How does microfinance help the poor?
Microfinance can help poor people in a number of ways.
Firstly, it can provide microentrepreneurs with the capital needed to operate and expand their businesses.
Indeed, having a reliable source of credit allows microentrepreneurs to better plan their business activities and manage their cash flow. Although the size of the loans may seem small, sometimes just $100, it is worth remembering that for half of the world’s population who survive on less than $2 a day; this is still a significant sum.
Secondly, through the increased income generated by their businesses as well as the ability to save and obtain loans, microfinance allows poor people to build their assets, for example by acquiring land, constructing or improving their homes and purchasing livestock and poultry.
Thirdly, it can reduce poor people’s vulnerability. Access to credit, savings and insurance can help them to smooth cash flows and avoid periods when access to food, clothing, shelter, or education is lost. Microfinance can make it easier to manage shocks such as sickness to the family breadwinner or theft.
How do savings services help poor people?
Secure and accessible savings facilities provide a means for poor people to reduce their vulnerability by allowing them to better manage risk and cash flow - poor people do not just have to cope with low incomes, but also with irregular and uncertain incomes. Savings are also used to accumulate money that can be used for investment or to meet the costs associated with expected commitments such as their children’s education and weddings or unexpected events such as ill health and funerals. In fact, very poor people tend to be much more comfortable investing what they already have than increasing their level of liability by taking out a loan. For this reason, for the very poorest people, savings facilities are often more important than access to loans.
In fact, all poor people already save but tend to use informal methods because they lack access to good formal banking deposit services. They may hide cash under the mattress or buy animals or other assets that can be sold when the need arises. However, these savings methods are fraught with risk - for example cash can be stolen and animals can become ill and even die. What poor people want is secure, convenient deposit services that allow them to frequently withdraw and deposit relatively small amounts of money. The difficulty with the savings facilities already offered by banks is that they may require savers to open an account with a large initial deposit or maintain a high minimum balance thereby excluding small savers or it may simply be that their nearest branch is located too far away.
How can you lend to poor people who can offer little or no collateral?
Actually it is not correct to assume that MFIs provide loans to poor people who lack collateral. Poor people simply lack traditional collateral in the form of property or land deeds. To overcome this MFIs use a number of methods to ensure repayment.
These include the use of one or two personal guarantors (often respected local community leaders) and the use of solidarity groups in which groups of poor people (usually 4-5) approach the MFI collectively for a loan. Within the groups, members decide how much each individual should receive from the group loan and the group as a whole is responsible for repayment.
Group members are usually from within the same community, know each other well and are best placed to judge if each other’s business ventures are going to be successful or not and they can also monitor loan use and encourage each other to repay. Lending to solidarity groups or individuals with personal guarantors has proved remarkably successful with very high loan repayments rates of around 97% - these are in fact higher than the repayments rates that commercial banks experience with wealthy borrowers. What explains the success of group lending? There are several reasons each of which may play a role of varying significance depending upon the context:
- Peer Monitoring: the ability of members to monitor the investment behaviour of one another during the course of a loan, making sure that each member only undertakes safe investment projects with the loans.
- Social Ties: the social cohesion that exists in some communities means that the sanctions that a member would receive from the group for defaulting results in each member wanting to repay faithfully.
- Group Pressure: the pressure between borrowers to repay means that the group can expel non-paying members if they default, thus excluding them from continued access to credit.
Why do MFIs charge high interest rates on loans to poor people?
MFIs generally charge annual interest rates of anwhere between 10-40%, although some charge lower or higher than this range. Apart from working in environments where inflation is higher, there are a number of reasons why the interest rates charged by MFIs can appear to be relatively high:
- Firstly, the administrative costs of making many small loans are much higher than making fewer larger loans. For example, it takes less time for staff to make one loan of £1,000 than ten loans of £100 each.
- Secondly, loan officers must work longer and harder to assess the feasibility of each loan application and thereby reduce risk because borrowers cannot generally offer traditional collateral nor do they have regular salaried income.
- Thirdly, MFIs often operate in geographically remote areas with low population densities and this means that they incur greater operational costs, especially when they must often travel to each borrower to disburse loans and collect repayment.
In recent years MFIs have focused increasingly on making their operations financially sustainable by charging interest rates that are high enough to cover all their costs. This approach can ensure that they can continue to operate and indeed expand to serve more people. If they do not make their operations sustainable then they must continually be reliant upon subsidies from donors, which may or may not be forthcoming, or they may have to close down altogether since they cannot cover their costs in which case many poor people would certainly be worse off. It is worth pointing out that as MFIs mature over time and become more efficient, transactions costs usually decrease and this can mean lower interest rates. Furthermore, it is also worth emphasising that the interest rates charged by MFIs are still far below what poor people can expect to pay to local moneylenders, who often charge annual interest rates of several hundred percent.
The MFIs that we work with tend to charge interest rates that are comparable to the rates charged by other microfinance providers working in that particular country. We would not consider working with MFIs that charge interest rates that might be considered as 'excessive'. Furthermore, our MFI partners sometimes reduce the rates they charge precisely because we are providing them with a relatively cheaper source of funds.
Do MFIs aim to help the poor or make a profit?
They want to do both: most MFIs have a ‘double bottom line’, that is, their main aim is to meet social objectives such as reducing poverty or empowering women, which they attempt to do while maintaining financial viability. Probably microfinance services that target very poor clients may be less profitable than those which target the slightly better off since they may have higher transactions costs providing very small loans to more isolated borrowers. Hence there is a concern that an excessive concern for profit or indeed sustainability in providing microfinance services will result in MFIs moving away from very poor clients to serve those who are less poor and who want slightly larger loans.
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 or it may be better to promote alternative financial solutions, such as local savings and credit associations that are managed by the local community themselves.
Why can’t poor people just go to a bank for financial services?
There are many reasons why poor people find it difficult to deal with banks. These include:
- They may live too far from the nearest bank branch and it may take too long or be too expensive for them to travel each time they wish to apply for a loan, make a repayment or access their savings.
- They may not have enough money to open a savings account or the minimum balance that the bank requires them to maintain may be too high.
- They may not have sufficient traditional collateral (such as the deeds to the house where they live or the land they farm) to secure their loan.
- They may be self-employed without regular or verifiable sources of income.
- They may have no existing history of receiving loans with the bank.
- They may be illiterate and be unable to complete all the necessary paperwork required for applying for a loan or opening a savings account.
- They may feel intimidated by a bank’s premises and staff who are used to dealing with well-dressed wealthy customers in salaried jobs rather than poor micro entrepreneurs who work in agriculture or markets.
- Some banks think it will be uneconomic for them to deal with poor people and they deliberately exclude poor people from their services.
They may consider that it is too costly for them to analyse and process the large number of loan applications made for the relatively small amounts of money required by poor people and instead prefer to make a few large loans to richer borrowers.
As a consequence poor people frequently rely on friends or family or private moneylenders as their principal sources of credit. Private moneylenders can offer several advantages that make their service convenient. They are often personally familiar with the borrower and therefore offer credit without collateral; they are generally located locally and can both disburse loans immediately with minimal paperwork as well as receive repayment without the need to travel great distances. Nevertheless, it is almost always the case that private moneylenders charge relatively high rates of interest and they may not be able to provide more than limited short-term capital. However, the successful provision of microfinance by institutions such as Grameen Bank in Bangladesh and BancoSol in Bolivia who specifically target micro entrepreneurs and the realisation that lending to poor people can be profitable and that poor people in fact also make very good clients has meant that, in addition to the increasing number of MFIs, more and more banks are promoting microfinance.
Should MFIs provide entrepreneurs with training as well as loans?
This is an area of some debate and while many MFIs focus solely on providing financial services, they are often referred to as minimalist MFIs; others often labelled ‘credit-plus’ MFIs do provide additional components such as training or education to borrowers as well because they believe that poor people face more than just financial constraints. For example, entrepreneurs who would like to expand their enterprises or enter newer more dynamic fields may face lack of access to markets, low technology levels, be illiterate or semi-literate, and may lack training in business and related skills. Some MFIs believe that additional support such as training and technical assistance is a pre-requisite to enhance poor people’s enterprises and productivity. Indeed the addition of training components has been justified as a means of guaranteeing effective use of credit and improvements in productivity and income for entrepreneurs, as well as being necessary to overcome a variety of non-financial barriers that they may encounter.
Usually training is provided in small business administration, basic accountancy, bookkeeping, and marketing. Although training may be ongoing it is generally only given once before the entrepreneur receives his or her first loan. In addition, there is also a concern that too many of the same types of business may be established – for example, too many dressmakers or too many small grocery stores, thereby flooding the local market. Therefore, some MFIs are concerned with encouraging entrepreneurs to diversify into new business opportunities.
However, despite these concerns most MFIs tend to focus quite narrowly on providing financial services because the provision of training can be costly and add significantly to the MFIs operational costs. The underlying philosophy of these MFIs is that they do not know what is best for entrepreneurs, rather that entrepreneurs must decide for themselves how best to use their own money.
Almost all the Microfinance Instituions we partner with offer specific training. You can find out more detailed information about each of our partners here.