1. What is microfinance?

To most, microfinance means providing very poor families with very small loans (microcredit) to help them engage in productive activities or grow their tiny businesses. Over time, microfinance has come to include a broader range of services (credit, savings, insurance, etc.) as we have come to realize that the poor and the very poor who lack access to traditional formal financial institutions require a variety of financial products.

Microcredit came to prominence in the 1980s, although early experiments date back 30 years in Bangladesh, Brazil and a few other countries. The important difference of microcredit was that it avoided the pitfalls of an earlier generation of targeted development lending, by insisting on repayment, by charging interest rates that could cover the costs of credit delivery, and by focusing on client groups whose alternative source of credit was the informal sector. Emphasis shifted from rapid disbursement of subsidized loans to prop up targeted sectors towards the building up of local, sustainable institutions to serve the poor. Microcredit has largely been a private (non-profit) sector initiative that avoided becoming overtly political, and as a consequence, has outperformed virtually all other forms of development lending.

Traditionally, microfinance was focused on providing a very standardized credit product. The poor, just like anyone else, need a diverse range of financial instruments to be able to build assets, stabilize consumption and protect themselves against risks. Thus, we see a broadening of the concept of microfinance--our current challenge is to find efficient and reliable ways of providing a richer menu of microfinance products.

2. What is the difference between microfinance and microcredit?

Microfinance refers to loans, savings, insurance, transfer services and other financial products targeted at low-income clients. Microcredit refers to a small loan to a client made by a bank or other institution. Microcredit can be offered, often without collateral, to an individual or through group lending.

3. Who are the clients of microfinance?

The typical microfinance clients are low-income persons that do not have access to formal financial institutions. Microfinance clients are typically self-employed, often household-based entrepreneurs. In rural areas, they are usually small farmers and others who are engaged in small income-generating activities such as food processing and petty trade. In urban areas, microfinance activities are more diverse and include shopkeepers, service providers, artisans, street vendors, etc. Microfinance clients are poor and vulnerable non-poor who have a relatively stable source of income.

Access to conventional formal financial institutions, for many reasons, is directly related to income: the poorer you are, the less likely that you have access. On the other hand, the chances are that, the poorer you are, the more expensive or onerous informal financial arrangements. Moreover, informal arrangements may not suitably meet certain financial service needs or may exclude you anyway. Individuals in this excluded and under-served market segment are the clients of microfinance.

As we broaden the notion of the types of services microfinance encompasses, the potential market of microfinance clients also expands. For instance, microcredit might have a far more limited market scope than, say, a more diversified range of financial services which includes various types of savings products, payment and remittance services, and various insurance products. For example, many very poor farmers may not really wish to borrow, but rather, would like a safer place to save the proceeds from their harvest as these are consumed over several months by the requirements of daily living.

4. How does microfinance help the poor?

Experience shows that microfinance can help the poor to increase income, build viable businesses, and reduce their vulnerability to external shocks. It can also be a powerful instrument for self-empowerment by enabling the poor, especially women, to become economic agents of change.

Poverty is multi-dimensional. By providing access to financial services, microfinance plays an important role in the fight against the many aspects of poverty. For instance, income generation from a business helps not only the business activity expand but also contributes to household income and its attendant benefits on food security, children's education, etc. Moreover, for women, who, in many contexts, are secluded from public space, transacting with formal institutions can also build confidence and empowerment.

Recent research has revealed the extent to which individuals around the poverty line are vulnerable to shocks such as illness of a wage earner, weather, theft, or other such events. These shocks produce a huge claim on the limited financial resources of the family unit, and, absent effective financial services, can drive a family so much deeper into poverty that it can take years to recover.

5. When is microfinance NOT an appropiate tool?

Microfinance increasingly refers to a host of financial services—savings, loans, insurance, remittances from abroad, and other products. It is hard to imagine that there would be any family in the world today for which some type of formal financial service couldn't be designed and made useful. But the fact of the matter is, that in most people's mind, "microfinance" still refers to microcredit.

Microcredit is only useful in certain situations, and with certain types of clients. As we are finding out, a great number of poor, and especially extremely poor, clients exclude themselves from microcredit as it is currently designed. Extremely poor people who do not have any stable income—such as the very destitute and the homeless—should not be microfinance clients, as they will only be pushed further into debt and poverty by loans that they cannot repay. As currently designed, microcredit requires sustained, regular, and often significant payments from poor families. At some level, the very cause of poverty is the lack of a sustained, regular, and significant income. Even though a family may have a significant income for extended periods, it may also face months of no income, thereby reducing its ability to enter into the type of commitment demanded today by most MFIs. Some people are just too poor, or have incomes that are too undependable to enter into today's loan products. These extremely poor people at the bottom percentiles of those living below the poverty line need safety net programs that can help them with basic needs; some of these are working to incorporate plans to help “graduate” recipients to microfinance programs.

Often times governments and aid agencies wish to use microfinance as a tool to compensate for some other social problem such as flooding, relocation of refugees from civil strife, recent graduates from vocational training, and redundant workers who have been laid off. Since microcredit has been sold as a poverty reduction tool, it is often expected to respond to these situations where whole classes of individuals have been “made poor”. Microcredit programs directed at these types of situations rarely work. Credit requires a 98% “hit” rate to be successful. This means that 98% of recent vocational school graduates or returning refugees would need to be successful in establishing a microenterprise for repayment rates to be high enough to allow for a program's overall sustainability. This is simply unrealistic. Running a program with substantial default rates undermines the very notion of credit and destroys credit discipline among those who could repay promptly but who look foolish given that many do not.
Microcredit serves best those who have identified an economic opportunity and who are in a position to capitalize on that opportunity if they are provided with a small amount of ready cash. Thus, those poor who work in stable or growing economies, who have demonstrated an ability to undertake the proposed activities in an entrepreneurial manner, and who have demonstrated a commitment to repay their debts (instead of feeling that the credit represents some form of social re-vindication), are the best candidates for microcredit. The universe of potential clients expands exponentially however, once we take into account the broader concept of “microfinance”.

 
6. Why do MFIs charge such high interest rates to poor people?

Providing financial services to poor people is quite expensive, especially in relation to the size of the transactions involved. This is one of the most important reasons why banks don't make small loans. A $100 dollar loan, for example, requires the same personnel and resources as a $2,000 one thus increasing per unit transaction costs. Loan officers must visit the client's home or place of work, evaluate creditworthiness on the basis of interviews with the client's family and references, and in many cases, follow through with visits to reinforce the repayment culture. It can easily cost US$25 to make a microloan. While that might not seem unreasonable in absolute terms, it might represent 25% of the value of the loan amount, and force the institution to charge a “high” rate of interest to cover its cost of loan administration.

The microfinance institution could subsidize the loans to make the credit more "affordable" to the poor. Many do. However, the institution then depends on permanent subsidy. Subsidy-dependent programs are always fighting to maintain their levels of activity against budget cuts, and seldom grow significantly. They simply aren't sustainable, especially if other microcredit operations have shown that they can provide credit and grow on the basis of “high” rates of interest—and along the way serve far greater numbers of clients.

Evidence shows that clients willingly pay the higher interest rates necessary to assure long term access to credit. They recognize that their alternatives—even higher interest rates in the informal finance sector (moneylenders, etc.) or simply no access to credit—are much less attractive for them. Interest rates in the informal sector can be as high as 20 percent per day among some urban market vendors. Many of the economic activities in which the poor engage are relatively low return on labor, and access to liquidity and capital can enable the poor to obtain higher returns, or to take advantage of economic opportunities. The return received on such investments may well be many times greater than the interest rate charged.

Moreover, the interest rate is only a small part of their overall transaction cost of credit, and if microfinance institutions offer credit on a more accessible basis, substantial costs in terms of time, travel, paperwork, etc. can be reduced, thus benefiting the poor. A long series of studies has shown that many programs that charge subsidized interest rates end up using rationing mechanisms to distribute credit in response to excess demand. These mechanisms cause the borrower to have to “jump through hoops”, increasing the time and money s/he must put out to get the loan. In fact, these transactions costs are frequently higher than the interest costs, which takes away the advantage to the borrower of the interest rate subsidy. However, while increased access to credit for the poor on a long term and sustainable basis can bring significant benefits, MFIs must continue to work to improve efficiency levels, and to increase scale. This will bring down the cost of providing loans, and the benefits transferred to the poor in terms improving loan products, better access to loans, and lower borrowing costs.

7. Aren't the poor too poor to save?

The poor already save in ways that we may not consider as "normal" savings--- investing in assets, for example, that can be easily exchanged to cash in the future (gold jewelry, domestic animals, building materials, etc.). After all, they face the same series of sudden demands for cash we all face: illness, school fees, need to expand the dwelling, burial, weddings.

These informal ways that people save are not without their problems. It is hard to cut off one leg of a goat that represents a family's savings mechanism when the sudden need for a small amount of cash arises. Or, if a poor woman has loaned her "saved" funds to a family member in order to keep them safe from theft (since the alternative would be to keep the funds stored under her mattress), these may not be readily available when the woman needs them. The poor need savings that are both safe and liquid. They care less about the interest rates that they can earn on the savings, since they are not used to saving in financial instruments and they place such a high premium on having savings readily available to meet emergency needs and accumulate assets.

These savings services must be adapted to meet the poor’s particular demand and their cash flow cycle. Most often, the poor not only have low income, but also irregular income flows. Thus, to maximize the savings propensity of the poor, institutions must provide flexible opportunities--- both in terms of amounts deposited and the frequency of pay ins and pay outs. This represents an important challenge for the microfinance industry that has not yet made a concerted attempt to profitably capture tiny deposits.

 8. What is a Microfinance Institution (MFI)?

Quite simply, a microfinance institution is an organization that offers financial services to low income populations. Almost all of these offer microcredit and only take back small amounts of savings from their own borrowers, not from the general public. Within the microfinance industry, the term microfinance institution has come to refer to a wide range of organizations dedicated to providing these services: NGOs, credit unions, cooperatives, private commercial banks and non-bank financial institutions (some that have transformed from NGOs into regulated institutions) and parts of state-owned banks, for example.

The image most of us have when we refer to MFIs is of a “financial NGO”, an NGO that is fully and virtually exclusively dedicated to offering financial services; in most cases microcredit NGOs are not allowed to capture savings deposits from the general public. This group of a few hundred NGOs have led the development of microcredit, and subsequently microfinance, the world over. Most of these constitute a group that is commonly referred to as "best practice" organizations, ones that employ the newest lending techniques to generate efficient outreach that permit them to reach down far into poor sectors of the economy on a sustainable basis.
A great many NGOs that offer microcredit, perhaps even a majority, do many other non-financial development activities and would bristle at the suggestion that they are essentially financial institutions. Yet, from an industry perspective, since they are engaged in supplying financial services to the poor, we call them MFIs. The same sort of situation exists with a small number of commercial banks that offer microfinance services. For our purposes, we refer to them as MFIs, even though only a small portion of their assets may actually be tied up in financial services for the poor. In both cases, when people in the industry refer to MFIs, they are referring only to that part of the institution that offers microfinance.

There are other institutions, however, that consider themselves to be in the business of microfinance and that will certainly play a role in a reshaped and deepened financial sector. These are community-based financial intermediaries. Some are membership based such as credit unions and cooperative housing societies. Others are owned and managed by local entrepreneurs or municipalities. These institutions tend to have a broader client base than the financial NGOs and already consider themselves to be part of the formal financial sector. It varies from country to country, but many poor people do have some access to these types of institutions, although they tend not to reach down market as far as the financial NGOs.

9. Can microfinance be profitable?

Yes it can. Data from the MicroBanking Bulletin reports that 63 of the world's top MFIs had an average rate of return, after adjusting for inflation and after taking out subsidies programs might have received, of about 2.5% of total assets. This compares favorably with returns in the commercial banking sector and gives credence to the hope of many that microfinance can be sufficiently attractive to mainstream into the retail banking sector. Many feel that once microfinance becomes mainstreamed, massive growth in the numbers of clients can be achieved.
Others worry that an excessive concern about profit in microfinance will lead MFIs up-market, to serve better off clients who can absorb larger loan amounts. This is the “crowding out” effect. This may happen; after all, there are a great number of very poor, poor, and vulnerable non-poor who are not reached by the banking sector.

It is interesting to note that while the programs that reach out to the poorest clients perform less well as a group than those who reach out to a somewhat better-off client segment, their performance is improving rapidly and at the same pace as the programs serving a broad-based client group did some years ago. More and more MFI managers have come to understand that sustainability is a precursor to reaching exponentially greater numbers of clients. Given this, managers of leading MFIs are seeking ways to dramatically increase operational efficiency. In short, we have every reason to expect that programs that reach out to the very poorest microclients can be sustainable once they have matured, and if they commit to that path. The evidence supports this position.