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Microfinance is the supply of loans, savings, and other basic financial services to the poor. People living in poverty, like everyone else, need a diverse range of financial instruments to run their businesses, build assets, stabilize consumption and shield themselves against risks. Financial services needed by the poor include working capital loans, consumer credit, savings, pensions, insurance, and money transfer services.

The poor rarely access services through the formal financial sector. They address their need for financial services through a variety of financial relationships, mostly informal. Credit is available from informal commercial and non-commercial money-lenders, but usually at a very high cost to borrowers. Savings services are available through a variety of informal relationships like savings clubs, rotating savings and credit associations, and mutual insurance societies that have a tendency to be erratic and insecure.

Providers of financial services to the poor include donor-supported, non-profit, non-governmental organizations (NGOs) and cooperatives, community-based development institutions like self-help groups and credit unions, commercial and state banks, insurance and credit card companies, post offices, and other points of sale. Non-bank financial institutions and NGOs have led the way in developing workable credit methodologies for the poor and reaching out to large numbers of the poor. Throughout the 1980s and 1990s, these programmes improved upon the original methodologies and bucked conventional wisdom about financing the poor. They have shown that the poor repay their loans and are willing and able to pay interest rates that cover the costs of providing the loans.

Financial services for the poor have proved to be a powerful instrument for poverty reduction that enables the poor to build assets, increase incomes, and reduce their vulnerability to economic stress. However, with nearly one billion people still lacking access to basic financial services (especially the very poor), the challenge of providing financial services to them remain. Convenient, safe, and secure deposit services are a particularly crucial need.

The clients of microfinance—female heads of households, pensioners, displaced persons, retrenched workers, small farmers, and micro-entrepreneurs—fall into four poverty levels: destitute, extreme poor, moderate poor, and vulnerable non-poor. While repayment capacity, collateral availability, and data availability vary across these categories, methodologies and operational structures have been developed that meet the financial needs of these client groups in a sustainable manner.

Poor people with access to savings, credit, insurance, and other financial services are more resilient and better able to cope with the everyday crises they face. Even the most rigorous econometric studies have proven that microfinance can smooth consumption levels and significantly reduce the need to sell assets to meet basic needs. With access to microinsurance, poor people can cope with sudden increased expenses associated with death, serious illness, and the loss of assets.

Access to credit allows poor people to take advantage of economic opportunities. While increased earnings are by no means automatic, clients have overwhelmingly demonstrated that reliable sources of credit provide a fundamental basis for planning and expanding business activities. Many studies show that clients who join and stay in programmes have better economic conditions than non-clients, suggesting that programmes contribute to these improvements. Some studies have also shown that many clients do actually graduate out of poverty over a long period of time.

By reducing vulnerability and increasing earnings and savings, financial services allow poor households to make the transformation from “every-day survival” to “planning for the future.” Households are able to send more children to school for longer periods, and make greater investments in their children’s education. Increased earnings from financial services lead to better nutrition and better living conditions, which translates into a lower incidence of illness. Increased earnings also mean that clients may seek out and pay for health care services when needed rather than go without or wait until their health seriously deteriorates.

Microfinance programmes have generally targeted poor women. By providing access to financial services only through women—making women responsible for loans, ensuring repayment through women, maintaining savings accounts for women, providing insurance coverage through women—microfinance programmes send a strong message to households as well as to communities. Many qualitative and quantitative studies have documented how access to financial services has improved the status of women within the family and the community. Women have become more assertive and confident. In regions where women’s mobility is strictly regulated, women have become more visible and are better able to negotiate in the public sphere. Women own assets including land and housing, and play a stronger role in decision-making. There are even reports of declining levels of violence against women in some programmes that have been active for many years.

Although access to financial services opens up possibilities of improving the economic conditions of the poor, in some cases, clients can be left worse-off. Ill-advised credit can lead to too much debt. Sustainable financial services that improve the conditions of the poor depend on a clear vision of sustainability, on careful programme design, on efficient operations, and most importantly, on constantly trying to understand and meet client needs.

In September 2000, the member states of the United Nations unanimously adopted the Millennium Development Goals (MDGs). The MDGs commit the international community to a common vision of development, one in which human development and poverty reduction have the highest priority. The objective of the MDGs is to serve as guideposts and focus the efforts of the world community on achieving significant, measurable improvements in poor people’s lives. The goals grew out of the agreements and resolutions of various development conferences organized by the UN in the 1990s.

Eradicate extreme poverty and hunger

The poor have physical assets—(food, clothing, housing)—and financial assets (income or savings)  with which to acquire basic necessities. Access to financial services enables the poor to increase income and smooth consumption flows, and thus expand their asset base and reduce their vulnerability. Empirical evidence shows that among the poor, those participating in microfinance programmes who had access to financial services were able to improve their well-being—both at the individual and household level—much more than those who did not have access to financial services.

Achieve universal primary education

Increased earning and savings provide poor people with some cushion from the day-to-day struggle of earning a living. This opens up the possibility of investing in their children’s future, and in education in particular. Empirical evidence indicates that in poor households with access to financial services, children are not only sent to school in larger numbers, but they also stay in school longer. Even where children help out in family enterprises, the poverty-induced imperative of child labour decreases; school drop-out rates are much lower in client households than in non-client households. 

Promote gender equality and empower women

Overall, the experience of microfinance programmes points to strong evidence that the access to financial services and the resultant transfer of financial resources to poor women, over time, lead to women becoming more confident, more assertive, and better able to confront systemic gender inequities. Access to finance enables poor women to become economic agents of change by increasing their income and productivity, access to markets and information, and decision-making power. Existing studies show that this empowerment is very real and can take different forms.

However, it would be wrong to assume access to financial services automatically has a positive impact on women’s welfare. In some instances, women’s access to microfinance may result in increased violence within the household, leaving them with a greater loss of power. Women borrowing for a microenterprise may end up being forced to work longer hours and lose control over financial resources and decision-making to male members of the family. Neither should microfinance be seen as a substitute for dealing with key structural issues pertinent to women and poverty, such as lack of skills and education, or legislation that discriminates against women (e.g., property rights, agrarian or land reform, trade agreements).

Combat HIV/AIDS, Malaria, and other diseases

Other than hunger, illness is generally the most important risk that poor people periodically face. Deaths due to illness, time taken off from work because of an illness, and health care-related expenses erode incomes and savings, and often force the poor to sell assets and go into debt. Increased earnings and savings allow clients to seek out and pay for health care services when needed rather than wait for conditions to deteriorate. In addition, many microfinance institutions actively promote health education. This may take the form of a few simple, preventive health care messages on immunization, safe drinking water, and pre   and post-natal care. Some programmes provide credit products for water and sanitation that directly improve clients’ living conditions. A few programmes have also taken initiatives to promote health insurance for their clients.

Ensure environmental sustainability

There has been very little study of the extent of the impact of financial services for the poor on safe drinking water, sanitation, or other forms of environmental sustainability. However, there is evidence that with increased earnings, the poor do invest in improved housing, water, and sanitation. Many microfinance programmes provide specific loans for tube wells and toilets. Other programmes, such as Self Employed Women's Association (SEWA) in India have creatively linked microfinance to slum improvement projects. Such projects help build community infrastructure tap water, toilets, drainage, and paved roads that are paid for by community residents through loans from microfinance institutions.

Develop a global partnership for development

The last MDG provides the means to achieve the other goals. Access to financial services enables the poor to fight the various dimensions of poverty and make improvements to their lives. Whether they save or borrow, evidence shows that when poor people have access to financial services, they choose to invest their loans, additional earnings, or savings in a wide range of activities and assets that benefit them and their households. Thus, access to financial services provides the poor with the means to make improvements in their lives—in other words, to achieve most of the MDGs—on their own terms, in a sustainable way. Access to credit, savings, or other financial services is only one of a series of strategies needed to reduce poverty and achieve the MDGs. Financial services need to be complemented by access to education, health care, housing, transportation, markets, and information.

A microfinance provider (MFP) is an organization that provides financial services to the poor. This very broad definition includes a wide range of providers that vary in their legal structure, mission, methodology, and sustainability. However, they all share the common characteristic of providing financial services to a clientele poorer and more vulnerable than traditional bank clients.

A historical context can help explain how specialized MFPs developed over the last few decades. Governments and donors focused on providing subsidized agricultural credit to small and marginal farmers, in the hopes of raising productivity and incomes between the 1950s and 1970s. Microenterprise credit concentrated on providing loans to poor women to invest in tiny businesses, enabling them to accumulate assets and raise household income and welfare during the 1980s. These experiments resulted in the emergence of non-governmental organizations (NGOs) that provided financial services for the poor. In the 1990s, many of these institutions transformed themselves into formal financial institutions in order to access and on-lend client savings, thus enhancing their outreach.

A MFP can be broadly defined as any organization—credit union, down-scaled commercial bank, specialized microfinance bank, financial NGO, or credit cooperative—that provides financial services to the poor.

The characteristics of microfinance providers

Formal providers are sometimes defined as those that are subject not only to general laws but also to specific banking regulation and supervision (development banks, savings and postal banks, microfinance banks, commercial banks, and non-bank financial intermediaries). Formal providers may also be any registered legal organizations offering any kind of financial services. Semi-formal providers are registered entities subject to general and commercial laws but are not usually under bank regulation and supervision (financial NGOs, credit unions, and cooperatives). Informal providers are non-registered groups such as rotating savings and credit associations (ROSCAs) and self-help groups.

The ownership structures of MFPs can be of almost any type imaginable. They can be government-owned, like Khushalli Bank Limited; member-owned, like the credit unions in West Africa; socially-minded shareholders, like many transformed NGOs in Latin America and profit-maximizing shareholders, like the microfinance banks in Eastern Europe.

The focus of some providers is exclusively on financial services to the poor. Others are focused on financial services in general, offering a wide range of financial services for different markets. Organizations providing financial services to the poor may also provide non-financial services. These services can include business-development services like training and technical assistance, or social services, like health and empowerment training.

The services that poor people need and demand are the same types of financial services that everyone else demands. The most well-known service is non-collateralized “micro-loans” delivered through a range of group-based and individual methodologies. The menu of services offered also includes others adapted to the specific needs of the poor, such as savings, insurance, and remittances. The types of services offered are limited by what is allowed by the legal structure of the provider (non-regulated institutions are not generally allowed to provide savings or insurance).

Microfinance, or financial services for the poor, can be profitable. The November 2001 issue of the MicroBanking Bulletin includes data from 62 self-sufficient MFIs. The average return on assets for this group is 5.5 %, which compares favourably to commercial-bank returns. Indeed, there are grounds for hope that microfinance can become attractive to mainstream retail bankers.

At the same time, some worry that an excessive concern for profit in microfinance will lead MFIs away from poor clients to serve better-off clients who want larger loans. It is true that programmes serving very poor clients are somewhat less profitable than those reaching better-off clients, but this may say more about managers’ objectives than an inherent conflict between serving the very poor and profitability. Microfinance institutions serving the very poor are showing rapid financial improvement. Microfinance programmes like Association for Social Advancement (ASA) in Bangladesh and the Bangladesh Rural Advancement Committee have already demonstrated that very poor clients can be reached profitably: both institutions had profits of more than four percent of assets in 2000.

There are cases where microfinance cannot be made profitable, for example, where potential clients are extremely poor and risk-averse or live in remote areas with very low population densities. In such settings, microfinance may require continuing subsidies. Whether microfinance is the best use of these subsidies will depend on evidence about its impact on the lives of these clients.

To maintain and increase its services over time, an MFP must charge interest rates high enough to cover the cost of its loans. Otherwise, the MFP will lose money. Its activities will shrink rather than grow unless it is continually infused with fresh money from private donors or governments. The problem is that donor and government money is not reliable and there is not enough to meet demand. Commercial investment funding is available, but MFPs must be sustainable, i.e., profitable enough to continue in order to attract this investment.

There are three kinds of costs the MFP has to cover when it makes microloans. The first two, the cost of the money that it lends and the cost of loan defaults, are proportional to the amount lent. For instance, if the cost paid by the MFP for the money it lends is ten percent and it experiences defaults of one percent of the amount lent, then these two costs will total 11 % for a loan of PKR 100, and PKR 55 for a loan of PKR 500. An interest rate of 11 % of the loan amount thus covers both these costs for either loan.

The third type of cost, the transaction cost, is not proportional to the amount lent. The transaction cost of the PKR 500 loan is not much different from the transaction cost of the PKR 100 loan. Both loans require roughly the same amount of staff time for meeting with the borrower to appraise the loan, processing the loan disbursement and repayments, and follow-up monitoring. If one assumes that the transaction cost is PKR 25 per loan and that the loans are for one year, the MFP would need to collect interest of 50 + 5 + 25 = PKR 80 to break even on the PKR 500 loan, which represents an annual interest rate of 16 %. To break even on the PKR 100 loan, the MFP would need to collect interest of 10 + 1 + 25 = PKR 36, which is an interest rate of 36 %. At first glance, a rate this high looks abusive to many people, especially when the clients are poor. But in fact, this interest rate simply reflects the basic reality that when loan sizes get very small, transaction costs loom larger because these costs cannot be cut below certain minimums.

Lending programmes that continually subsidize their borrowers will de-capitalize themselves unless they continue to receive new subsidies from donors or governments. By contrast, MFPs who charge their clients enough to cover all the loan costs can attract funding from commercial sources and are capable of exponential growth without relying on scarce and uncertain subsidies as funding sources. Microfinance institutions have to charge rates that are higher than normal banking rates to keep the service available, but even these rates are far below what poor people routinely pay to village money-lenders and other informal sources, whose percentage interest rates routinely rise into the hundreds and even the thousands.

This does not mean that all high-interest charges by MFPs are justifiable. Sometimes MFPs, especially ones that are funded by donors, are not aggressive enough in containing transaction costs. The result is that they pass on unnecessarily high transaction costs to their borrowers. Sustainability should be pursued by cutting costs as much as possible, not just by raising interest rates to whatever the market will bear.

Poor people save all the time, although mostly in informal ways. They invest in assets such as gold, jewellery, domestic animals, building materials, and things that can be easily exchanged for cash. They may set aside corn from their harvest to sell at a later date. They bury cash in the garden or stash it under the mattress. They participate in informal savings groups where everyone contributes a small amount of cash each day, week, or month, and is successively awarded the pot on a rotating basis. Some of these groups allow members to borrow from the pot as well. The poor also give their money to neighbours to hold or pay local cash collectors to keep it safe.

However widely used, informal savings mechanisms have serious limitations. It is not possible, for example, to cut a leg off a goat when the family suddenly needs a small amount of cash. In-kind savings are subject to fluctuations in commodity prices, destruction by insects, fire, thieves, or illness (in the case of livestock). Informal rotating savings groups tend to be small and rotate limited amounts of money. Moreover, these groups often require rigid amounts of money at set intervals and do not react to changes in their members’ ability to save. Perhaps most importantly, the poor are more likely to lose their money through fraud or mismanagement in informal savings arrangements than are depositors in formal financial institutions.

The poor lack access to safe, formal deposit services. Institutions that mobilize deposits like banks, credit unions, and postal savings banks are often too far away, or the time and procedures needed to complete transactions are onerous. These organizations may also impose minimum transaction sizes and/or require depositors to retain a minimum balance, both of which can exclude the poor. Operating hours may not be convenient for poor depositors, nor are they welcome as clients.

Despite these constraints, some financial institutions have developed savings products appropriate to the needs of the poor. These institutions have found that when poor people have a choice, they choose to save far more often than they choose to borrow.

Governments play a complex role in microfinance. Until recently, many governments believed that it was their responsibility to provide development finance, including direct lending to the disadvantaged. But decades of experience have shown that when governments engage in retail lending to the poor, they almost always do it badly. Short-term political gain is very tempting for politically controlled lending organizations: they disburse too quickly, and they collect too sporadically because they are unwilling to be tough on defaulters. Furthermore, good microfinance requires an agile and efficient corporate culture which can be difficult to maintain in an organization subject to government hiring and firing policies.

More recently, many governments have recognized that they can not do a good job of lending to the poor, yet they still seek to promote such lending by setting up apex facilities that make wholesale funding available to a range of private microfinance providers. Such apexes can be useful if the country has a critical mass of solid microfinance providers (MFPs). However, they usually have not been effective in developing good institutions where few or none existed before, and they are likely to be subjected to political pressure unless their structure effectively precludes government influence.

Although governments are not usually good at lending, they play an important role in setting appropriate policies. The key things a government can do for microfinance are to maintain macroeconomic stability and to avoid interest-rate caps that prevent MFPs from covering their costs and operating sustainably. Beyond this, it is doubtful that the development of microfinance, at least in its earlier stages, requires a national policy framework. No such framework was present in most countries where microfinance first reached massive numbers of clients—for instance, in Bangladesh, Indonesia, and Bolivia. In fact, political attention to microfinance has sometimes done more harm than good.

When microfinance providers take up voluntary deposit services, governments need to regulate it in order to protect depositors. For more information on governments and protecting depositors, see the FAQ regarding the role of financial regulation and supervision

Banks are regulated to protect their depositors and to prevent risks to the financial system. Credit-only MFPs do not take deposits from the public and are too small to pose much risk for the financial system. Regulation by the financial authorities is needed for MFPs that do take deposits, for instance, savings-based financial cooperatives or credit-based MFPs that want to start taking deposits to finance their growth.

In many countries, various factions are pushing for new laws to create a special, new type of financial license that is tailor-made for deposit-taking MFPs. Such laws need to be approached with care. New licensing windows for MFPs have been most successful in countries where a critical mass of profitable credit-only MFPs existed before the opening of the window.

Drafters of new legislation typically fail to give enough attention to the practical feasibility of supervising compliance with new regulations.

Microfinance institutions that do not take deposits do not need intensive regulation and supervision, but they do need a certain minimum regulatory structure in order to operate. In the transition economies of former socialist countries, legislation is sometimes necessary to clarify the right of NGOs and other non-bank institutions to engage in the business of lending.

In all countries, enforcement of unrealistically low interest-rate caps can make sustainable micro-lending impossible. Microfinance institutions need to charge interest rates that are considerably higher than normal bank rates because the administrative costs of making small loans are high in relation to the amount lent.

Donors who support financial services for the poor are advised to search out MFPs that are committed to financial self-sufficiency. Sustainability—the ability of an MFP to cover all of its costs through interest paid by its clients and other income—is the cornerstone of sound microfinance. Financially sustainable MFPs can become a permanent part of the financial system because they can stay in business when grants or soft loans are no longer available.

To promote sustainable providers of financial services to the poor, donors are advised to make capacity building a key component of their microfinance programming. Many small MFPs require institution-strengthening grants and technical assistance before they can reach the operational and financial self-sufficiency needed to sustain large-scale growth.

The time-intensive task of building institutional capacity includes such varied tasks as designing and implementing a management information system, cultivating strategic and human resource management, developing financial forecasting capabilities, instituting transparent financial reporting, internal controls, and audit practices, and implementing a product development process. For NGOs seeking to transform into regulated financial institutions, it also means creating a shareholder organization, attracting equity investment, and forming a strong board of directors.

At the other end of the spectrum, donors are discouraged from only funding strong MFPs that already have access to commercial investors. The principal task of donors should be to identify and bet on promising but riskier MFPs, leaving the known winners to commercial investors.

Donors are also encouraged to adjust their country-level programming to facilitate funding of global or multi-country MFP networks. These networks provide much-needed technical assistance to their members while supporting industry-wide measures such as performance standards and transparency in financial reporting.

In the last two decades, substantial progress has been made in developing techniques to deliver financial services to the poor on a sustainable basis. Most donor interventions have concentrated on one of these services For microcredit to be appropriate however, clients must have the capacity to repay loans under the terms by which they were provided. Otherwise, clients may not be able to benefit from credit, and may instead risk being pushed into debt problems. This sounds obvious, but microcredit is viewed by some as a “one-size-fits-all” solution. Instead, microcredit should be carefully evaluated against the alternatives when choosing the most appropriate intervention tool for a specific situation.

Microcredit may be inappropriate where conditions pose severe challenges to standard microcredit methodologies. Populations that are geographically dispersed or nomadic may not be suitable microfinance candidates. Microfinance may not be appropriate for populations with a high incidence of debilitating illnesses (e.g., HIV/AIDS). Dependence on a single economic activity or single agricultural crop, or reliance on barter rather than cash transactions may pose problems as well. The presence of hyperinflation or absence of law and order may stress the ability of microfinance to operate. Microcredit is also much more difficult when laws and regulations create significant barriers to the sustainability of microfinance providers (for example, by mandating interest-rate caps). However, strong and innovative microfinance providers are able to operate even in extremely challenging circumstances. These providers uphold two prerequisites of successful microcredit: discipline (both for clients [timely repayment] and institutions [business practices that lead to sustainability]); and no subsidization of interest rates.

Examples of alternative strategies

Savings can benefit people in many of the situations unsuitable for microcredit outlined above, if savings can be protected against losses. For example, after war or other conflicts, people want to rapidly begin saving small amounts of cash so that they can buy more productive assets in the future. Savings facilities also provide a means to reduce vulnerability by managing risk and cash flow. The product range, information systems, physical infrastructure, and lending capacity (for intermediating the savings collected) of regulated financial institutions may need to be strengthened in order to provide well-designed and secure deposit services to the poor. At the same time, non-regulated institutions may first need to transition to a regulated legal form in order to be allowed to offer deposits to the public.

Financial entitlements such as termination payments and one-time grants are often more suitable for immediate post-crisis situations, as well as for assisting the chronically poor, retrenched workers, and high-risk groups with little work experience.

Safety-net grants can provide a temporary solution to people hit by crisis. Displaced persons during or immediately following a conflict, or those affected by natural disasters, such as earthquakes and floods, may be better-suited for targeted “safety-net” grants that enable them to rebuild their livelihoods and replace lost assets. The alternative of providing credit to those not able to use it productively could push already vulnerable people into debt.

Grants can be used to help overcome the social isolation, lack of productive skills, and low self-confidence of the extreme poor, and prepare them for the eventual use of microcredit. Small grants and other financial entitlements can work well as first steps to “graduate” the poor from vulnerability to economic self-sufficiency.

Investments in infrastructure, such as roads, communications, and education, provide a foundation for economic activities. Community-level investments in commercial or productive infrastructure (such as market centres or small-scale irrigation schemes) also facilitate business activity.

Employment programmes prepare the poor for self-employment. Food-for-work programmes and public works projects fit this model. In many cases, these programmes may be out of reach for cash-strapped local governments, but within the purview of donors.

Non-financial services range from literacy classes and community development to market-based business-development services. While non-financial services should be provided by separate institutional providers, there are clear, complementary links with the demand for and impact of microcredit. For example, improved access to market opportunities stimulates—and depends on—securing credit to cover the costs (product design, transport, etc.) of taking advantage of those opportunities.

Legal and institutional reforms can create incentives for microfinance by improving the operating environment for both microfinance providers and their clients. For example, streamlining microenterprise registration, abolishing caps on interest rates, loosening regulations governing non-mortgage collateral, strengthening the judicial system, and reducing the cost and time of property and asset registration, can foster a supportive climate for microfinance