An Introduction to Microfinance

By Gregory Gethard AAA

It has long been a challenge for interested parties, such as government officials, non-governmental organizations (NGOs) and philanthropists, to improve access by the poor to financial resources that can help them increase their incomes.

Most of those trapped in poverty do not have enough income to open accounts with traditional banks. As a result, many look for loans from family, friends and even loan sharks exploiting the black market. One way to help the world's poorest comes in the form of microfinance, which brings basic banking tools to the world's most needy.

Microfinance groups lend to customers who have low incomes and, at least anecdotally, have helped many of those trapped in the most extreme form of poverty better their lives by loaning them amounts of money that many others would consider a paltry sum. They also provide borrowers with access to education, credit and basic savings accounts. Read on to find out how microfinance works and the evidence behind its claims to helping the poorest people lift themselves out of poverty.

How It Works
Many microfinance proprietors look to educate the destitute groups they serve about how basic banking services work. In many instances, people looking to join microfinance organizations are first required to take a basic money management class. Lessons focus on ways to develop savings, understand how banks work, and how how to budget, manage debt and manage cash flow.

Once educated on how the process works, customers are then allowed access to loans. Just as one would find at a traditional bank, a loan officer approves and helps borrowers with loan applications and oversight. The typical loan - usually $100 or less - does not seem like much to many in the developed world. But to people trapped in rural poverty, this figure is enough to start a business or engage in other profitable activities.

Many potential borrowers cannot offer any collateral. As a buffer, microlending operations often pool together people seeking loans. After receiving loans, recipients repay their debts together. Because the success of the program depends on everyone's contributions, a form of peer pressure helps ensure loan repayment. For example, if an individual is having trouble using his or her money to start a business, that person can seek help from other group members or from the loan officer. Through repayment, loan recipients start to develop credit, allowing them to obtain larger loans down the line.

Also, many microfinance operations require loan recipients to set aside parts of their income in a savings account used as insurance in case of a loan default. Others also require borrowers to allocate a portion of their income to a personal savings account for use at a later date.

Who Provides the Services?
The concept of microfinance started in the late '70s and early '80s. The first organization to receive attention for its success was the Grameen Bank, which was started by Muhammad Yunus in Bangladesh. On top of providing loans to its clients, the Grameen Bank also suggests its customers subscribe to its "16 Decisions," a basic list of ways the poor can improve their lives. The 16 Decisions touch on a wide variety of subjects ranging from a request to stop the practice of issuing dowries upon a couple's marriage to ensuring drinking water is kept sanitary. In 2006, the Nobel Peace Prize was awarded to both Yunus and the Grameen Bank for their efforts in developing the microfinance system.

India's SKS Microfinance also serves a large number of poor clients. While India has made great economic strides since the 1970s, the nation still has millions of people living with little more than the clothes on their backs. Formed in 1998, SKS has grown to become one of the biggest microfinance operations in the world. SKS works in a similar fashion to the Grameen Bank, pooling all borrowers into groups of five members who work together to ensure loan repayment.

There are other microfinance operations around the world. Some larger organizations work closely with the World Bank, while other smaller groups operate in different nations. Most were formed with the simple goal of improving lives with funding from donations, grants and other forms of generosity.

But a new trend has emerged in the world of microfinance - one where groups seek to use microfinance not just to help others, but to also turn a profit.

For Profit
One of the largest, and most controversial, microfinance firms is Mexico's Compartamos Banco. The bank was started in 1990 as a nonprofit organization (NPO). However, 10 years later, the bank's owners decided to transform the firm into a traditional, for-profit company. In 2007, the bank decided to go public on the Mexican Stock Exchange, and its initial public offering (IPO) raised more than $400 million.

Compartamos Banco makes loans like most other microfinance companies in that its clients are mostly women, its customers are pooled into groups, and loans are issued in relatively small amounts. However, Compartamos Banco differs from other groups when clients repay their loans. Nonprofit institutions take a more philanthropic bent with the profits, using them to expand the organization's reach or create more programs. Compartamos Banco is a publicly owned company, meaning the company's management team has to ultimately answer to its shareholders.

As a result, Compartamos Banco has been criticized by many. The bank's most visible opponent is the grandfather of microfinance himself, Muhammad Yunus. Yunus, and others, argue that a for-profit organization works against the original mission of microfinance, which put helping the poor above all else. Compartamos argues that by becoming a profitable business, it will be able to extend its reach and help more of Mexico's poor.

In addition to Compartamos Banco, many of the world's major financial institutions and other large corporations have launched for-profit microfinance projects to turn a profit by lending small amounts to the poor. CitiGroup (NYSE:C), Barclay's (NYSE:BCS), General Electric (NYSE:GE) and others have started microfinance divisions in many countries. Other companies have issued funds that invest primarily in microfinance firms, which provide money to microfinance lenders in exchange for a cut of the profits in return.

Other Criticisms
On top of the divide between non- and for-profit microfinance enterprises, other criticisms exist. Because microfinance loans are typically in the range of $100 or less, some critics say this is not enough money to provide stability while also keeping recipients working in subsistence-level trades. They cite the examples of China and India, where millions have emerged from the lowest levels of poverty due to the development of large industries. The jobs created by constructing new factories and producing new goods have led to stable employment and higher wages for employees.

Other critics have said that microfinance can hurt the poor by charging high interest rates. There are borrowers who cannot, or do not, repay loans. The added debt can make microfinance clients poorer than when they started, leaving them in debt and living hand-to-mouth. That said, according to IFAD, these rates are well below what local money lenders would charge, making these micro loans a viable alternative for financing.

The Bottom Line
Microfinance provides small loans to the world's poorest people, either through nonprofit organizations or through larger commercial lenders. Whether providing financial services to groups that traditionally could not access them helps these people or only puts them further in debt is still up for debate. What is certain is that this relatively new industry is in it for the long haul.

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