What is microfinance and how does it work?

Financial inclusion is very important for economic development. After all, this is the tool with which people can build better lives, and smaller entrepreneurs can continue running their business. Did you know that around 1.4 billion people do not have a bank account? There are close to 400 million small firms that are informal and have no access to financial resources.

This is where microfinance comes to the rescue. It offers a solution to those who are excluded from mainstream financial systems. But what is microfinance, and how does it provide a source of credit to those who are economically weak?

Microfinance: helping people plan their future

Essentially microfinance means providing financial services to those who have low income or groups that cannot avail of any traditional banking services. Microfinance involves providing smaller credit facilities to those who are unbanked and underbanked. It provides economic opportunity to such groups of people.

Microfinancing extends beyond just providing small loans. Over the years, the term has expanded to include a wide range of financial products, including savings, insurance and even money transfers. How are these different to what banks offer? Well, the only difference is that these products are designed specifically for people who have low income or living in rural areas as well as small enterprises that operate in the informal economy.

Let’s say you wish to take a loan from the bank. The bank would conduct a thorough check to make sure you can repay the loan. If the bank is unsure whether you can pay back the amount borrowed, it asks for a collateral. If you’re unable to repay, the bank has the right to sell the collateral (asset) and recover the money. But what happens if you do not have any collateral to provide? Microfinance institutions use alternative lending models, often relying on social collateral, lending small amounts, group lending, and frequent repayment schedules to provide loans.

So microfinance is important for financial inclusion because it gives those who are financially weak a way to plan their future. They can now borrow money to study for a better career or expand their small businesses to improve their living standards. This way, it helps break the vicious cycle of poverty.

Moving beyond economic benefits, financial inclusion gives a sense of dignity and self-reliance to the underprivileged. This enables them to save for emergencies and invest in their children’s education. It integrates marginalised populations into the formal economy, which then contributes to broader economic growth and stability.

Nuts and bolts of microfinance

The backbone of the microfinance ecosystem is the microfinance institution. These organisations, ranging from non-profit and non-governmental organisations to commercial banks with dedicated microfinance divisions, are specifically designed to cater to the needs of their target clientele. They often have a deep understanding of local market conditions and cultural nuances, which is crucial for effective outreach and loan recovery.

The way small loans and credit systems function in microfinancing differs significantly from traditional banking. A common model is group lending, where a small group of individuals (often five-10 people) collectively guarantees each other’s loans. This peer pressure acts as a form of collateral, encouraging timely repayment. If one member defaults, the entire group may be ineligible for future loans, creating a strong incentive for mutual support and accountability.

This model also fosters community building and knowledge sharing among borrowers. Loan amounts are typically small, often ranging from a few tens to a few hundred dollars, sufficient to fund micro-enterprises like street vending, tailoring or small-scale farming. Repayment schedules are usually frequent, often weekly or bi-weekly, to align with the irregular income streams of borrowers.

Comparing microfinance with traditional banking

Traditional banks primarily serve clients with established credit histories, regular incomes and collateral. Their processes are often bureaucratic and costly for small transactions.

Microfinance, on the other hand, targets the unbanked, focusing on character-based lending and leveraging local knowledge. While traditional banks prioritise profit maximisation, microfinance institutions often have a dual bottom line: financial sustainability and social impact. This different operational philosophy allows them to reach populations considered ‘unbankable’ by conventional standards.

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Every coin has two sides

Like anything in life, microfinancing has its own set of advantages and challenges.

Financial inclusion, empowerment of the less fortunate and broader economic growth are just some of the benefits. Microfinance has brought millions into the formal financial system, allowing them to save and access credit during an emergency or for bettering their lives. It also helps them manage their finances more effectively.

Microfinance has supported women, who often reinvest their profits into their families and communities. This has led to improved health, nutrition and educational outcomes.

In addition, by enabling the creation and expansion of small businesses, microfinance stimulates local economies, creates employment opportunities and contributes to poverty reduction. It has the power to transform entire communities.

What are the potential drawbacks? Microfinance institutions bear the high operational cost of managing a large number of small loans. These loans are often in remote areas. That’s why the interest rates charged by microfinance institutions can be much higher than those charged by traditional banks. High interest rates mean that people can fall into a debt trap if they do not repay in time.

Furthermore, the sustainability of some institutions can be precarious, relying on grants and donor funding rather than becoming fully self-sufficient. There are also concerns about mission drift, where some microfinance institutions may prioritise profit over their social mission, potentially compromising their core values.

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Examples of microfinance in practice

Organisations such as France’s Adie showcase how microfinance works, offering microloans and support to entrepreneurs shut out of traditional banking. The European Investment Fund (EIF) also plays a key role by investing in microfinance institutions across Europe to support small businesses and job creation.

In Latin America, organisations like Compartamos Banco in Mexico have demonstrated how microfinance can scale, although their high interest rates have also sparked debate. In Africa, various microfinance institutions are working to address the unique challenges of rural populations, often integrating financial services with agricultural support and health education. These initiatives highlight the diverse applications and adaptations of microfinance to different socio-economic contexts.

Lessons from successful microfinance initiatives emphasise several key factors: a strong understanding of the local context, innovative and flexible lending methodologies, robust repayment mechanisms and a commitment to social impact, while considering financial viability.

The importance of non-financial services, such as financial literacy training and business development support, is also increasingly recognised as crucial for the long-term success of borrowers. Microfinance is not a silver bullet, but when implemented thoughtfully and ethically, it can be a powerful engine for poverty alleviation and economic empowerment.

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FAQs

What is microfinance?

Microfinance provides financial services, such as small loans, savings and insurance to the unbanked and underbanked populations. Its primary goal is to promote financial inclusion and economic empowerment among low-income groups and those who lack access to traditional banking services.

How do microfinance institutions operate?

Microfinance institutions offer tailored financial products, often utilising group lending models where borrowers collectively guarantee loans. They focus on character-based lending rather than collateral and have frequent repayment schedules to suit the irregular incomes of their clients.

What are the risks of microfinancing?

Potential risks include high interest rates due to the operational costs of administering small loans, which can sometimes burden borrowers. There are also sustainability challenges for some institutions and concerns about mission drift if profit gets prioritised over social impact.

How does microfinance benefit small businesses?

Microfinance provides crucial capital for small businesses to start, expand or invest in inventory, equipment or training. This access to credit enables entrepreneurs to generate income, create jobs and contribute to local economic growth, breaking poverty cycles.