What is microfinance?

Microfinance is the provision of financial services to poor people in developing countries who lack access to the commercial banking system.  Unlike traditional banks, microfinance institutions typically offer very small loans (often less than $100 per person), charge interest rates that are affordable for low-income clients, and do not require collateral.  Though the microfinance industry includes both nonprofit organizations and commercial banks, the principal goal of microfinance work is social impact rather than profitability.  There are many types of microfinance institutions:  local organizations that provide a small number of donor-based loans and multi-million dollar banks that work to establish country-wide savings and loan industries for the poor; those that combine their lending activities with education and social work and those that limit themselves financial services; those that provide credit only and those that also offer savings deposits and insurance.  Some practitioners believe that in order for the industry to grow fast enough to meet the demand, microfinance institutions should aim to become profitable by setting interest rates high enough to exceed their costs.  Others argue that most low-income borrowers cannot afford such high interest rates and that there is a trade-off between profitability and poverty-fighting impact.

Why do poor people in developing countries need financial services?

Even the poorest of the poor in developing countries engage in business activities.  These range from cash cropping, raising and selling livestock, and marketing garden produce and handicrafts to long-distance trade and managing tiny shops, food stands and even cybercafés.  A fisherman who makes a living from his handmade wooden canoe and nets, or a housewife who sews clothing or sells mangoes on the side of the road in her spare time, may well earn less than a dollar a day, but their business acumen is every bit as sharp as that of people in industrialized countries.  And like business owners everywhere, these “microentrepreneurs” need investment capital in order to expand their businesses and boost profits.  The fisherman’s small canoe might provide him with barely enough fish to make ends meet for his family, but investment in a motor or a longer boat could increase his revenue dramatically by allowing him to go farther out to sea and transport a larger catch back to shore.  The housewife could more than double her income by purchasing a sewing machine or paying to transport her mangoes to the city where they fetch higher prices.  In these cases, the increase in profits would be far greater than the cost of the investment, but without access to financial services the poor are unlikely to be able to mobilize enough capital to make the investment. 

Why can’t these microentrepreneurs get a commercial bank loan?

Lending to the poor is not very profitable because the loan amounts (and thus interest earnings) are modest and transaction costs are high.  Moreover, commercial banks tend to consider loans to low-income households prohibitively risky because they usually lack formal employment or credit history and are unable to put up adequate collateral.  Low-income entrepreneurs are thus trapped in a Catch-22: since they don’t earn enough to put up collateral for a commercial bank loan, they are unable to invest in the expansion of their income-generating activities, their enterprises stay tiny and barely profitable and their incomes stagnant.  Microfinance institutions work to bridge this gap by offering uncollateralized financial services specially designed for low-income microentrepreneurs.

If microfinance institutions don’t require collateral, how do they minimize default?

Microfinance institutions tend to have very low default rates – usually less than 3% - thanks to a variety of lending practices developed to compensate for the lack of collateral.  Perhaps the most innovative of these strategies is group lending, or extending loans to small groups of individuals who collectively guarantee each other’s borrowing and put pressure on each other to repay.  Other common microfinance practices include progressive lending, in which the line of credit is initially very small and the ability to borrow larger amounts is dependent on the repayment of anterior loans; and agreeing loan contracts and processing repayments publicly in the borrowers’ villages. 

Wouldn’t it be better to provide the poor with grants rather than loans?

Microfinance is not a panacea, since the lack of access to financial services is only one of many dilemmas facing the poor in developing countries.  And there are clearly situations of humanitarian disaster in which free distribution of resources to people who have lost everything is more appropriate than extending credit.  Microfinance is designed to allow individuals who are excluded from the formal banking system to lift themselves from their poverty trap through the provision of capital for their own income-generating investments.  Providing loans instead of grants in this situation has several advantages: