MICROFINANCE
LECTURER
MR. DANIEL OFORI-SASU
Overview of Microfinance
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OBJECTIVES
Briefly outline the history of microfinance
Explain the characteristics of the poor
Explain why the formal credit market fails to meet the
financial needs of the poor
Explain how microfinance seeks to circumvent the
problems faced by banks in lending to the poor.
Discuss why capital is far more likely to flow from poor to
rich regions/entities, and not in the other direction.
Outline some key principles of microfinance
What is Microfinance?
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 Microfinance refers to financial services for the poor.
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These include:
Credit
Savings
Insurance
Money transfer
History of Microfinance
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 Small, informal savings and credit groups have
operated for centuries.
 In Europe (15th century), the Catholic Church
founded pawn shops.
 1950–1970: State-owned development finance
institutions, or farmers’ cooperatives were formed
 Devt. banks lost most or all of their capital because
subsidized lending rates could not cover their costs.
History of Microfinance
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 Early 1970s saw experimental programs to extend
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tiny loans to poor women in micro-businesses.
Microcredit is born.
Early pioneers include Grameen Bank in
Bangladesh; ACCION International-Latin America.
1980s saw microcredit programs seeking to improve
on original methodologies.
Microlenders, eg. Bank Rakayat, Indonesia defied
conventional wisdom about financing the poor.
History of Microfinance
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 Cost-recovery interest rates and high repayment
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allowed for long-term sustainability.
In the early 1990s, the term “microfinance” rather
than “microcredit” became popular.
Today, borders between traditional microfinance and
the larger financial system are starting to blur.
In some countries, banks and other commercial
actors are entering microfinance.
Increasing emphasis is placed on building entire
financial systems that work for the poor.
History of Microfinance
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 To reach ever larger numbers of poor clients, MFIs
began to pursue a strategy of commercialization.
 More MFIs transformed themselves into for-profit
companies that could attract more capital.
 An emphasis on creating and growing strong
institutions is a core element of the recent history.
 Microfinance has achieved astonishing
accomplishments over the past 30 years.
History of Microfinance
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 We’ve seen evidence that poor people are viable
customers, thereby attracting private investors.
 Three major challenges remain:
(1) Scaling up quality financial services to serve large
numbers of people (scale);
(2) Reaching increasingly poorer and more remote people
(depth); and
(3) Lowering costs to both clients and financial service
providers (cost).
 The question is: How do we overcome these challenges?
Characteristics of the Poor
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 The definition of who is poor varies by country and
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over time.
The poor basically include those who work within the
informal sector in developing countries.
Fishermen and pastoralists
Low wage earners
Casual laborers
Small-holder farmers
Unemployed
Micro– entrepreneurs
Characteristics of the Poor
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 They range from the very poor to the vulnerable non
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poor.
Life-cycle events, livelihoods, geography, income
levels, and gender influence their behavior.
Financial needs and vulnerabilities change sharply
through the life-cycle.
Often migrate in search of more income.
Struggle to care health, education and other
expenses.
Characteristics of the Poor
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 Low financial literacy.
 Concept of family extends well beyond spouses, siblings,
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children, and grandparents.
Large families live together in one compound.
Income is often shared among a large number of people.
Community elders control assets and decide how they
will be distributed.
Financial pressures to cover daily expenses, unexpected
emergencies, and life-cycle events weigh heavily on them.
Income is often inconsistent/irregular.
Characteristics of the Poor
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 Poorest of the poor mostly live in rural areas or
urban slums.
 Live in areas where access to markets or supplies is
limited, and infrastructure is undeveloped.
 Have lower savings balances, less capacity to take on
debt, and fewer opportunities to generate income.
 Need financial tools to improve productivity and
secure best possible consumption and investment
Rationale for Microfinance
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 Traditional commercial banks avoid the poor.
 The loans are so small that profits are typically hard
to find.
 Lending seems risky since the borrowers are too poor
to offer much in the way of collateral.
 Yet MFIs, such as ASA (Bangladesh), have reported
high loan and costs recovery rates for several years.
 ASA and others challenge decades of thinking about
markets and social policy in low-income regions.
Rationale for Microfinance
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 Pioneering models grew out of experiments in low-
income countries, not from standard banking.
 MFIs have attracted entrepreneurs, academics, social
activists, and development experts.
 There are lessons about retail banking and getting
much-needed resources to underserved populations.
 Scores of doctoral dissertations, master’s theses, and
academic studies have now been written on MFIs.
Rationale for Microfinance
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 From basic economics, the need for microfinance is
somewhat surprising.
 Diminishing marginal returns to capital shows that
those with little capital should earn higher returns.
 Poorer enterprises should thus be able to pay banks
higher interest rates than richer enterprises.
 Money should flow from rich depositors to poor
entrepreneurs.
Rationale for Microfinance
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 The “diminishing returns principle” is derived from
the assumed concavity of production functions.
 When an enterprise invests more (i.e., uses more
capital), it should expect to produce more output.
 But each additional unit of capital will bring smaller
and smaller incremental (“marginal”) gains.
 Concavity implies that poor entrepreneur has a
higher MR to capital than a richer entrepreneur.
Rationale for Microfinance
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 When tailor buys first sewing machine, production
can rise quickly than using needle/thread.
 The next investment, say for a set of electric scissors,
will also bring gains, but not likely to be as great.
 If this basic principle in introductory economics is
correct, global investors have got it all wrong.
 Wise investors should direct their funds toward
India, Kenya, Ghana and not New York and London.
Rationale for Microfinance
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 Money should move from North to South, not out of
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philanthropy but in pursuit of profit.
By the same argument, capital should naturally flow
from rich to poor borrowers within any country.
Money should flow from High Street to Chorkor.
A woman selling cloth at Makola should be able to
offer investors higher returns than MTN or Toyota.
Banks and investors should respond accordingly.
Rationale for Microfinance
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 Given that investors are basically prudent and self-
interested, how has economics got it wrong?
 Why are investments far more likely to flow from
poor to rich countries?
 Why do large companies find it far easier obtaining
financing from banks than self-employed?
 One issue that helps in sorting out the puzzle is risk
Rationale for Microfinance
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 The problems largely hinge on:
 market failures that stem from incomplete info. on poor
borrowers (adverse selection and moral hazard),
 lack of collateral,
 high transactions costs in handling small transactions, and
 difficulties enforcing contracts in countries with weak
judicial systems.
 Similar problems exist between the poor and
relatively well-off in a country.
Rationale for Microfinance
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 Investing in Kenya or Ghana is for many a far riskier
prospect than investing in U.S. or European equities.
 The same is true of lending to cobblers and cloth
sellers versus lending to large, regulated companies.
 But why can’t cobblers and cloth sellers offer such
high returns to investors to cover their risk?
 Government-imposed interest rate restrictions may
prevent banks from charging the required rates
Rationale for Microfinance
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 Even if usury laws could be removed, providing
freedom to cover costs is not the only answer.
 Raising interest rates can undermine institutions by
weakening incentives for borrowers.
 The important factors are:
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the bank’s incomplete information about poor borrowers, and
the poor borrowers’ lack of collateral to offer as security to
banks.
 Adverse selection occurs when banks cannot easily
determine which customers are likely to be more risky.
Rationale for Microfinance
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 Banks would like to charge riskier customers more
than safer customers in order to compensate them.
 But the bank does not know who is who, and raising
average interest rates drives safer customers away.
 Moral hazard arises because banks are unable to
ensure customers are making the full effort required.
 Moral hazard also arises when customers try to
abscond with the bank’s money.
Rationale for Microfinance
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 Both problems are made worse by the difficulty of
enforcing contracts with weak judicial systems.
 These problems could be dealt with if banks had
cheap ways to gather info. and to enforce contracts.
 Banks face high costs handling many small
transactions than servicing one large transaction.
 And if borrowers had marketable assets to offer as
collateral, banks could lend without risk.
Rationale for Microfinance
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 Starting point for microfinance is that new ways
of delivering loans are needed precisely because:
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borrowers do not have collateral.
 MF is seen as a way to break the vicious circle of
poverty by:
reducing transaction costs, and
 overcoming information problems.
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 Without banks, poor individuals borrow from
informal sources:
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moneylenders, neighbors, relatives, and local traders.
Rationale for Microfinance
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 Informal lenders often have:
 the
rich information (and effective means of
enforcing contracts) that banks lack.
 But their resources are limited.
 MF is seen as the solution to the challenge of:
 finding a way to combine banks’ resources
 with informational/cost advantages of
moneylenders.
Rationale for Microfinance
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 Like banks, MFIs can bring in resources from
outside the community.
 MF is not the first attempt to do this, but it is by far
the most successful.
 Low-income countries attempted to develop their
agricultural sectors after World War II:
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by providing subsidized credit with disastrous outcomes.
 MF presents itself as a new market-based strategy
for poverty reduction:
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free of the heavy subsidies that brought down large state
banks.
Rationale for Microfinance
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 Agency theory explains a mismatch of resources and
abilities.
 Banks have funds to lend, but lack adequate info.
and effective ways of enforcing contracts.
 Moneylenders, traders, and others who live and work
in poor communities have:
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quite good information and enforcement mechanisms,
but lack resources.
 Why don’t banks and moneylenders join forces?
Rationale for Microfinance
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 Why don’t banks hire moneylenders to disburse
loans and collect payments for a fee?
 Why not employ susu collectors as loan officers for
banks?
 The bank can end up replacing one agency problem
with another:
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how to get the collectors to honestly and reliably carry out the
bank’s wishes.
Rationale for Microfinance
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 When lending his own money, the moneylender has
a strong reputation for getting loans repaid.
 But will the moneylender be as vigilant when acting
as the bank’s agent?
 Moneylender may collude with borrowers, pocket the
loan, or falsely say borrowers cannot repay.
 How can the bank monitor the agent-moneylender?
Rationale for Microfinance
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 A different way to expand financial services is by
increasing supply.
 Microeconomic theory suggests that increasing the
supply of capital will:
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alleviate credit constraints and
reduce interest rates for poor borrowers.
 Subsidizing the capital infusion should, in principle,
create even stronger downward pressure on rates.
Rationale for Microfinance
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 But when local markets are imperfectly competitive
and info. is costly, the prediction is not so simple.
 MF innovations provide ways around the adverse
selection and moral hazard problems.
 Microfinance approaches have shown that
improvements are possible:
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even when lenders do not actually acquire more information.
 They design contracts that harness local information
and give borrowers incentives to:
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use their own information on their peers to the advantage of
the bank
Rationale for Microfinance
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 The challenge for microfinance is to:
 couple smart interest rate policies with
 new ways of doing business to ensure good incentives for
customers.
 In Bangladesh, MFIs serve 10–12 million clients
written off by banks as being “unbankable”.
 Microfinance presents a series of exciting
possibilities for:
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extending markets,
reducing poverty, and
fostering social change.
Rationale for Microfinance
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 Ongoing debates include whether:
 the poorest are best served by loans or
 by better ways to save, and whether
 subsidies are a help or a hindrance.
 Others are:
 whether providing credit without training and other
complements is enough, and
 which aspects of lending mechanisms have driven
performances.
CGAP’s Key Principles of Microfinance
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Poor people need a variety of financial services.
MF is a powerful tool to fight poverty.
MF means building financial systems that serve the poor.
MF can pay for itself.
MF is about building permanent local FIs.
Microcredit is not always the answer.
Interest rate ceilings hurt poor people.
The job of govt. is to enable fin. services, not to provide them.
Donor funds should complement private capital, not
compete.
10) The key bottleneck is shortage of strong institutions and
managers.
11) MF works best when it measures—and discloses—its
performance.
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