What is Microfinance?
"Microfinance is the supply of loans, savings, and other basic financial services to the poor." ¹
As these financial services usually involve small amounts of money - small loans, small savings, etc. - the term "microfinance" helps to differentiate these services from those which formal banks provide. Why are they small? Someone who doesn't have a lot of money isn't likely to want or be able to take out a $50,000 loan, or be able to open a savings account with an opening balance of $1,000.
It's easy to imagine poor people don't need financial services, but when you think about it they are using these services already, although they might look a little different. Poor people save all the time, although mostly in informal ways. They invest in assets such as gold, jewelry, domestic animals, building materials, and things that can be easily exchanged for cash. They may set aside corn from their harvest to sell at a later date. They bury cash in the garden or stash it under the mattress. They participate in informal savings groups where everyone contributes a small amount of cash each day, week, or month, and is successively awarded the pot on a rotating basis. Some of these groups allow members to borrow from the pot as well. The poor also give their money to neighbors to hold or pay local cash collectors to keep it safe.
History of Microfinance
Credit unions and lending cooperatives have been around hundreds of years. However, the pioneering of modern microfinance is often credited to Dr. Mohammad Yunus, who began experimenting with lending to poor women in the village of Jobra, Bangladesh during his tenure as a professor of economics at Chittagong University in the 1970s. He would go on to found Grameen Bank in 1983 and win the Nobel Peace Price in 2006.²
Since then, innovation in microfinance has continued and providers of financial services to the poor continue to evolve. Today, the world bank estimates that about 160 million people in developing countries are served by microfinance.³
Interest Rates (They May Seem High)
The nature of microcredit - small loans - is such that interest rates need to be high to return the cost of the loan.
There are two kinds of costs the MFI has to cover when it makes microloans – the cost of the money that it lends and the cost of loan defaults, are proportional to the amount lent. For instance, if the cost paid by the MFI for the money it lends is 10%, and it experiences defaults of 1% of the amount lent, then these two costs will total $11 for a loan of $100, and $55 for a loan of $500. An interest rate of 11% of the loan amount thus covers both these costs for either loan.⁴
Evidence That Microfinance Works
Poor people, with access to savings, credit, insurance, and other financial services, are more resilient and better able to cope with the everyday crises they face. Even the most rigorous econometric studies have proven that microfinance can smooth consumption levels and significantly reduce the need to sell assets to meet basic needs.
Microfinance helps very poor households meet basic needs and protect against risks. The use of financial services by low-income households is associated with improvements in household economic welfare and enterprise stability or growth. By supporting women's economic participation, microfinance helps to empower women, thus promoting gender-equity and improving household well-being.⁵
Access to credit allows poor people to take advantage of economic opportunities. While increased earnings are by no means automatic, clients have overwhelmingly demonstrated that reliable sources of credit provide a fundamental basis for planning and expanding business activities. Many studies show that clients who join and stay in programs have better economic conditions than non-clients, suggesting that programs contribute to these improvements. A few studies have also shown that over a long period of time many clients do actually graduate out of poverty.
By reducing vulnerability and increasing earnings and savings, financial services allow poor households to make the transformation from "every-day survival" to "planning for the future." Households are able to send more children to school for longer periods and to make greater investments in their children's education.
¹ CGAP: Consultative Group to Assist the Poor
² Global Envision
³ The World Bank
⁴ CGAP: Consultative Group to Assist the Poor
⁵ CGAP: Consultative Group to Assist the Poor