How Does Microfinance Work?

There has been a dramatic rise in financial inclusion and poverty alleviation efforts across the developing world. Microfinance has been viewed as an important instrument of bringing about the many development objectives. The 2006 Nobel Peace Prize awarded to Mohammad Yunus, the founder of Grameen Bank, has only reaffirmed this importance. Since then, microfinance has come a long way. We’ve all heard of the term microfinance. But what is microfinance? Let’s try and take a more technical view to understand its precise nature.

Microfinance is the provision of financial services such as credit, savings, insurance among others to households and micro-enterprises who are excluded from traditional commercial banking services. These people typically fall in the lower income strata and have little to no legally recognized possession which they can leverage to avail financial services. There are two essential barriers that limit the access to these services – risk and high cost. Microfinance institutions face a trade-off between their source of funds and the loans. They incur a fixed cost in terms of the amount of interest to be paid on funds they have raised. This could be in terms of deposits or loans which they have raised. On the other hand, there are small ticket size transactions and loans which they disburse to their target population. The cost of disbursing small value loans to a large number of people is high. Thus, costs tend to increase and put pressure on the margins.

The other aspect is that of risk. Since their target customers typically lack documentation, KYC issues arise. Identification issues are a big challenge. There is also the issue of collateral. The fundamental problem with loans is that of information asymmetry. The borrower tends to know more than the lender. Thus, collateral plays an important role. While these people have houses, they may not be legally owned by them as they could be unauthorized construction on government property. Thus, in the absence of collateral, risk tends to increase.The traditional method of lending involves one person going to the bank/MFI, taking a loan and coming. These independent loans are but one way of disbursing loans. In the absence of collateral and other institutional mechanisms, MFIs have come up with numerous ways of disbursing funds – joint liability lending, dynamic incentives, and high repayment frequency.

One way that they have found to overcome the collateral problem is to lend to a group where the liability of repayment falls on all the group members. This is called joint lending. This mechanism ensures that there is an internal check on the members of the group for repayment. The closeness of the relationship has been viewed to be a good indicator of repayment. High levels of social trust among members tends to reflect in the repayment and default rates. However, when dealing with a large number of people, there is a possibility that the group members may try to game the system. If sufficient number of members are intent on defaulting, the others also tend to default given the shared burden. There is no incentive to repay. Thus, strategic defaults are a possibility and have been viewed in some instances with high social coordination.

The essential question here is, is joint liability lending better than individual lending? Empirical evidence shows that the default rates are roughly the same. Since the ability to enforce claims is limited, there is another method developed to ensure higher compliance. This brings us to the next method of lending – dynamic incentives. Here, the incentive for repayment is an increase in the loan size next time round. The eligibility to borrow higher amounts acts as a very strong incentive to repay the loan. It acts as an internal disciplining mechanism to ensure compliance, thus lowering monitoring costs.

The last type of MFI credit is characterized by high repayment frequency. This of the street hawkers you buy your flowers or tender coconut from. These people have steady cash flows on a daily basis. However, they might find it difficult to accumulate and pay a sum once a month or some such relatively long period. This could be due to the nature of their transaction, the amounts they are able to save, cultural and behavioural traits, etc. The product developed here is of having repayment schedules that are daily or weekly to ensure steady cash flows. Thus, when the borrower is liquid, s/he is able to repay without having to try and accumulate.

While saying an otherwise rise, the proliferation of microfinance in Islamic countries has been limited by their cultural factors. Charging interest or usury is viewed as a taboo. Thus, lending activities like these tend be difficult. The method they have found to go around this has been to charge fees instead of interest. Clearly then, despite being a rather successful endeavour in several areas, a variety of aspects influence MFIs.

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