An Introduction to Microfinance, Part 1

The best way to introduce microfinance in a simple way is through a series of questions and answers. Below are frequently asked questions regarding microfinance:

What is microfinance?

Microfinance is the extension of basic financial services such as loans, savings, money transfer services, and insurance to the poor. The term “microfinance” is used to differentiate from the services your local bank may provide. Microloans generally range from $50 USD to $350 USD, hence the term “micro”.

Who are the clients (borrowers) of microfinance?

Microfinance clients are the poor, and are often classified based on their poverty level-vulnerable non-poor, upper poor, poor, and very poor. Microfinance clients are a diverse group of people, and therefore, require a wide range of products. Women make up the majority of microfinance clientele, as research as indicated that women borrowers are much more likely to repay their outstanding loans. A microfinance client can be anyone from a Bolivian farmer to a Nigerian food store owner. These clients operate small businesses (microenterprises) such as small retail kiosks, sewing workshops, carpentry shops, and small farms.

How does access to financial services help the poor?

To answer this question, think about yourself. If you were deemed “unviable” for the banking sector or “non credit-worthy” how would this change your situation? Would you be able to attend college? Buy a home? Start a business? The “credit crunch” that all our financial pundits refer to has caused many developed Western economies and their respective economies to shrink (as measured by GDP) significantly. (US GDP down more than 6% last quarter). Why is this? Part of the reason, is certainly the tightening credit markets. The availability of credit is an underlying fundamental and lifeline of all developed economies. With tightened credits, businesses in the US have been unable to increase capital expenditures and therefore have had to contract operations. Because credit is less readily available, consumers have been unable to purchase “big ticket” items such as homes and cars, which has lowered their consumption patterns. This example illustrates how just “tightened” credit markets affect us in the developed world. Now imagine our world’s poor, who literally have NO credit available to them. How do they access capital to grow their business? How do they graduate out of poverty.

It may seem as if the poor don’t require financial services, but they already engage in informal financial transactions. Poor people save all the time- they may not put cash aside in their 1.5% interest bearing account, however, they invest in assets such as gold, jewelry, domestic animals , and other liquid assets. They may also set aside rice from their most recent harvest to sell at a later date. Often times, the poor also participate in informal savings groups. Informal financial transactions are very risky and have severe limitations. The prevalence of fraud and mismanagement in these transactions is high.

It is clear that the poor require financial services to run their businesses, build assets, smooth consumption, protect from catastrophic events, and ultimately shield themselves from poverty. Microfinance has the ability to:

• Increase household income-reliable sources of credit allow for planning and growing business activities, which allow clients to save, manage cash flows, and reduce the need to sell assets during distressed times.
• Increase asset building- Due to increased income, and the ability to save and take on credit, clients consequently can acquire land, build proper homes, purchase animals, and invest more into their businesses.
• Reduce Vulnerability- The mindset of the poor changes with the presence of microfinance from one of meeting the needs of every day survival to planning for the future. Increased earnings lead to better nutrition, better living conditions, which subsequently results in lower incidence of illness. Increased earnings and microinsurance allow poor clients to seek out medical services rather than waiting until their health seriously deteriorates.
• Microfinance creates the POSSIBILITY of improving the economic conditions for the poor. Debt is certainly a huge burden, and cases of over-indebtedness do occur, which ultimately make the poor WORSE off. Thus, microcredit lenders must be judicious and prudent when issuing credit.

Stay tuned for Part 2 of the introductory series on Microfinance.