Breaking the word "microfinance" apart gives the first clues to its meaning. "Micro," meaning small, refers to the small sums of capital that microfinance institutions rely on to help men and women around the world begin their ascent out of poverty. Microfinance institutions are, in effect, banks—but instead of targeting the wealthy or the middle class, they target the poor—those whom the financial sector has typically shunned. While a traditional bank might make loans ranging from thousands to hundreds of thousands of dollars, a microfinance institution typically loans sums ranging from $100-$2,000.
Credit is a fundamental facet of life. It has so permeated our society that a bad credit score can hinder a job search and a good one can open the door to great financial opportunities. Much of what most individuals have accomplished (such as buying a car, going to college, or starting a business) could not have been realized without the help of a loan. Credit in the developed world is often cheap and easy to access, but in the developing world it can be unavailable, prohibitively costly, or even dangerous when loan sharks become involved.
Microfinance institutions acknowledge the distinct advantage access to capital creates and the inequity of a global economy in which the vast majority of the world's population lacks financial services. Microfinance affirms the dignity of the men and women served by acknowledging that their poverty is due not to intrinsic lack but rather to a lack of opportunity. Microfinance attempts to sustainably break the cycle of poverty for a family by enabling them to put their gifts and talents to work by starting or expanding their own business, generally through the provision of a loan.
But microcredit, or the provision of loans, is just one piece of microfinance. The developing world lacks not only credit but also, more fundamentally, savings. Many of the world's poor have no place to safely accumulate practicable sums of money. Without the ability to deposit their savings, people living in poverty often resort to hiding their money, leaving it vulnerable to theft, deterioration, or simple forgetfulness. Since many developing countries are marked by their communal cultures, the poor can also feel compelled to give any sums they have accumulated to relatives or friends who are experiencing a need. While virtuous, this behavior, when practiced perpetually, can prevent the poor from accumulating a lump sum that can pay for school fees, medications to treat an illness, or a business endeavor. Savings services are so desirable that many individuals will pay interest for the privilege of saving (instead of receiving interest on their savings, as is common in developed countries).
Many microfinance institutions also offer "microfinance plus" services, which range from health insurance to domestic violence prevention training. All of these services aim to add value to the clients and are generally provided free of charge or at highly subsidized rates.
Microfinance is a holistic outreach. While many interventions will aid in a family's health or housing or nutrition, microfinance can achieve all of these ends. When microcredit is properly applied to begin or grow a business, the profits earned because of the additional business investment are sufficient not only to repay the interest owed the institution but also to meet the family's most pressing needs. Microfinance allows a family to determine its own priorities. If an entrepreneur feels that her children most need education, she will be able to provide it. If what the family needs is shelter, she can save to fix a leaking roof or rebuild a crumbling wall. And in every case it is her own money and hard work that have made the difference. Microfinance is a dignified solution to poverty alleviation.
The microfinance industry places great emphasis on sustainability, for the clients and the institutions themselves. There are two desirable outcomes for a microfinance institution in regard to its clients. The first is that the clients reach the point where their business growth is sufficient to provide for their families and they no longer need loans. Equally desirable is that the clients' increased income and established credit history enable them to access traditional sources of funding for further business growth.
Because the funds received from a microfinance institution are not gifts or grants but rather loans, clients must repay them. Repayment is both an aid in reaching institutional sustainability and a powerful motivator to strive for sustainability, since the promise of future loans is one of the strongest compulsions for clients to repay funds they have already borrowed. As with a traditional bank loan, the clients pay interest on the funds. This repayment enables microfinance providers to reach additional clients with the same funds and to eventually reach operational self-sufficiency, the point when operating revenue covers operating expenses. At this point in the institution's development, any further influxes of capital can be used to fuel additional program growth, reaching ever-increasing numbers of new clients.
The now-worldwide microfinance movement was spawned in Bangladesh following a devastating famine in 1974. As an economics professor, Dr. Muhammad Yunus grew disenchanted with teaching eloquent theories that weren't making a practical difference for those struggling right outside his door. In 1976, Yunus, who is widely credited as the father of microfinance and who was awarded the 2006 Nobel Peace Prize for his efforts, loaned $27 from his own pocket to a group of 42 businesswomen with the mandate to repay their debts to moneylenders (whose exorbitant interest rates were keeping the women shackled to their poverty) and focus on building their businesses. The women were incredibly grateful—but more than just that, they were eager to repay the loans and did so with interest. In 1983, Yunus founded the Grameen Bank to provide financial services to impoverished entrepreneurs on a wider scale. Grameen Bank focused largely on women, and microfinance organizations founded since that time have largely done the same. Women traditionally have a more difficult time accessing bank loans in many countries, in part due to discriminatory property laws that don't allow for female property ownership. For a bank, lack of property translates to lack of collateral, disqualifying many potential borrowers. But studies have shown that women are a good investment. When a woman is empowered to improve her income, she typically uses the additional funds to benefit her family.
There is much talk of microfinance institutions issuing loans to those who lack collateral. It is more accurate to say that microfinance institutions issue loans to those who lack traditional collateral. Institutions practice different methodologies to ensure repayment, including the use of co-signers, but one of the most effective and widely utilized forms of alternative collateral is social collateral or community banking. Social collateral draws on the strength of relationships that those who would seek a loan have built with other members of their communities. Loan seekers approach the microfinance institution not as individuals but rather as a group that has come together to form a community bank. Within the group, members decide how much it would be appropriate for each individual to receive, and they then seek that sum from the microfinance institution. It is vital that they agree, since members of each group are responsible for not only their own repayment but also the repayment of any other member of the group who defaults on his/her loan. The community bank methodology is highly successful, with most lenders boasting repayment rates that are substantially better than repayment rates of commercial banks in the United States. Loan cycles vary in duration but typically run 4-12 months. For micro-level businesses, this can be enough time to see substantial improvements and repay loans.
As previously mentioned, microfinance institutions charge interest on loans they issue. Interest rates vary widely by context, based on inflation, risk, and a number of other factors. Microfinance institutions establish their interest rates with the long-term goal of institutional sustainability. In setting interest rates, institutions walk a fine line. Their goal is to help those living in poverty, so interest rates cannot be too high, yet the costs the institutions incur in making the loans are great. It takes the same amount of work to service a $50 loan as it takes to service a $50,000 loan, and yet the interest earned on the latter amount is substantially greater. In reality, it is likely more expensive to make these small loans because loan officers travel to rural villages where borrowers reside, far removed from institution headquarters and often difficult to reach due to poor infrastructure. Loan officers can spend significant portions of their day in transit from one rural community bank to the next.
Despite microfinance's increased traction and the ensuing influx of capital to the sector in recent years, the demand for small business loans and the other services provided by microfinance institutions vastly outstrips the supply. An estimated 1.5 billion people who stand to benefit from microcredit still have no access to these valuable services. Estimates suggest that it would take $230 billion to bring services to all the families who could benefit.
In order to reach a greater number of borrowers, many institutions are restructuring to be able to utilize investments as well as donations. There are pros and cons to this arrangement. Investment could be a boon to the industry, helping to close the tremendous funding gap, but it also raises concerns. Investors expect returns, and in order to consistently post returns, microfinance institutions might be tempted to increase their profitability by moving away from the poorest clients. Microfinance has reached a crucial crux where the industry must reaffirm that its primary concern is the poor, not profits.