Microfinance and microcredit

Principles of microfinance

Micro Financial Institutions

Poverty is the main cause of concern in improving the economic status of developing
countries. A microfinance institution is an organization that offers financial services to
low income populations. Almost all give loans to their members, and many offer
insurance, deposit and other services.

A great scale of organizations is regarded as microfinance institutes. They are those that
offer credits and other financial services to the representatives of poor strata of
population (except for extremely poor strata).

Microfinance is increasingly being considered as one of the most effective tools of

reducing poverty. Microfinance has a significant role in bridging the gap between the
formal financial institutions and the rural poor. The Micro Finance Institutions (MFIs)
accesses financial resources from the Banks and other mainstream Financial Institutions
and provide financial and support services to the poor.

MFIs are the pivotal overseas organizations in each country that make individual
microcredit loans directly to villagers, microentrepreneurs, impoverished women and
poor families. An overseas MFI is like a small bank with the same challenges and capital
needs confronting any expanding small venture but with the added responsibility of
serving economically-marginalized populations. Many MFIs are creditworthy and well-
run with proven records of success, many are operationally self-sufficient.

Various types of institutions offer microfinance: credit unions, commercial banks, NGOs
(Non-governmental Organizations), cooperatives, and sectors of government banks. The
emergence of “for-profit” MFIs is growing. In India , these ‘for-profit’ MFIs are referred
to as Non-Banking Financial Companies (NBFC). NGOs mainly work in remote rural
areas thereby providing financial services to the persons with no access to banking
services.

The term “transformation,” or commercialization, of a microfinance institution (MFI)

refers to a change in legal status from an unregulated nonprofit or non-governmental
organization (NGO) into a regulated, for-profit institution. Regulated, transformed
organizations differ from nonprofits in that they are held to performance and capital
adequacy standards and are supervised by a financial authority, typically the central bank
of the country where they are registered. A transformed MFI also attracts equity
investors. The equity investors want to ensure that the values of their investments are
maintained or enhanced and elect Board members who share a common vision for the
new for-profit institution. Among transformed MFIs, varying classifications of regulated
institutions exist, the strictest being banks — rural banks and thrift banks — followed by
non-bank financial institutions. Different countries have varied names for these regulated
MFIs.

The microfinance sector consistently focuses on understanding the needs of the poor and
on devising better ways of delivering services in line with their requirements, developing
the most efficient and effective mechanisms to deliver finance to the poor. Continuous
efforts towards automation of operations is steady improving in efficiency. The
automated systems have also helped accelerate the growth rate of the microfinance
sector.

The goal for MFIs should be:

• To improve the quality of life of the poor by providing access to financial and support
services;

• To be a viable financial institution developing sustainable communities;

• To mobilize resources in order to provide financial and support services to the poor,
particularly women, for viable productive income generation enterprises enabling them to
reduce their poverty;

• Learn and evaluate what helps people to move out of poverty faster;

• To create opportunities for selfemployment for the underprivileged;

• To train rural poor in simple skills and enable them to utilize the available resources and
contribute to employment and income generation in rural areas.

Many institutions practice microfinance, or raise funds for microfinance, including the
following:

Microfinance and microcredit

Principles of microfinance

History of microfinance
The history of microfinancing can be traced back as long to the middle of the 1800s when
the theorist Lysander Spooner was writing over the benefits from small credits to
entrepreneurs and farmers as a way getting the people out of poverty. But it was at the
end of World War II with the Marshall plan the concept had an big impact.
The today use of the expression microfinancing has it roots in the 1970s when
organizations, such as Grameen Bank of Bangladesh with the microfinance pioneer
Mohammad Yunus, where starting and shaping the modern industry of microfinancing.
Another pioneer in this sector is Akhtar Hameed Khan. At that time a new wave of
microfinance initiatives introduced many new innovations into the sector. Many
pioneering enterprises began experimenting with loaning to the underserved people. The
main reason why microfinance is dated to the 1970s is that the programs could show that
people can be relied on to repay their loans and that it´s possible to provide financial
services to poor people through marketbased enterprises without subsidy. Shorebank was
the first microfinance and community development bank founded 1974 in Chicago .

An economical historian at Yale named Timothy Guinnane has been doing some research
on Friedrich Wilhelm Raiffeisen´s village bank movement in Germany which started in
1864 an by the year 1901 the bank had reached 2million rural farmers. Timothy
Guinnane means that already then it was proved that microcredit could pass the two tests
concerning peoples paybackmoral and the possibility to provide the financial service to
poor people.

Another organization, The caisse populaire movement grounded by Alphone and

Dorimène Desjardins in Quebec , was also concerned about the poverty, and passed those
two tests. Between 1900 to 1906 when they founded the first caisse, they passed a law
governing them in the Quebec assembly , they risked their private assets and must have
been very sure about the idea about microcredit.

Today the World Bank estimates that more than 16 million people are served by some
7000 microfinance institutions all over the world. CGAP experts means that about 500
million families benefits from these small loans making new business possible. In a
gathering at a Microcredit Summit in Washington DC the goal was reaching 100 million
of the world´s poorest people by credits from the world leaders and major financial
institutions.

The year 2005 was proclaimed as the International year of Microcredit by The Economic
and Social Council of the United Nations in a call for the financial and building sector to
“fuel” the strong entrepreneurial spirit of the poor people around the world.

The International year of Microcredit consists of five goals:

• Assess and promote the contribution of microfinance to the MFIs

• Make microfinance more visible for public awareness und understanding as a very
important part of the development situation

• The promotion should be inclusive the financial sector

• Make a supporting system for sustainable access to financial services

• Support strategic partnerships by encouraging new partnerships and innovation to build
and expand the outreach and success of microfinance for all

The economics professor Mohammad Yunus and the founder of Grameen Bank were
awarded the Nobel Prize 2006 for his efforts. The press release from nobelprize.org
states:

“The Norwegian Nobel Committee has decided to award the Nobel Peace Prize for 2006,
divided into two equal parts, to Muhammad Yunus and Grameen Bank for their efforts to
create economic and social development from below. Lasting peace can not be achieved
unless large population groups find ways in which to break out of poverty. Micro-credit
is one such means. Development from below also serves to advance democracy and
human rights. Muhammad Yunus has shown himself to be a leader who has managed to
translate visions into practical action for the benefit of millions of people, not only in
Bangladesh , but also in many other countries. Loans to poor people without any financial
security had appeared to be an impossible idea. From modest beginnings three decades
ago, Yunus has, first and foremost through Grameen Bank, developed micro-credit into
an ever more important instrument in the struggle against poverty. Grameen Bank has
been a source of ideas and models for the many institutions in the field of micro-credit
that have sprung up around the world.
Every single individual on earth has both the potential and the right to live a decent life.
Across cultures and civilizations, Yunus and Grameen Bank have shown that even the
poorest of the poor can work to bring about their own development.
Micro-credit has proved to be an important liberating force in societies where women in
particular have to struggle against repressive social and economic conditions. Economic
growth and political democracy can not achieve their full potential unless the female half
of humanity participates on an equal footing with the male.
Yunus’s long-term vision is to eliminate poverty in the world. That vision can not be
realised by means of micro-credit alone. But Muhammad Yunus and Grameen Bank have
shown that, in the continuing efforts to achieve it, micro-credit must play a major part.”

Microfinance and microcredit

Principles of microfinance

Working method for microfinance institutions

The Grameen Bank of Bangladesh has developed a joint liability model that its MFIs are
using suited for local conditions.

When choosing a village the MFI conduct a comprehensive survey to brief the potential
for operations and the local conditions in a village. The MFI are evaluating some key
factors like village population, degree of poverty, road accessibility, political stability and
safety. When a village has been selected, the MFI introduces its mission, methodology
and the services they are offering.

After the informational presentation interested women are gathered in group formations.
They have to be in the age between 18 and 59. The women put them self together in
groups of five to serve as guarantors for each other. Earlier experience has shown that a
group of five persons is small enough to create group pressure between the members,
enforcing them to be loyal to each other. In case someone of the group members are not
able to repay the loan the group is big enough to help with the payments. The company
does not influence the selection of group members nor the decision regarding the income
generation activity nor the loan amount they intend to take. Group members must live
close to each other and cannot be related to each other.

If a borrower defaults on her loan, the entire

group typically is penalized and sometimes
barred altogether from taking further loans.
This peer pressure encourages borrowers to
be very selective about their peer group
members and to repay loans in full and on
time.

Then the group training begins, usually as a five day program. The purpose is to educate
the members in the procedures of the financial products, delivery methods, calculation of
interest rates, business development skills and how to sign their names. The members are
also taught in quality management, to identify an income generation activity, how to set
prices and how to market. They field staff also build a culture of credit discipline and
collective responsibility. The field staff makes sure the members qualifies for the
program and collect data for future analysis. Within the village, a center is created
collecting the groups. The center is responsible for the payments of all groups, enabling a
dual liability system. When the villagecenter is created the financial transactions can
begin.

The groups meet weekly in the villagecenter where they can discuss new loan
applications, loan utilization, and community issues. The field staff of the MFIs conduct
the meetings with rigid discipline in order to sustain the credit discipline of the group. All
financial transactions are conducted during the meetings.

Microfinance is a relatively new segment of the market economy that is why institutions
created in this segment have short experience in their activities, and their personnel is not
sufficiently experienced and qualified. Taking this into consideration, staff of these
institutes is recommended to follow the internationally recognized principles of
microfinance:

• thorough examination of potential clients of the microfinance institution;

 • thorough estimation of business viability and also factors which can positively or
negatively affect the results of work in specific conditions;
• thorough registration of documents and contracts related to loan issuance and
microfinance services providing;
• keep in touch with client in combination with monitoring of the terms of paying a
credit, interests payments and with the aim to find out potential and real problems;
• setting of interest rates for microfinance services compatible with market ones;
• quick reaction to any problems which can complicate the perspectives of getting
of issued credit payed back.

Microfinance and microcredit

Principles of microfinance

Funding / Financial Institutions

The mission for the funding institutions is to help MFIs operating more efficiently and be
more effective. They provide each partner with financial products and services that are
tailored to meet their needs.

A goal is to ensure the partners are moving their clients out of poverty and to foster good
practices for measuring the progress of the individuals movement across poverty lines.
MFIs must show results, yet many do not have the tools to evaluate how well they are
fulfilling their mission of reducing poverty, reaching people excluded from financial
services, empowering women, or promoting community solidarity. That´s why they
should also equip microfinance institutions with tools to measure their clients’ progress
out of poverty. Built on the learnings of previous efforts in the microfinance industry they
can develop the operational methods in reaching the clients. Innovative financing
solutions and strategies to expand the capacity and efficiency of the MFIs provide a direct
impact on the lives of the poor, and advancing the microfinance industry as it moves
toward even higher standards in terms of anti-poverty impact and financial performance.

Microfinance and microcredit

Principles of microfinance

Fundamentals of microfinancing
The managers at the MFIs are careful to ensure the borrower success and informs about
the risks involved, that makes in general the borrower performing better. This leads often
to earned dignity and lasting self-confidence associated with responsible loan repayment.
To have a sustainable growing economy it takes high entrepreneurship and energy in
order to develop the world and fight poverty. Independet and responsible entrepreneurs
are valuable resources which can take advantage of the microfinance industry. They will
not take big risks and must be supported by predictable financing.

Normal bankoperations suits better to large transactions which is more profitable, the
traditional operating philosophy is to invest in facilities and they have costly operating
structures. The traditional financing industry must either change themselves or stay out of
the microfinance business. A new generation of banking institutions is growing in a
market of very small transactions and less affluent clients. With lowered transactions
costs through institutional specialization and innovation in delivery systems, they will be
able to operate profitable in this market serving the poor with financial services.

The poor entrepreneurs are the future representing the population who will become
successful in the nearby future. They have the same will and skills as the toughest
business operators. The are economical, don’t take big risks and repay debts as scheduled
to maintain possibility borrowing money in the future.

This require a totally new ground breaking banking system with scale economics.
Modifying the standard system will simply not be enough, the poor people will continue
stay outside their country´s economy. Building up microfinance institutions serving poor
people is a relatively costeffective use of subsidies for economic development compared
to other supporting strategies for welfare.