The future of microfinance

Microfinance deals with microcredits and microloans which are very small loans offered to poor people and mostly commonly used in developing countries.

Unlike commercial loans, microloans require no collateral, enabling individuals who were previously unable to access credit the opportunity to do so through microcredit.

Furthermore, the loans are provided at a low interest which aids in preventing the individuals from an interest trap.

According to the Grameen Bank the credit default rate is low at less than 5 percent.

The Grameen Bank was one of the first microfinance institutions that offered small loans. It was founded in 1976 and is one of the biggest providers of microloans and microsavings that empower people to save small amounts on an account. Most of these institutions started as non-profit organizations.

The World Bank estimates more than half a billion people have benefited from microfinance with borrowed amounts being as small as 50 euros. In 2010 there were 105 million active borrowers with a total loan of 54 billion euros and average borrowings of approximately 430 euros.

Of these borrowers 70 percent live in rural areas, and approximately 80 percent receive group credits to make investments on behalf of their villages; for instance through the purchasing of farming equipment to maximize harvesting.

The remaining 20 percent of loans are given to individuals and are used in various ways. The past year has seen a steady rise in the total borrowing of microcredit as the availability of microcredits becomes more accessible.

Business opportunities for women

Microcredits are significantly claimed by women, who represent 80 percent of creditors often providing them with the opportunity to start their own enterprise or send their children to school.

Furthermore, the use of microcredits is extended to people aged below 40 in more than 50 percent of the cases, reflecting the fact that users are predominantly unemployed  people who hope that the use of a loan will provide them with an employment opportunity often in the form of a business development.

These figures therefore underline the positive effects the microloans have for the individuals who are able to access and make effective use of them.

Grameen Bank, photo by monkiemag via Flickr (some rights reserved)

The necessity of small loans is evident when one considers approximately 1.6 billion people live on 2 dollars or less a day. However, it can be argued that these people should be able to borrow and save money similar to the rest of the population who have higher earnings.

What’s in it for the banks?

Until the recent development of microaccounts only one in five individuals of very low income had access to savings accounts as it was not a financially viable option for the majority of banks for a range of reasons, the most prevalent being the administration costs of small saving accounts.

For the majority of banks the costs of providing the micro service is too high and would not provide a profitable opportunity. Additionally, the small market size of microfinance acts as a further disincentive for banks to enter the industry.

Approximately 40 percent of the microfinance market is served by banks and finance firms which are able to offer the service and see it as a profitable opportunity. However, to what extent it can be seen as sustainable is questionable.

One can argue that since firms create profits – although they are assumed to be low – their decision in offering the service can partly be seen as an act of goodwill as it provides the poorer individuals with the opportunity to advance their livelihoods and can aid in increasing the national wealth.

Nonetheless, many critics argue the banks are acting in an immoral way making profits out of the poor knowing that despite their good intentions the individuals who have taken the microloan will more often than not be unable to repay the bank.

Most recently there has been a development of a new type of microcredit in the form of peer to peer lending through the use of the internet. This enables the average person to allocate some of their savings to the lending platform from which other individuals can directly borrow money from.

This can be seen as a forward movement in terms of microfinance in that more individuals are now able to access the service and gain credit.

However, critics claim the online platform is often unreliable with particular reference to the terms associated with guaranteed interest rates.

Due to the uncertainty in operating over the internet the platform requires a significantly higher interest rate than the lender receives as their profit. Solutions to this can perhaps be found in operating the platform on non-profit organizations websites which would circumvent the problem of exploiting the poor.

Transparency issues

The major problem with microcredits is the level of transparency within the industry.

Mr. Yunus, Nobel laureate and founder of Grameen Bank along with others state that interest rates should only be 10-15 percent above the cost of raising the necessary capital.

Higher rates would take the form of loan sharking otherwise known as a “red zone”; despite this however 75 percent of institutions fall into this “red zone” as defined by Yunus.

More transparency should lower the percentage of interest rates within the red zone as lenders would be able to choose between institutions.

In the majority of cases individuals are likely to choose the institution with the lower interest rate and the firms which have a larger market share such as Grameen bank could thus negotiate with loan sharks offering substantially higher rates.

The principal reason for the high interest rates by these institutions is that without them they are unable to reach a financially sustainable position in terms of long term profitability. With the majority of donors preferring efficient institutions, they are put under constant pressure to manage the trade-off between sustainability and outreach.

Perhaps a point to consider for future improvements in the microcredit sector is the enhancement of the loan contracts. The contracts individuals sign on receiving the loan are often highly restrictive and therefore impact how individuals are able to use the loans.

Therefore, through the loosening of contracts this is likely to increase the use of loans for long term projects which if successful are likely to have far greater long standing economic impacts than short term projects that have little time to develop.

This potential has been recognized and some institutions are trying to solve the trade-off problem with the help of social networks in rural areas to increase their outreach to microfinance.

By Christian Peters
INFOCUS Committee

SourceINFOCUS, Magazine of the Financial Study Association SCOPE|FOCUS, January 2013

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