About Microfinance

Microfinance is a general term to describe financial services to low-income individuals

or to those who do not have access to typical banking services.

Microfinance is also the idea that low-income individuals are capable of lifting
themselves out of poverty if given access to financial services. While some studies
indicate that microfinance can play a role in the battle against poverty, it is also
recognized that is not always the appropriate method, and that it should never be
seen as the only tool for ending poverty.

I. Overview

What is Microfinance?

Florinda Agustina Garcia Lopez sells aprons in Guatemala. She takes out micro-loans to
grow her business and hopes to provide improved living conditions for her children.

"Microfinance is the supply of loans, savings, and other basic financial services to the
poor." (http://cgap.org)

As these financial services usually involve small amounts of money - small loans,
small savings, etc. - the term "microfinance" helps to differentiate these services
from those which formal banks provide
Why are they small? Someone who doesn't have a lot of money isn't likely to want or be
able to take out a $50,000 loan, or be able to open a savings account with an opening
balance of $1,000.

It's easy to imagine poor people don't need financial services, but when you think about it
they are using these services already, although they might look a little different.

"Poor people save all the time, although mostly in informal ways. They invest in
assets such as gold, jewelry, 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 neighbors 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." (http://cgap.org)

"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."
(http://cgap.org)

The History of Modern Microfinance

Percentage of Population living on less than $1 a day (http://wikipedia.org)

Credit unions and lending cooperatives have been around hundreds of years. However,
the pioneering of modern microfinance is often credited to Dr. Mohammad Yunus,
who began experimenting with lending to poor women in the village of Jobra,
Bangladesh during his tenure as a professor of economics at Chittagong University
in the 1970s. He would go on to found Grameen Bank in 1983 and win the Nobel
Peace Price in 2006. (http://globalenvision.org)

Since then, innovation in microfinance has continued and providers of financial services
to the poor continue to evolve. Today, the world bank estimates that about 160
million people in developing countries are served by microfinance.
(http://web.worldbank.org)

II. Microfinance Providers

Microfinance Institutions

A microfinance institution (MFI) is an organization that provides microfinance

services. MFIs range from small non-profit organizations to large commercial
banks.

"Historical context can help explain how specialized MFIs developed over the last few
decades. Between the 1950s and 1970s, governments and donors focused on providing
subsidized agricultural credit to small and marginal farmers, in hopes of raising
productivity and incomes. During the 1980s, micro-enterprise credit concentrated on
providing loans to poor women to invest in tiny businesses, enabling them to accumulate
assets and raise household income and welfare. These experiments resulted in the
emergence of nongovernmental 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." (http://cgap.org)

Why don't banks serve poor people?

World population with access to Finance (http://worldbank.org)

Formal financial institutions were not designed to help those who don't already have
financial assets - they were designed to help those who do. So what do poor people
do?

"Credit is available from informal commercial and non-commerical 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."
(http://cgap.org)

Some banks do provide these services, however. Grameen Bank in Bangladesh was
formed out of a project providing small loans to women in the village of Jobra.
Bancosol, a commercial bank in Bolivia, is also a bank which provides microfinance
services for the poor of Bolivia.

However, the majority of formal banks do not provide microfinance products as

microfinance is an expensive enterprise - you can make a lot more money on a large
loan than a small loan, and you won't make much money holding
savings accounts with very little funds in them. Banks can make more
money if they only provide financial services to those who already have
money.

III. Costs, Interest Rates, and Sustainability

back to top

Interest Rates (They're High)

Sikiratou Salami is from Togo, she took a loan out to purchase supplies for her cosmetics
business and plans to use part of her profits to finance the schooling of her three children.

The nature of microcredit - small loans - is such that interest rates need to be high to
return the cost of the loan.

"There are three kinds of costs the MFI 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 MFI for the money it lends is 10%,
and it experiences defaults of 1% of the amount lent, then these two costs will total $11
for a loan of $100, and $55 for a loan of $500. An interest rate of 11% of the loan amount
thus covers both these costs for either loan.

"The third type of cost, transaction costs, is not proportional to the amount lent. The
transaction cost of the $500 loan is not much different from the transaction cost of the
$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. Suppose that the transaction cost is $25 per loan and that the loans
are for one year. To break even on the $500 loan, the MFI would need to collect interest
of $50 + 5 + $25 = $80, which represents an annual interest rate of 16%. To break even
on the $100 loan, the MFI would need to collect interest of $10 + 1 + $25 = $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 can't be cut below certain minimums." (http://cgap.org)

Profitability and Sustainability of MFIs

"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 programs
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. MFIs serving the very poor are showing
rapid financial improvement. Microfinance programs like Bangladesh Rural
Advancement Committee and ASA in Bangladesh have already
demonstrated that very poor clients can be reached profitably: both
institutions had profits of more than 4% 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 density. 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." (http://cgap.org)

IV. Microfinance Impact and Outcomes

back to top

Evidence that Microfinance Works

"Gun Keshari has become a regular borrower of [an MFI] and over time, with the support
of small, low-interest loans, Gun Keshari has seen a dramatic improvement in the living
standards of her family."
- Polly Banks Kiva Fellow, Nepal

According to CGAP, "Comprehensive impact studies have demonstrated that:

• Microfinance helps very poor households meet basic needs and protect against
risks
 • The use of financial services by low-income households is associated with
improvements in household economic welfare and enterprise stability or growth;
• By supporting women's economic participation, microfinance helps to empower
women, thus promoting gender-equity and improving household well-being;
• For almost all significant impacts, the magnitude of impact is positively related to
the length of time that clients have been in the program." (UNCDF Microfinance)

"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 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
programs have better economic conditions than non-clients, suggesting that programs
contribute to these improvements. A few studies have also shown that over a long period
of time many clients do actually graduate out of poverty.

"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 to
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." (http://cgap.org)

"Empirical evidence shows that, among the poor, those participating in microfinance
programs 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.

• In Bangladesh, Bangladesh Rural Advancement Committee (BRAC) clients

increased household expenditures by 28% and assets by 112%. The incomes of
Grameen members were 43% higher than incomes in non-program villages.
• In El Salvador, the weekly income of FINCA clients increased on average by
145%.
• In India, half of SHARE clients graduated out of poverty.
• In Ghana, 80% of clients of Freedom from Hunger had secondary income sources,
compared to 50% for non-clients.
• In Lombok, Indonesia, the average income of Bank Rakyat Indonesia (BRI)
borrowers increased by 112%, and 90% of households graduated out of poverty.
 • In Vietnam, Save the Children clients reduced food deficits from three months to
one month." (http://cgap.org)

"Microcredit may be inappropriate where conditions pose severe challenges to loan

repayment. For example, populations that are geographically dispersed or have a high
incidence of disease may not be suitable microfinance clients. In these cases, grants,
infrastructure improvements or education and training programs are more effective. For
microcredit to be appropriate, the clients must have the capacity to repay the loan under
the terms by which it is provided." (http://yearofmicrocredit.org)

Microfinance Can Be a Good Tool For Empowering Women

"Microfinance programs 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 programs 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 the public sphere. Women own assets,
including land and housing, and play a stronger role in decision making.

In some programs that have been active over many years, there are even
reports of declining levels of violence against women." (http://cgap.org)

"Today I'm a very respected woman in the community. I have come out of the crowd of
women who are looked down upon. Due to the loan that I received... you have made me
to be a champion out of nobody."
- Rose Athieno, Produce Reseller, Uganda

Microfinance is Not a Silver Bullet

"Microfinance is but one strategy battling an immense problem.

"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, microcredit. For microcredit to be appropriate
however, the clients must have the capacity to repay the loan under the terms by which it
is provided. Otherwise, clients may not be able to benefit from credit and risk being
pushed into debt problems. This sounds obvious, but microcredit is viewed by some as
"one size fits all." 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. 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). (http://cgap.org)

While microfinance can not reach all economic segments of society, it has been shown to
reach segments previously un-serviced by other financial markets.

- "Evidence of Microfinance's Contribution to Achieving the Millennium Development

Goals", http://freedomfromhunger.org

Examples of Some Alternative Strategies

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 centers or small-scale irrigation schemes) also
facilitate business activity.

Employment programs prepare the poor for self-employment. Food-for-work programs

and public works projects fit this model. In many cases, these programs 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 micro-enterprise 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." (http://cgap.org)

…………
SKS Microfinance, India's largest microfinance player, arrived with a bang with its
hugely successful IPO in August. However, the recent sacking of its MD and CEO
Suresh Gurumani has opened up a pandora's box that is now threatening to expose the
ugly underbelly of the sector which, many allege, is teeming with players who are no
better than moneylenders but have so far been able to operate under the pious garb of
poverty eradicators.

TOI spoke to a cross-section of people associated with the sector and found that most are
of the opinion that far from pursuing their socalled vision of eradicating poverty and
being poor-friendly , private MFIs are actually in it just for profiteering as they are
lending to the poor at interest rates as steep as those charged by moneylenders, or
'Pathaani Vyaaj' , a sobriquet derived from the ruthless moneylenders of Afghan origin
who operated during the early 20th century.

Those familiar with the functioning of MFIs point out that the lending model of for-profit
MFIs is not exactly pro-poor . While offering a loan, they often quote a "10% flat" rate of
interest, which, on the face of it, appears like a good deal. However, there is a catch. This
'flat' rate of interest means that it will not be calculated on reducing balance. It implies
that even after the borrower has paid a few installments, the interest would still be
calculated on the initial sum borrowed, and not on the balance loan amount. The result is
a (hidden) final rate of interest of 24-30 %, or even higher for the poor who can barely
afford a square meal a day. "Microfinance, as practised by MFIs is unethical to the extent
that it evades the truth in lending," said R Balakrishnan, a financial market veteran turned
independent adviser . The high rate of interest is also leading to defaults and fraud.
Recently , there has been a spurt in suicides in Andhra Pradesh and Orissa, allegedly due
to harassment by MFI agents who started resorting to strong-arm tactics to recover loans
as chances of default rise. M Subba Rao, of NGO Masses, who trained under Grameen
Bank founder and Nobel prize winner Muhammad Yunus in Bangladesh, describes the
cases of alleged harassment by MFIs as the result of 'irresponsible lending' . "There is
high pressure on the staff (of private MFIs) to lend. They have targets to meet and they
dump money (on people)," said Rao.

Consider this: The loan outstanding , according to the latest estimate by Microfinance
Institutions Network (MFIN), the organization of 40 MFIs, is about Rs 30,000 crore with
about 3 crore poor banking on MFIs for their financial needs. While the four southern
states of AP, Tamil Nadu , Karnataka and Kerala account for a chunk of this borrowing,
West Bengal and Orissa too have rural poor relying on MFIs. Besides, the sector is also
on an uptick in UP and Haryana.

SKS Microfinance founder and chairman, Vikram Akula, is at great pains to ensure that
everything is above board in the company. And more so due to the bad publicity the
company got after its board sacked Gurumani. "We believe there is a right way to do
microfinance and we have been practising it over the past 13 years with not a single case
of unethical practice against us." The company, Akula said, clearly communicates to the
borrowers that though the loan was at a flat rate of 12.5%, it effectively works out to over
26% because there is an "extraordinarily high cost of doing microfinance" . Since most of
its lenders don't understand rate of interest, SKS' agents communicate to its borrower
how much they have to pay in terms of rupees per week.

Akula, whose company is the largest MFI in the country with over 73 lakh customers,
also denies the possibility of its staff using strongarm tactics or misleading borrowers .
Instead, he blames the bad name that the sector is getting to new MFIs jumping into the
fray sensing a lucrative business.

Of course, eradicating poverty through the MFI route, for some, is a lucrative business.
The IPO document by SKS disclosed that Gurumani was drawing an annual salary of Rs
1.5 crore, an equal amount or more as performance bonus, and also a one-time bonus of
Rs 1 crore. Akula is entitled to up to 1% of SKS's net profit, in addition to ESOPs.

Not surprisingly the 'success' of some of the MFIs and the mega-listing of SKS recently
have stunned even seasoned bankers. When asked about the success of the MFI business
in India, during a recent interview with TOI, SBI chairman O P Bhatt said even he was
surprised by their numbers. He wanted to go deeper into their finances and business
model to understand how MFIs, which borrow from banks including SBI, can make
profits which these very banks can't make. After all, like mobile tariff plans, no financial
product is protected by patents and IPRs and the uniqueness of any new and lucrative one
cannot last for more than 24 hours.

The problem seems to be with the business model, and not the approach . In India, there
are three kinds of MFIs: The government-supported self-help groups, non-profit NGOs
and the private for-profit firms. While private MFIs say that the smaller entities have
earned the sector a bad name, social workers and industry veterans at the grassroots say
that bigger players with bigger targets have led to such incidents. In many instances,
multiple MFIs lend to the same clients, resulting in repayment problems and eventually to
defaults.

'MFIs have lost ethical values'

ANABARD-funded study says Vijay Mahajan's Basix Microfinance — with funding

from Ford Foundation , Swiss Agency for Development and Cooperation and Sri Ratan
Tata Trust — became the first MFI with a 'forprofit model' not only in AP but also India.

Industry observers point to a trend: Register a company under Section 25 of Companies

Act, 1956 as a not-forprofit entity, use grants — local as well as foreign — and do social
lending to build a book, buy an NBFC (preferably a dormant one), do a reverse merger
and become a for-profit MFI. Says the head of a financial services company : "The
problem starts when shareholders of forprofit companies put pressure for return."
Read more: The ugly underbelly of Microfinance - The Times of India
http://timesofindia.indiatimes.com/business/india-business/The-ugly-underbelly-of-
Microfinance/articleshow/6766589.cms#ixzz12uHz5PDQ
………………………

SKS Microfinance, India's largest microfinance player, arrived with a bang with its
hugely successful IPO in August. However, the recent sacking of its MD and CEO
Suresh Gurumani has opened up a pandora's box that is now threatening to expose the
ugly underbelly of the sector which, many allege, is teeming with players who are no
better than moneylenders but have so far been able to operate under the pious garb of
poverty eradicators.

TOI spoke to a cross-section of people associated with the sector and found that most are
of the opinion that far from pursuing their socalled vision of eradicating poverty and
being poor-friendly , private MFIs are actually in it just for profiteering as they are
lending to the poor at interest rates as steep as those charged by moneylenders, or
'Pathaani Vyaaj' , a sobriquet derived from the ruthless moneylenders of Afghan origin
who operated during the early 20th century.

Those familiar with the functioning of MFIs point out that the lending model of for-profit
MFIs is not exactly pro-poor . While offering a loan, they often quote a "10% flat" rate of
interest, which, on the face of it, appears like a good deal. However, there is a catch. This
'flat' rate of interest means that it will not be calculated on reducing balance. It implies
that even after the borrower has paid a few installments, the interest would still be
calculated on the initial sum borrowed, and not on the balance loan amount. The result is
a (hidden) final rate of interest of 24-30 %, or even higher for the poor who can barely
afford a square meal a day. "Microfinance, as practised by MFIs is unethical to the extent
that it evades the truth in lending," said R Balakrishnan, a financial market veteran turned
independent adviser . The high rate of interest is also leading to defaults and fraud.
Recently , there has been a spurt in suicides in Andhra Pradesh and Orissa, allegedly due
to harassment by MFI agents who started resorting to strong-arm tactics to recover loans
as chances of default rise. M Subba Rao, of NGO Masses, who trained under Grameen
Bank founder and Nobel prize winner Muhammad Yunus in Bangladesh, describes the
cases of alleged harassment by MFIs as the result of 'irresponsible lending' . "There is
high pressure on the staff (of private MFIs) to lend. They have targets to meet and they
dump money (on people)," said Rao.

Consider this: The loan outstanding , according to the latest estimate by Microfinance
Institutions Network (MFIN), the organization of 40 MFIs, is about Rs 30,000 crore with
about 3 crore poor banking on MFIs for their financial needs. While the four southern
states of AP, Tamil Nadu , Karnataka and Kerala account for a chunk of this borrowing,
West Bengal and Orissa too have rural poor relying on MFIs. Besides, the sector is also
on an uptick in UP and Haryana.

SKS Microfinance founder and chairman, Vikram Akula, is at great pains to ensure that
everything is above board in the company. And more so due to the bad publicity the
company got after its board sacked Gurumani. "We believe there is a right way to do
microfinance and we have been practising it over the past 13 years with not a single case
of unethical practice against us." The company, Akula said, clearly communicates to the
borrowers that though the loan was at a flat rate of 12.5%, it effectively works out to over
26% because there is an "extraordinarily high cost of doing microfinance" . Since most of
its lenders don't understand rate of interest, SKS' agents communicate to its borrower
how much they have to pay in terms of rupees per week.

Akula, whose company is the largest MFI in the country with over 73 lakh customers,
also denies the possibility of its staff using strongarm tactics or misleading borrowers .
Instead, he blames the bad name that the sector is getting to new MFIs jumping into the
fray sensing a lucrative business.

Of course, eradicating poverty through the MFI route, for some, is a lucrative business.
The IPO document by SKS disclosed that Gurumani was drawing an annual salary of Rs
1.5 crore, an equal amount or more as performance bonus, and also a one-time bonus of
Rs 1 crore. Akula is entitled to up to 1% of SKS's net profit, in addition to ESOPs.

Not surprisingly the 'success' of some of the MFIs and the mega-listing of SKS recently
have stunned even seasoned bankers. When asked about the success of the MFI business
in India, during a recent interview with TOI, SBI chairman O P Bhatt said even he was
surprised by their numbers. He wanted to go deeper into their finances and business
model to understand how MFIs, which borrow from banks including SBI, can make
profits which these very banks can't make. After all, like mobile tariff plans, no financial
product is protected by patents and IPRs and the uniqueness of any new and lucrative one
cannot last for more than 24 hours.

The problem seems to be with the business model, and not the approach . In India, there
are three kinds of MFIs: The government-supported self-help groups, non-profit NGOs
and the private for-profit firms. While private MFIs say that the smaller entities have
earned the sector a bad name, social workers and industry veterans at the grassroots say
that bigger players with bigger targets have led to such incidents. In many instances,
multiple MFIs lend to the same clients, resulting in repayment problems and eventually to
defaults.

'MFIs have lost ethical values'

ANABARD-funded study says Vijay Mahajan's Basix Microfinance — with funding

from Ford Foundation , Swiss Agency for Development and Cooperation and Sri Ratan
Tata Trust — became the first MFI with a 'forprofit model' not only in AP but also India.

Industry observers point to a trend: Register a company under Section 25 of Companies

Act, 1956 as a not-forprofit entity, use grants — local as well as foreign — and do social
lending to build a book, buy an NBFC (preferably a dormant one), do a reverse merger
and become a for-profit MFI. Says the head of a financial services company : "The
problem starts when shareholders of forprofit companies put pressure for return."

Read more: The ugly underbelly of Microfinance - The Times of India

http://timesofindia.indiatimes.com/business/india-business/The-ugly-underbelly-of-
Microfinance/articleshow/6766589.cms#ixzz12uHz5PDQ