In my last post, I promised to go into depth about what microfinance is and how it helps combat poverty. But to start with, here’s a short video from Kiva for those of you who prefer a quick version:
Microfinance is a broad term describing financial services for low-income individuals such as credit, saving, insurance, money transfers, and other basic services. The “micro” part of the phase obviously refers to amount of money involved in these services. Someone who is poor is unlikely to take out a loan for $25,000, and having a separate term helps to distinguish these institutions from regular commercial banks.
While credit unions and lending cooperatives have been used for hundreds of years, microfinance wasn’t explored until the 1970s. Dr. Muhammad Yunus is often credited as being the primary pioneer of this field (As well as being a hero of mine). He experimented with giving small loans and financial education to women in Bangladesh. In 1983, Yunus founded the independent Grameen Bank. The Grameen Bank and Yunas jointly won the Noble Peace Prize in 2006. The success of Grameen Bank has inspired similar projects in over 40 countries, effectively spreading the ideas of microfinance throughout the developing world.[i] For more information on Yunus, I highly recommend his memoir Banker to the Poor: The Story of the Grameen Bank.[ii]
Let’s get back to the definitions. People often confuse the term microfinance with microcredit. Like I stated earlier, microfinance is an umbrella term referring to all of the financial services offered to the poor. Microcredit is a subset of the term as it includes only one type of service. Microcredit refers to the practice of issuing small loans to low-income borrowers with little to no collateral, instable incomes, and unverifiable credit histories. These loans are often given to entrepreneurs, particularly women, to invest in their small businesses.
Microcredit and other services are provided by microfinance institutions (Creative name, I know). Why don’t regular banks handle these services? Well, some do. However, microfinance isn’t attractive to most commercial banks because its lack of profitability. It is much less lucrative to handle the small amounts of money found in microfinance rather than larger accounts. MFIs first emerged as non-profit organizations, such as NGOs or credit unions. In order for an entity to get a license to offer savings services, it must have a for-profit status. Thus an increasing amount of MFIs are now for-profit and categorized as non-banks financial institutions.[iii]
Now that we all know what microfinance and microcredit are, why is it such a big deal? Well, traditional financial institutions are designed to support people who already have money. So what do poor people do? The poor save informally by buying gold, jewelry, domestic animals, or other liquid assets. The first benefit of MFIs is that they provide a secure and accessible means of savings, which can be essential for managing crises, investing in opportunities, or paying for large expenses such as schooling.[iv]
Next, microfinance is important because people in developing countries rarely have access to credit. Often the only credit available is through pawnbrokers or moneylenders who charge staggeringly high interest rates or use violence against borrowers when they default on payments. Access to ethical credit options helps the poor to smooth cash flows and helps to ensure continuous access to food, clothing, housing, and education. Credit can help with economic shocks or with building up assets, such as land. Lastly microcredit, unlike other credit options, is inclusive to women and has encouraged empowerment and financial independence.[v]
So far all the information I’ve included has been positive. I truly believe that microfinance is important strategy in eliminating poverty. However, it’s naive to think that it is the only strategy. Microfinance has its problems. As MFIs moved from non-profits to for-profit organizations, some lenders starting focusing on making a profit by charging high interest rates rather than providing services for the poor. As Muhammad Yunus stated in a 2011 op-ed piece, “Commercialization has been a terrible wrong turn for microfinance, and it indicates a worrying ‘mission drift’ in the motivation of those lending to the poor. Poverty should be eradicated, not seen as a money-making opportunity.”[vi]
The other main critique of microfinance is that the lack of financial education provided by some MFIs. Clients of MFIs are often have limited education, particularly when it comes to money. Financial education helps the poor effectively understand their financial circumstances, choose among financial options and manage the financial resources they have. MFIs that do not help provide this education are generally are less successful and in some cases, harmful.
Overall, the point of microfinance is to provide financial services to the poor, who are often ignored by traditional institutions. While some MFIs suffer from high interest rate and other flaws, I believe that they have done more good than harm by empowering the poor to take control over their financial situations.
More information: For a good overview of microfinance that discusses the positive and negative effects, read this article by YES! Magazine.[vii]