Microfinance: What It Is And How To Get Involved

By Investopedia Staff AAA

In 2007, the microfinance market served more than 33 million borrowers and 48 million savers. Statistics provided by Unitus, an organization devoted toward fighting global poverty show that 80% of the potential market has not yet been reached. How will the worldwide growth of this market impact you?

TUTORIAL: Financial Concepts

What is microfinance?
The term "microfinance" describes the range of financial products (such as microloans, microsavings and micro-insurance products) that microfinance institutions (MFIs) offer to their clients. Microfinance began in the 1970s when social entrepreneurs began lending money on a large scale to the working poor. One individual who gained worldwide recognition for his work in microfinance is professor Muhammad Yunus who, with Grameen Bank, won the 2006 Nobel Peace Prize. Yunas and Grameen Bank demonstrated that the poor have the ability to pull themselves out of poverty. Yunus also demonstrated that loans made to the working poor, if properly structured, had very high repayment rates. His work caught the attention of both social engineers and profit-seeking investors. (Learn more in The Who, What And How Of Microfinance.)

Historically, the goal of microfinance was the alleviation of poverty. For many years, microfinance had this primary social objective and so traditional MFIs consisted only of non-governmental organizations (NGO), specialized microfinance banks and public sector banks. More recently, the marketplace has been evolving. For example, some non-profit MFIs are transforming themselves into profit-seeking institutions to achieve greater strength, sustainability and market reach. They are being joined in the microfinance marketplace by consumer finance companies, like GE Finance and Citi Finance. "Big-box" consumer retailers, like Wal-Mart, Elektra and Tesco are beginning to emerge as consumer lenders and a few are venturing into microfinance. Although most MFIs still consider poverty alleviation the primary goal, selling more products to more consumers is the primary motivation of many new entrants.

Microfinance Products and Services
The following products and services are currently being offered by MFIs:

  • Microloans: Microloans (also known as microcredit) are loans that have a small value; most loans are less than $100 in size. These loans are generally issued to finance entrepreneurs who run micro-enterprises in developing countries. Examples of micro-enterprises include basket-making, sewing, street vending and raising poultry. The average global interest rate charged on micro-loans is about 35%. Although this may sound high, it is much lower than other available alternatives (such as informal local money lenders). Moreover, MFIs must charge interest rates that cover the higher costs associated with processing the labor-intensive micro-loan transactions. (Learn more about microfinance in Microfinance: Philanthropy Through Industry.)
  • Microsavings: Microsavings accounts allow individuals to store small amounts of money for future use without minimum balance requirements. Like traditional savings accounts in developed nations, micro-savings accounts are tapped by the saver for life needs such as weddings, funerals and old-age supplementary income.
  • Micro-Insurance: Individuals living in developing nations have more risks and uncertainties in their lives. For example, there is more direct exposure to natural disasters, such as mudslides, and more health-related risks, such as communicable diseases. Micro-insurance, like its non-micro counterpart, pools risks and helps provide risk management. But unlike its traditional counterpart, micro-insurance allows for insurance policies that have very small premiums and policy amounts. Examples of micro-insurance policies include crop insurance and policies that cover outstanding balances of micro-loans in the event a borrower dies. Due to the high administrative expense ratios, micro-insurance is most efficient for MFIs when premiums are collected together with microloan repayments. (To learn more about the importance of insurance, see Fifteen Insurance Policies You Don't Need and Five Insurance Policies Everyone Should Have.)

What does microfinance mean for you?
The development and growth of the microfinance market affects more than just those who are engaging in or contemplating microfinance services. Here's how it may affect you:

  • As an investor: Return-focused institutional investors are now making microfinance-related investments. In addition, major ratings agencies are rating microfinance transactions. For example, Morgan Stanley issued a microfinance backed bond, which contained tranches and was rated "AA" by S&P. (To learn more about debt rating, please see: What Is A Corporate Credit Rating?)

    This shows that microfinance is beginning to provide investment opportunities for all investors. The Micro Banking Bulletin reports that 63 of the world's top MFIs have an average return (after adjusting for inflation and after taking out subsidies programs received) of about 2.5% of total assets. Local and regional banks are generally the first to integrate microfinance investments into their portfolios, while large international banks currently prefer to provide financing to other banks, MFIs or NGOs. As mentioned earlier, even consumer finance companies may have exposure to microfinance activities. As an investor, you may wish to look to see whether the companies you are investing in have exposure to microfinance and if so, whether the risk-return characteristics of those activities appeal to you. Visit the MIX market for current information on the supply, demand and facilitation of capital within the microfinance market.

  • As a finance professional: Microfinance requires highly specialized financial knowledge as well as a unique combination of skills, such as knowledge of social science, local languages and customs. New careers are emerging to fit these unique demands. For finance professionals, this means that new careers are opening up for those who have this unique combinations of skills and experiences. Moreover, traditional career roles are blurring as microfinance brings together professionals with varied backgrounds to work in collaborative teams. For example, development professionals (such as people who have worked for the Asian Development Bank or other development agencies) can now be found working side by side with venture capitalists. A wide range of microfinance career opportunities can be found at Microfinance Gateway.
  • As an individual: Some believe that we are living in a time when poverty may be eradicated. Studies support that belief. According to the Virtual Library on Microcredit, during an eight-year period, among the poorest in Bangladesh with no credit service of any type, only 4% pulled themselves above the poverty line. But with individuals and families with microcredit from an MFI, more than 48% rose above the poverty line. What poverty eradication means to you as an individual depends largely upon your personal philosophy. You might welcome it as a key achievement in the history of humanity. You also might celebrate the possibility that we each can all buy and sell to one another. Individuals who seek to be a part of this poverty eradication phenomenon may now loan money to a micro-entrepreneur in another part of the world through the non-profit online service Kiva.

Conclusion
Capital and expertise are increasingly flowing into microfinance. Increased competition can be seen among MFIs. As they continue to develop their internal operating capacities, more of the potential 80% of the market will be served. Key players such as ratings agencies and institutional investors are also moving into the marketplace, signaling the fact that a true market is developing. Although microfinance has been happening since the 1970s, it is now much more relevant to investors, finance professionals and individuals. Specifically, you might wish to look at your portfolio, your career opportunities, or your personal philosophy to determine how the microfinance phenomenon is impacting you. (To read more on this subject, see Using Social Finance To Produce A Better World.)

comments powered by Disqus
Related Articles
  1. Entrepreneur Vs. Small Business Owner, ...
    Investing Basics

    Entrepreneur Vs. Small Business Owner, ...

  2. Six Steps To A Better Business Budget
    Entrepreneurship

    Six Steps To A Better Business Budget

  3. The Government And Risk: A Love-Hate ...
    Insurance

    The Government And Risk: A Love-Hate ...

  4. 5 Services To Usher In New Clients
    Professionals

    5 Services To Usher In New Clients

  5. Hypothesis Testing in Finance: Concept ...
    Active Trading Fundamentals

    Hypothesis Testing in Finance: Concept ...

Trading Center