

For vulnerable populations, being able to save their money securely with a system that is adapted to their needs can be just as important as receiving a microcredit.

So what exactly is a microfinance institution (MFI)?

To put it simply, a microfinance institution is an organisation that offers financial services to low-income people who do not have access, or have limited access, to the formal financial sector.

Today, the term microfinance is applied to a large range of organisations that have diverse sizes, structures and legal statuses (NGO, association, savings and credit mutuals/unions, public companies, banks, financial establishments, etc.). Depending on the country and their status, these institutions might or might not be regulated, supervised by monetary authorities, or authorised to collect savings.

The image that is most often associated with microfinance institutions is that of a financial NGO- an organisation completely and sometimes solely dedicated to offering financial services that help the economic and social self-advancement of low-income populations. Although their number remains small, an increasing number of these NGOs have already transitioned into formalised financial institutions or banks, or are preparing to make this jump.

Can microfinance be profitable?

Yes. Contrary to many perceptions, a well run microfinance organisation presents little risk. That being said, this typically only applies to the ‘upper crust’ of these organisations- those that are the most developed, mature and who maintain good profit margins.

Furthermore, profitability- and therefore the ability to avoid dependence on grants- is the only way to reach the massive number of people that need access to microfinance in the world. It is necessary to find a balance between the social and the financial missions of microfinance institutions in order to make them sustainable so that they can continue serving their target populations.

Today, rating agencies tend to focus more on social performance ratings as opposed to financial ratings. Although such ratings are somewhat new and not yet standardised, they help reassure organisations and individuals that place a high importance on the social mission. Social investors tend to be more interested in social impacts than on the financial returns of their investments.

What is the role of the government in the development of microfinance?

Governments play an active role in financing development activities and among the various methods used credit has always played an important role. Unfortunately, repayment rates tend to be low because the processes and services frequently follow a 'one size fits all' model that does not always fit the needs of the recipients. There are very few examples where loans granted by governments to poor people are recuperated at a relatively acceptable cost.

Today, microfinance professionals have proven that credit provided to poor people can be managed without having to rely on grants from outside sources. The best way for governments to help the microfinance sector is to create a favourable legislative and regulatory environment. To do so, they should take a global look at the sector and all the actors that are involved and, if the sector is not well developed, take advantage of the experience of other countries.

Putting in place appropriate regulations, getting rid of interest rate caps and managing the sector with a light hand is the best way to increase the number of microfinance people beneficiaries and to contribute to the fight against poverty.