Middle Management Training Course
Handout 2
Basic Concept of Financial Intermediation and Microfinance
(Required reading prior to taking the Middle Management Training Course)
Objective of Reading:
1. Define and write the meaning of financial intermediation and microfinance
2. Explain the role of rural banks as financial intermediaries and as microfinance
providers
3. Identify the different credit methodologies in microfinance and explain their major
differences.
1. FINANCIAL INTERMEDIATION
There are two basic types of financial transactions – Direct and Indirect.
Direct Financial Transaction
The example below shows a financial transaction between the source of funds and the
user of funds.
USER OF FUNDS
SOURCE OF FUNDS
Loans/Investments
Repayments/Returns
This example of financial transaction is called direct financial
transaction.
As you can see, direct financial transactions do not involve any “middleman” or
intermediary. Those who have excess funds either lend or invest them directly to those
who are in need of these funds. Examples of these include: lending to friends, relatives
and neighbors; lending by informal moneylenders; investments in business enterprises
owned by friends, relatives or neighbors.
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Advantage of Direct Financial Transaction:
The user of funds normally is known personally to the source of these funds, such that
the latter knows who is using his/her funds and what the risks are of the funds not being
returned by the user. When you know who is using your money and how the money is
being used, you would, more or less, know whether or not you would get your money
back.
Disadvantage of Direct Financial Transaction:
The basic limitation of direct financial transactions is that the persons or households with
excess funds normally would not know of other lending or investment opportunities that
may give higher returns at lower risks, outside of their own small circle of acquaintances.
In rural areas, it is common for households to keep their excess funds in the house (e.g.
pillows, bamboo posts, piggy banks). They may not know that in another part of the
town, there are micro entrepreneurs who need additional funds for their business and
who are willing to pay a reasonable price for these funds. Because they do not know
each other, both the households with excess funds and those that need these funds for
productive investments, lose – the former would have earned higher returns for their
excess funds, while the latter would have expanded their businesses and generate
higher incomes.
Indirect Financial Transaction
The following example shows how an indirect financial transaction works.
P1,000
P10,000 +
P1,000
P20,000
P8,000
This is an example of a small community. Maria and Rene live in this community. Maria
is a worker with enough money she has saved 10,000 pesos which she keeps under a
mattress. Rene is a basket weaver who needs 10,000 pesos to get the material to
complete an order which he can sell for 20,000 pesos. There is a third person in the
community, Cecil, who knows both Maria and Rene. Maria trusts Cecil and is willing to
give her money if she agrees to pay her interest. Cecil receives the 10,000 from Maria
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and lends it to Rene, who she trusts and knows has good business orders. Rene uses
the money to buy the raw materials needed in order to make the furniture. He sells the
furniture and pays Cecil 12,000. Cecil gives maria back her 10,000 with interest of 1,000
pesos. Cecil keeps the 1,000 pesos and Rene has 8,000 pesos.
In an indirect financial transaction, there is a middle man who facilitates the transaction
between two parties.
What the Cecils of this world do is what we call financial intermediation and this is
also what rural banks do everyday. They receive money in the form of savings from the
Marias of this world which they provide to the Renes of this world in the form of loans or
credit. This is what financial institutions practice all over the world. When we talk of
microfinance, what we are really talking about is taking micro savings (which we will
define as those with initial deposits of under 1,000 pesos) and packaging them as micro
loans (loans to first time clients under 25,000 or P50,000 to some).
What is Financial Intermediation?
Financial Intermediation is the transfer of capital or liquidity from those who have excess
at a particular time to those who are short at that same time, through a financial
intermediary.
Sources of Funds
Deposits
Repayments/Returns
Financial Intermediaries
Users of Funds
Loan
Investments
In very simple terms, it is the transfer of funds from one entity to another through a
mediator or a middleman. Finanical Intermediation is also called Indirect Financial
Intermediation and it is all actually about the basic role played by banks and other
financial institutions in bringing about economic prosperity.
A financial intermediary acts as the link between the funds providers and the funds
users. It may be an institution, a firm, or an individual who performs intermediation
between two or more parties in a financial context. Typically the FIRST PARTY is a
provider of a product or service and the SECOND PARTY is a consumer or customer.
Examples of financial intermediaries are banks, credit cooperatives, lending investors,
insurance companies, and mutual funds.
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Why are Financial Intermediaries Necessary?
1. A financial intermediary can pool together the resources of thousands of savers and
make these available to borrowers who can make the best use of these funds. –
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It is the role of financial intermediaries to pool together the money of savers and
make these available to borrowers. The financial intermediaries are in the best
position to mediate the transactions between the savers and borrowers. Without
a financial intermediary, a person in need of funds to finance a good investment
project may have to spend a large amount of time locating and talking to a
number of small savers in order to generate the amount he needs. With a
financial intermediary, which is able to pool these small deposits together into a
large investment funds, fund sourcing becomes easier.
2. Without financial intermediaries, the bulk of surplus funds will be lying idle, while
many economic activities will not be able to expand or take off the ground.
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Again, without financial intermediaries, bulks of funds will be lying idle while a
good number of potential economic activities will not materialize for lack of
funds. Without a safe, convenient, and financially attractive place to keep
their excess funds, such as that provided by banks, most savers will just keep
their funds at home. With so much funds lying idle and inaccessible, many
entrepreneurs will have difficulty sourcing funds for investments.
Consequently, the community’s economic growth will be slow.
Take note that savings and investment do not necessarily occur simultaneously. When
people save, that means that they do not have particular use for their funds for a certain
period of time – be it today, tomorrow, next week, next month, or next year. Without a
financial intermediary, savers would have very limited options where to keep their
surplus funds. They can keep these at home, but the value of these funds would soon be
eroded by inflation. Or, they can lend these to their acquaintances with little or no return
(interest), but always with risk. Those in need of funds, on the other hand, will have to
rely on their small circle of acquaintances (who may not have enough funds,
themselves), or on moneylenders (who have funds to lend but at prohibitive costs). It is
the role of financial intermediaries to look for funds and make these available for the
users. Without the financial intermediaries, the funds provider would not know the best
use of their money while the users of funds would not know the best source of
investment funds.
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Rural Banks as Financial Intermediaries
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Enabling legislation in 1952 (Rep. Act 720) authorized the establishment of rural
banks; updated law is contained in Rural Banking Act of 1992.
The original law allowing the establishment of rural banks was enacted in 1952 to
provide financial services to farmers, fishermen and rural folks access to financial
services and to stimulate rural economic activities. RB Act of 1992 contains the
latest enabling law.
805 head offices and 1,075 branches covers 85% of the municipalities and cities
nationwide.
Size and locations make RBs a strategic player in countryside development.
Compared to other types of banks, RBs operations are considered to be more
responsive to the needs of communities.
Rural Banks as Microfinance Institutions
Rural Banks have several advantages in their favor as microfinance lending service
providers because:
 RBs are located closest to micro-entrepreneurs
 RBs can provide products appropriate to the needs of micro-enterprise operators;
 RBs can mobilize deposits for sustaining their microfinance operations;
 RBs can offer deposit products with low opening and maintaining balance
 RBs have comparatively lower administrative cost
 RBs are supervised by BSP
 RBs engaged in microfinance have proven that microfinance can be a profitable
banking activity.
2. MICROFINANCE
Microfinance is the provision of financial services, both deposits and loans, to lowincome clients for their micro-enterprises and small businesses. Please take note that
the BSP definition of microfinance excludes salary loans.
Loan amounts in microfinance are small up to a maximum of P150,000 only.
Employees of enterprises doing microfinance are usually less than 10 people and
oftentimes, members of the family.
For an enterprise to qualify as in microfinance, it’s capitalization should not be more than
P150,000.
Knowing all these, let’s talk about the clients of microfinance, the micro entrepreneurs
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The Micro Entrepreneur
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Most micro entrepreneurs have low educational level, some are even illiterate.
Most of them have no marketable collaterals to offer, limiting their access even to
formal loan products that require collateral requirements. Examples of this are land,
property and equipment.
And you’ll find that most of them have basic or no business record. They don’t have
financial statements, much more an audited one. Most of the financial information
given by the micro entrepreneurs are based on memory.
Because of their low educational background, most of them have very basic financial
skills. The records they keep are very elementary.
Given the constraints I just mentioned, the micro entrepreneurs have very limited
access to formal sources of credit.
And because most of them have very limited access to formal credit, they actively
participate in informal sources of credit.
Micro entrepreneurs usually have large families that include not only the children but
extended families as well.
Majority of the micro entrepreneurs do not only rely on one source of income, they
are also involved in multi-income generation activities.
In the lives of micro entrepreneurs, there is no clear delineation between family and
business activities. They are most of the time, if not always, considered as one.
When there’s no food on the table, the easiest and fastest way to find one is to get
from the business, say for example, from the sari-sari store.
The equipment used by micro entrepreneurs in the business are usually very basic
and Obsolete. They don’t have the latest equipment that is fast, performs better and
provides volume.
Because of the small size of their businesses, their volume of operations is also
small.
Because they have small businesses, the micro entrepreneurs have few employees,
some even don’t have any at all and if they have, these are usually members of the
family.
Micro Entrepreneur Environment
The following are examples of the kind of environment a micro entrepreneur moves in:
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Local policies are sometimes onerous and difficult to comply with. Sometimes
Local Government Units require very small market vegetable stalls to get a
business permit that is most of the time more expensive than what the business
earns in a week.
There is limited market for goods and services. This is especially true to micro
entrepreneurs who are into production and are located in far flung areas.
There is stiff competition because of the ease of entry and exit of other micro
entrepreneurs.
Execution of registration of collateral, if there is any, is time consuming and even
more expensive than the actual value of the collateral. More often than not, the
execution of collateral takes longer, that it’s no longer worth pursuing
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Microfinance Credit Delivery Methods
Because of the characteristics and business environment in which micro businesses
operate, unique delivery methods for the products that suit them have been based on
the experiences of the informal lenders. There are two more popular methodologies that
have been implemented in the Philippines.
1. Individual lending where loans are given to individual borrowers. Loan products are
tailored to the specific needs of the business.
2. Group lending where loans are given to the individual members of a group on the
basis of the guarantee provided by the group or center. It’s a “one size fits all”
design. Loans are given to self-formed groups that have unrelated members. These
groups are organized into centers. Ideally, each group should have at least 5
members and each center should have at least 6 groups. The group screens its own
members for loans and every members go through training before they are granted a
loan.
Differences between Individual and Group Lending Methods
Individual Lending Methodology
Loans are given to individuals borrowers.
Group Lending Methodology
Peer groups of unrelated members
are self-formed and organized into
“centers” of up to eight groups
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Most successful for larger ,urbanbased, production-oriented business.
Business must have been existing for
at least 1 year. - it is important that a
business should be at least one year in
operation to make sure that the
borrower has already acquired the
skills, knowledge and understanding of
the highs and lows of the business.
This is important since repayment
relies on the business and if the
business fails, there is a high possibility
of default on loan payment
It also works for non-manufacturing
enterprises located urbanized areas
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Appropriate clients are from rural or
urban (densely populated) areas and
are usually women from low-income
groups.
Usually includes start-up businesses. a business of a group member may not
necessarily be 1 year in operation
since this type of product is typically
designed to assist very poor women
who may want to start their business.
Many group lending schemes
worldwide accept start ups clients.
Since loan amounts for the first cycle
are so small (P2,000 to P5,000),
members can easily invest in or even
shift, to different income generating
activities. The trade sector, due to low
skills entry requirements, offers the
easiest options.
These groups are organized into
centers. The group screens its own
members for loans and every members
go through training before they are
granted a loan.
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Requires some form of collateral
(substitute) or co-signatories. - requires
some collateral in the form of co-makers,
household and business assets. Most
banks prefer serialized assets compared to
non-serialized assets
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Credit products tailored to the specific
needs of the business.
One single product that is not necessarily
tailored to specific needs of the members
of the group (one size fits all).
Loan amounts and terms are based on
careful analysis by the credit officer. - loan
amounts and terms of loan are based on
careful analysis of the client’s character
and repayment capacity, as results of
credit and background investigations
conducted by the Loan Officer
Loan amounts are pre-determined. Loan
appraisal is performed by group members
and center leaders. Branch staff verify
information and make periodic visits to
clients business. - loan amounts are predetermined. Again, it’s the “One size fits
all” design. Since it is the members
themselves who choose who their comembers will be, it follows that Loan
Appraisal is also performed by the
members. The role of the Account Officer
is to verify the information presented by the
group and to conduct periodic visits to
client’s business. In order to facilitate
group loan management and collection,
loan terms are the same for all members
(e.g. four months). Different maturity dates
under the same loan cycle just adds
unnecessary complexity to the Center loan
management, and increases administrative
costs for the bank.
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Group members mutually guarantee
each others loans. No further loans are
given to member if all loans of the
group members are not repaid on time.
No collateral is required - the members
of a group jointly guarantee each
other’s loan. This means that group
members are liable if other members of
the group default or miss any
amortization payments. In the same
manner, the Center is liable if any
member of any group defaults or
misses any amortization payment
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Requires frequent and close contact with
individual clients. - collection is usually
conducted weekly. Sometimes, clients
bring their payments to the bank. In this
case, there is a need for the Account
Officer to regularly visit the client to
monitor the status of the business
Credit Officers usually work with a
relatively small number of clients (between
60-150) and close relationship with them
over the years, often providing minimum
technical assistance - more than this
number, the Account Officer would already
have difficulties dealing with clients
individually and monitoring their
businesses regularly
Attendance at weekly meetings and
weekly savings contributions, group
fund contributions ,and insurance
payments are mandatory. - AOs contact
with clients is also done weekly during the
weekly meetings where members of the
group remit their loan payments.
Attendance to the meeting is mandatory
and a condition to avail of another loan. A
member who can not abide by this rule
must be referred to individual lending
Credit officers usually carry between 250350 clients. - Account Officer can handle
more since the latter does not deal with the
clients individually.
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