What is microfinance?

3 billion people live on less than $2 a day. 600 million poor people could improve their lives and become self-sufficient with a small business loan.

WORLD BANK

Microfinance involves providing financial services to the entrepreneurial impoverished, to help them establish or expand a small, self-sustaining business. Microfinance is an important tool for eradicating poverty and hunger. These service providers are commonly known as microfinance institutions. These institutions commonly tend to use methods developed over the last 30 years to minimize the associated risks. These methods include group lending and liability, pre-loan savings requirements, gradually increasing loan amounts, and an implicit guarantee of ready access to future loans if present loans are repaid fully and promptly.

What is microcredit?

Microcredit refers to very small loans for unsalaried borrowers with little or no collateral, provided by legally registered institutions. These individuals lack collateral, steady employment, and a verifiable credit history and therefore cannot meet even the most minimal qualifications to gain access to traditional credit. Microcredit is a part of microfinance, which is the provision of a wider range of financial services to the very impoverished.

Microfinance borrowers may be impoverished but overwhelmingly they are also proud, honest, and hardworking people. Most borrowers will want to come back for more, so it is vital for them to build up a clean credit history. In practice, default rates in microfinance are a fraction of the levels we accept as standard in conventional commercial lending in developed economies.

History of microfinance

The concept of microfinance is not new. Although it is difficult to track the information it has been found that in 1720, Jonathan Swift, an Irish pastor and writer, started the first Irish Loan Fund, providing loans without collateral to the impoverished of Dublin. Since then, the microfinance sector has been evolving worldwide.

The first formal Asian micro bank was the Priyayi Bank of Purwokerto in Java, Indonesia, set up in 1895, which is the predecessor of the current Bank Rakyat Indonesia.

In the 1970s, experimental programs in Bangladesh, Brazil, and a few other countries extended tiny loans to groups of impoverished women to invest in micro-businesses :

• ACCION International : Early pioneer in Latin America's cities. ACCION is one of the first microfinance organizations in the world

• SEWA Bank : In 1972 the Self Employed Women's Association (SEWA) was registered as a trade union in Gujarat (India)

• Grameen Bank : In Bangladesh, Professor Muhammad Yunus addressed the banking problem faced by the impoverished through a programme of action-research. He received the Nobel prized in 2006

During the 1980’s, microcredit programs throughout the world improved upon the original methodologies and defied conventional wisdom about financing the impoverished. First, they showed that impoverished people, especially women, had excellent repayment rates. In fact, repayment rates were better than the formal financial sectors of most emerging countries. Second, the impoverished were willing and able to pay interest rates that allowed microfinance institutions (MFIs) to cover their operational costs.

In 1990s, these two features, high repayment and cost-recovery interest rates, permitted some MFIs to achieve long-term sustainability and reach large numbers of clients.

It was not until the mid-1990s that the term "microcredit" began to be replaced by a new term that included not only credit, but also savings and other financial services. "Microfinance" emerged as the term of choice to refer to a range of financial services to the impoverished, which included credit, savings, insurance, money transfers, and other services.

Despite the success of life-transforming microfinance services, the World Bank says that the industry is not close to meeting the demand. Five hundred million people living in poverty could benefit from a small business loan and only one-third of the world's population has access to any kind of bank account.

As the microfinance industry continues to mature, there is a danger that it will drift toward a more secure client base. It is critical that microfinance organizations continue to focus on those with the greatest needs – those who have been displaced, those in rural areas, those who traditional institutions consider “unbankable”. Maintaining that focus, microfinance can help create a world in which the impoverished have fair access to economic opportunities and the hope to move beyond poverty.

Money lenders

Parallel to the microfinance movement we have money lenders. Lending by money lenders is an activity that predates the contemporary banking system from ancient times. They have been organized in the form of family or individual business. They vary in their size from small petty money lenders to substantial indigenous bankers whose businesses, at times, have exceeded that of commercial banks.

Money lenders usually use working capital of their own, and do not generally get deposits or solicit savings from the public. They grant loans on personnel recommendation and guarantee to persons well-known to them. They also sometimes grant loans against securities such as gold, jewellery, land, promissory notes, etc.

Rates are normally extremely high, sometimes up to 100% or 120%. Besides the high interest rates informal money lenders are still widely used.

“According to Grameen and others, microcredit should reduce impoverished people’s need to use moneylenders, who are widely regarded as exploiters. Microcredit is booming in India. But a December 15, 2009, article in the Wall Street Journal reports that the number of moneylenders is growing fast too.”

“Members of Grameen and other MFIs in several Bangladesh villages used moneylenders as often as non-members, or more often. That sounds counter-intuitive, until we remember that most microcredit requires a fixed weekly repayment schedule that probably doesn’t match up very well with the irregular income streams of many borrowers. It isn’t so surprising that they would occasionally go to a more expensive short-term loan from a moneylender in order to bridge a gap in repayment of a less expensive long-term loan. Businesses small and large do exactly the same thing all the time.”

CGAP, 2010

Peer to peer lending

Peer-to-peer lending or social lending refers to a transaction between two parties (lender and borrower) with no intermediation of a traditional financial institution. The Internet has been the enabling technology for social lending allowing this interconnection.

Although there are several models, the most commonly used is the one using micro finance institutions. On the one hand MFI provides the link to the borrower. And on the other hand the web platform provides the link to the lender closing the chain.

Despite the high complexity of the system, the costs remain relatively low. By peer to peer lending someone in Finland is able to connect with someone in a rural village in Tanzania.

Peer to peer lending costs

Although peer to peer lending services are relatively low, there are some costs that need to be covered. These costs are mainly related to the bank transfers and currency change fluctuation. Every time that there are funds to be transferred to a partner in an emerging country, there is a cost. Another important cost is the maintenance of the website to continually improve and adapt the services in the best way to Amifi’s community.