By definition, microfinance is used to describe small loans and financial products to individuals that have a low income. These folks, who are often either living in poverty or at the brink of it, would normally be excluded from the traditional banking industry. Loans are the most common financial product offered in the world of microfinance, but insurance products, checking accounts, savings account, and other products are also available.
“Micro” simply refers to the smaller amounts of money that are being saved, spent, and borrowed within each transaction.
The history of microfinance begins in the 1970s in rural Bangladesh, but there is evidence that in the APAC region, informal lending and borrowing has been taking place for centuries. Our first modern microfinance transaction of record involves a Professor named Doctor Muhammad Yunus, who was employed at the time by the University of Chittagong in their Economics department.
Yunus was determined to find a practical solution to help small villages struggling in the midst of a mighty famine. As he toured the region, he noticed in the village of Jorba that a group of women were making bamboo stools. These women were stuck in a cycle of debt because they were forced to borrow funds for the raw materials for the stool, then forced to sell the stools at a razor-thin margin.
When Yunus investigated what their borrowing needs would be to end this repressive cycle of debt, he couldn’t believe that the amount was just $27. He pulled out his wallet, loaned the money to these women without interest, and this helped them be able to move away from the local traders.
This became the foundation of what would eventually become the Grameen Bank Project. They have proved that even those who are in abject poverty have the ability to bring about their own development.
What Is the Grameen Bank Project?
The Grameen Bank is an organization that is dedicated to microfinance. It is a community development bank that was founded in Bangladesh to provide small loans to those in need without the requirement of collateral in return. Starting Jobra where Yunus made his first loan, this project incorporated neighboring villages from 1976-1979 to expand the provision of banking services to the rural poor of the region.
In these early years, the Grameen Bank Project was sponsored by the central bank of Bangladesh and several nationalized commercial banks. This allowed the project to continue expanding and by 1983, it would be transformed into an independent bank through government legislation.
In 2006, Yunus and the Grameen Bank were awarded the Nobel Peace Prize for their work. The project was also a winner of the World Habitat Award. The duo have also received numerous international recognitions, including the US Presidential Medal of Freedom, the Congressional Gold Medal, and being ranked #2 in Foreign Policy magazine’s list of the Top 100 Global Thinkers of today.
It currently operates over 2,500 locations, employs more than 22,000 people, and has a net operating income that was last reported to be over 12 billion Taka, or the equivalent of $120 million.
In 2011, the Bangladeshi government forced Yunus to resign from the bank due to his age. Today, the borrowers from the bank own 90% of its shares, with the other 10% being owned by the government. This means the rural poor own the financial institution which has helped to pull many of them out of abject poverty.
Why Choose Microfinance as a Way to Combat Poverty?
Yunus and Grameen Bank are founded on the idea that a loan is a better way to stop poverty than simple charity. When a charitable gift is given, there is no need to take a personal initiative in the final product being delivered. With a microloan or another form of microcredit, it allows an individual to feel the responsibility of being an entrepreneur.
What is unique about microfinance is that classes of people who would traditionally be seen as something barely above “worthless” by traditional banking institutions are able to receive loans that can help them become productive and profitable. Over the last 40 years, Grameen Bank and others in the microfinance world have lent money to people who are illiterate and unemployed. They offer loans to the poor who may not be able to make monthly payments right away.
And, most importantly, women are given the opportunity to become entrepreneurs through microfinance. That $27 0% interest loan that Yunus first offered has encouraged many more women to explore their own talents. 95% of the loans which are made through Grameen Bank are given to women.
Microfinance also targets the poorest of the poor with their financial products to help eliminate poverty. When deposits are made in villages, the project converts those funds into loans for those who are needy in other villages. 90% of its loans with interest income and deposits are aligned to the interests of new borrowers and shareholders.
Yet despite these many positives, there are some critics who make valid points about the microfinance industry which should be discussed.
What Makes Microfinance Different from Other Forms of Lending?
All one has to do is look at how the staff of Grameen Bank are trained to understand that the world of microfinance is very different from the traditional banking industry. Conditions are often grueling and harsh. Every potential employee receives six months of on-the-job training as they shadow current employees to get out and experience what poverty is like.
The goal of this training isn’t necessarily to put someone outside of their comfort zone, though that is a natural side effect of this process. Grameen Bank wants its employees to be able to appreciate the potential that every person has. It is that potential which qualifies people for microcredit, even if they are out of work, have a disability, or no collateral to offer.
Some forms of microfinance are also guaranteed by a backing government. Grameen Bank, for example, offers financial products for investors to consider that are guaranteed by the Government of Bangladesh.
Why Microfinance May Not Be as Positive as It Appears to Be
The interest rates that are charged by many microfinance institutions, including Grameen Bank, are very high compared to what traditional banks charge in interest. The primary microloan product offered by the project, for example, has a standard interest rate of about 20%. Some loans are even higher than this.
This was a shift that first started taking place in the 1980s and 1990s. The original format for microlending involved grants from institutions and private individuals, much like the initial loan that Yunus offered. When the size and scope of microfinance began to be uncovered, the institutions involved in lending determined that relying on grants wouldn’t allow for the sheer number of people who could benefit from these products.
Over time, this means microfinance has gone from receiving the bulk of its funds from donor agencies that were offered at low interest rates. This transitioned to receiving the bulk of its funds from centralized banking operations. Now institutions like Grameen Bank are issuing bonds as a source of financing while engaging social business and entrepreneurship fields for further support.
Part of the reason behind the high interest rates has to do with the amount of risk that is involved in giving out a loan. Because there isn’t a guaranteed return due to the lack of collateral, enough interest must be charged in order to continue funding loans. That way, should one of the microloans not be able to be paid in full, the financial institution providing microfinance will still be able to survive.
In addition to the regular operational costs that must be covered by microcredit products, a microfinance institution must also be able to cover the following costs.
- Funding to major foreign investors. Foreign investors typically demand a higher return to cover their own risks when extended credit to a microfinance institution. This is then built on top of the added risk given to a low-income entrepreneur without collateral.
- Exchange rate risks. Developing countries tend to have currencies that are volatile in trading. Some are not liquid. Others may be impacted by sudden and high inflation.
- Administrative costs. Imagine how much it would cost to send an employee to a rural village with no way to communicate compared to the administrative costs of a typical bank. The cost of a microloan must incorporate the price required to send people out to collect payments.
This creates a large number of loans that are overdue. In a 2001 audit by the Wall Street Journal, Grameen Bank had 20% of its outstanding loans showing as being a year or more overdue. If the number of missed weekly or monthly payments is taken out of the statistics, however, Grameen Bank reports a total payback rate that exceeds 98%.
How can a struggling entrepreneur in a low-income situation afford high interest rates? According to Microworld, some micro-businesses are paying an interest rate that is as high as 847%. That’s even higher than most unregulated payday loan opportunities that are available to modern banking consumers. It’s a rate that would strangle most, but for the micro-entrepreneur, yet repayment rates are extraordinarily high in microfinance.
This is because the interest charge only makes up a small proportion of the input cost a micro-business faces. It’s a smaller scale proposition. If you’re paying a high interest rate on a loan that amounts to about $100 in US equivalency on a weekly or monthly basis over a long period of time, the actual amount due is quite small. Even during a bad week of business, the repayment structures are set in such a way that a payment can still be made.
What Is the Future of Microfinance?
There have been several new and innovative microcredit products that have been developed by Yunus, Grameen Bank, and similar institutions. Here are just a few examples of the new loan programs that have found success in various ways.
- Village Phone Programs. Women in this type of program are able to start a business by providing a wireless payphone service. This program mostly targets rural areas and allows for direct communication and mobile payments to be made from virtually anywhere services are provided. As of today, more than 55,000 phones allow for direct communication to over 28,000 remote villages that would not normally have access to this information.
- Struggling People Programs. Another new program that has been offered by microfinance institutions is an interest-free loan program to people who are classified as “beggars.” The repayment period on these loans can be extended nearly indefinitely and the borrower who accepts the loan is covered under life insurance for no cost. A loan of just $1.50 might be paid back at a rate of just $0.03 per week using US currency equivalents.
- Housing Loan Programs. Since 1999, Grameen has made a total of $190 million in housing loans. This has helped nearly 600,000 homes to be built and repayment on these loans has been nearly perfect. From the beginning of this program, the average housing loan has risen from $125 to $300.
Loans and microcredit will continue to evolve as more people and more institutions get involved in this ever-growing area of finance. Platforms like Kiva make it possible for individuals to become part of the micro-lending process as well on an even larger scale and receive a real return on that investment.
Look for businesses in microfinance to begin tackling social issues as well, empowering those in social businesses to resolve social problems around the world. Yunus is currently involved in an incubator program that will do this in developing countries around the world while also providing advisory services to those involved in this new form of entrepreneurialism.
This helps to stop the cycle of poverty. No longer is the cycle of having a low income mean having low savings levels and low investment opportunities. As Grameen Banks puts it on their website:
“We turn poverty into a virtuous circle of low income, injection of credit, investment, more income, more savings, more investment, and then more income.”
How Is Microfinance Operated Today?
In recent years, the world of microfinance has shifted in several different ways. An emphasis on mobile payments has proven to be successful so that consumers can make individual loans or contribute to a larger microloan with others through texts or platform accounts.
New loan products have also been introduced in microfinance within the past few years so that those in need can receive financing for specific items. Products include cattle fattening loans, inventory purchasing loans, harvest stock spaces, and even machinery loans.
There have also been expansions in products like micro-insurance and micro-checking, though microloans and other forms of credit are still the most popular products being offered.
The history of microfinance proves that a little help can allow people to use their own hard work and ingenuity to take on poverty and be successful. This doesn’t mean that charity doesn’t have a place in the world – it does. What microfinance proves is that when people are given an opportunity to do something better and they have one chance to get things right, they almost always get it right.
Today there are an estimated 1.5 billion people who may lack access to traditional banking services because of their current economic situation. By providing these individuals with microfinance resources, the same benefits once seen in Jorba could be seen all over the world.