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What is 'Microfinance'

Microfinance, also called microcredit​, is a type of banking service that is provided to unemployed or low-income individuals or groups who otherwise have no other access to financial services. While institutions participating in the area of microfinance are most often associated with lending (microloans can be anywhere from $100 to $25,000), many offer additional services, including bank accounts and micro-insurance products, and provide financial and business education. Ultimately, the goal of microfinance is to give impoverished people an opportunity to become self-sufficient.

BREAKING DOWN 'Microfinance'

Most of those trapped in poverty or with limited resources do not have enough income to do business with traditional financial institutions. Despite being excluded from banking services, however, those who live off of as little as $2 a day do attempt to save, borrow, acquire credit or insurance and make payments on their debts. As a result, many look for help from family, friends and even loan sharks, who often charge exorbitant interest rates.

Microfinance allows people to safely take on reasonable small business loans in a manner that is consistent with ethical lending practices. Although they exist all around the world, the majority of microfinancing operations occur in developing nations, such as Uganda, Indonesia, Serbia and Honduras. Many microfinance institutions (MFIs) focus on helping women in particular.

How It Works

Microfinancing organizations support a wide range of activities, ranging from business start-up capital to educational programs that allow people to develop the skills necessary to succeed as an entrepreneur. These programs can focus on such skills as bookkeeping, cash flow management and even technical or professional skills. Unlike typical financing situations, in which the lender is primarily concerned with the borrower having enough collateral to cover the loan, many microfinance organizations focus on helping entrepreneurs succeed.

In many instances, people looking to join microfinance organizations are first required to take a basic money management class. Lessons focus on understanding interest rates and the concept of cash flow, how financing agreements and savings accounts work, how to budget, and how to manage debt.

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

Microfinance Loan Terms

Like conventional lenders, microfinanciers must charge interest on loans, and they institute specific repayment plans with payments due at regular intervals. Some require loan recipients to set aside parts of their income in a savings account used as insurance in case of default; if the borrower repays the loan successfully, he has use of this account, of course.

Because many applicants cannot offer any collateral, microlenders often pool borrowers together, as a buffer. 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 a good credit history, allowing them to obtain larger loans down the line.

Interestingly, even though the borrowers often qualify as very poor, repayment rates on microloans are often higher than the average rate on more conventional forms of financing. For example, the microfinancing institution Opportunity International reported repayment rates of approximately 98.9% in 2016.

History of Microfinance

Microfinance is not a new concept: Small operations have existed since the 18th century. The first occurrence of microlending is attributed to the Irish Loan Fund system, introduced by Jonathan Swift, which sought to improve conditions for impoverished Irish citizens.

But in its modern form, microfinancing became popular on a large scale in the 1970s. The first organization to receive attention was the Grameen Bank, which was started in 1976  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. Formed in 1998, it 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. Some organizations enable lenders to choose exactly who they want to support, categorizing borrowers on criteria like level of poverty, geographical region and type of small business. Others are very specifically targeted: There are those in Uganda, for example, that focus on providing women with capital required to undertake projects such as growing eggplants and opening small cafés. Some groups tend to focus their efforts only on businesses which are created with the intent of improving the overall community through initiatives like education, job training and clean water.

Benefits of Microfinance

The World Bank estimates that more than 500 million people have directly or indirectly benefited from microfinance-related operations. The International Finance Corporation (IFC), part of the larger World Bank Group, estimates that more than 130 million people have directly benefited from microfinance-related operations as of 2014. However, these operations are only available to approximately 20% of the 3 billion people who qualify as part of the world’s poor.

In addition to providing microfinancing options, the IFC has assisted developing nations in the creation or improvement of credit reporting bureaus in 30 nations. It has also advocated for the addition of relevant laws governing financial activities in 33 countries.

The benefits of microfinance extend beyond the direct effects of giving people a source for capital. Entrepreneurs who create a successful business create jobs, trade and overall economic improvement within the community. Empowering women in particular, as many MFIs do, leads to more stability and prosperity for families. 

The For-Profit Microfinance Controversy

While there are countless heartwarming success stories ranging from micro-entrepreneurs starting their own water supply business in Tanzania  to a $1,500 loan allowing a family to open a barbecue restaurant in China, to immigrants in the U.S. being able to build their own business, microfinance has sometimes falls under criticism.

While microfinance interest rates are generally lower than conventional banks', critics have charged that these operations are making money off of the poor – especially since the trend in for-profit MFIs, such as BancoSol in Bolivia and the above-mentioned SKS (which actually began as a nonprofit organization (NPO), but became for-profit in 2003).

One of the largest, and most controversial, is Mexico's Compartamos Banco. The bank was started in 1990 as a nonprofit. However, 10 years later, management decided to transform the enterprise into a traditional, for-profit company. In 2007, it went public on the Mexican Stock Exchange, and its initial public offering (IPO) raised more than $400 million. Like most other microfinance companies, Compartamos Banco makes relatively small loans, serves a largely female clientele, and pools borrowers into groups. The main difference comes with its use of the funds it nets in interest and repayments: Like any public company, it distributes them to shareholders. In contrast, nonprofit institutions take a more philanthropic bent with any profits, using them to expand the number of people it helps or create more programs.

In addition to Compartamos Banco, many major financial institutions and other large corporations have launched for-profit microfinance projects. CitiGroup (NYSE:C), Barclay's (NYSE:BCS) and General Electric (NYSE:GE) have started microfinance divisions in many countries, for example. Other companies have created mutual funds that invest primarily in microfinance firms.

Compartamos Banco and its for-profit ilk have been criticized by many, including the grandfather of modern microfinance himself, Muhammad Yunus. The immediate, pragmatic fear is that, out of desire to make money, these MFIs will charge higher interest rates that may create a debt trap for low-income borrowers. But Yunus and others also have a more fundamental concern: that the incentive for microcredit should be poverty alleviation, not profit. By their very nature (and their obligation to stockholders), these publicly traded firms work against the original mission of microfinance – helping the poor above all else.

In response, Compartamos and other for-profit MFIs counter that commercialization allows them to operate more efficiently, and to attract more capital by appealing to profit-seeking investors. By becoming a profitable business, their argument goes, an MFI is able to extend its reach, providing more money and more loans to low-income applicants.

For now, charitable and commercialized MFIs co-exist.

Other Concerns Regarding Microfinance

On top of the divide between non- and for-profit microfinance enterprises, other criticisms exist. Some say that individual microloans of $100 or so really are not enough money to provide independence – they just keep recipients working in subsistence-level trades, or just cover basic needs, like food and shelter. A better approach, these critics maintain, is to create  jobs by constructing new factories and producing new goods. They cite the examples of China and India, where the development of large industries has led to stable employment and higher wages, which in turn has helped millions to emerge from the lowest levels of poverty.

Other critics have said that the presence of interest payments, however low, are still a burden. Despite the high repayment rates, there still are microfinance borrowers who cannot, or do not, repay loans, due to the failure of their ventures, personal catastrophe, or other reasons. The added debt can make these people poorer than when they started, even living hand-to-mouth.

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