What is Microfinance and How Does it Affect Financial Inclusion?

This article will give you a detailed look into what microfinance is, including what its purpose is, how it works, and the reason why it is seen as a powerful idea.

In finances, it is difficult to avoid the term ‘capital’. More often than not, you will see it correlate with the topic of financial assets. This is because the term itself is basically another way of addressing certain types of assets. These include such things as funds in deposit accounts and funds that special financing sources manage to obtain. It’s easy to associate capital with capital assets of a company that requires substantial amounts of capital in order to finance. Alternatively, it needs these amounts if it wants to properly expand.

Businesses will often concentrate on three main types of business capital:

  • Working capital
  • Equity capital
  • Debt capital.

Overall, business capital is a vital element pertaining to running a business and financing capital intensive assets.

It is imperative that small business owners and entrepreneurs alike have reliable access to capital. More often than not, these small and individual businesses do not have the luxury of easy access to traditional financial resources from major institutions. This essentially means that it is a lot harder to access various necessities. These include loans, insurance, and investments; all of which can help their business grow.

This is where something called ‘microfinance’ comes into play. With it, smaller businesses have a way of acquiring capital. The practice provides them with loans, credit, and access to savings accounts. Not only that, but they even provide insurance policies and money transfers.

What is microfinance?

‘Microfinance’, alternatively known as ‘microcredit​’, is a specific type of banking service. Its focal demographic is those without employment or low-income individuals or groups who have no access to financial services.

For additional elaboration, microcredit is a prevalent form of microfinance. It typically involves an extremely small loan for an individual to help them become self-employed or develop a small business. These borrowers will often be low-income individuals and especially residing in less developed countries. Microcredit goes by other names, like ‘microlending’ or ‘microloan’.

The core concept of microcredit draws its foundation from an idea involving skillful people in underdeveloped countries. Those who live outside of traditional banking and monetary systems could obtain entry into an economy by way of a small loan. Those who receive the offer of microcredit will sometimes live in barter systems. In other words, where there is no exchange of actual currency.

Institutions that participate in the area of microfinance will frequently provide lending. In fact, microloans can be as little as $100 and as large as $25,000. However, there are a good amount of banks that offer additional services. Such services include checking and savings accounts, as well as micro-insurance products. There are some that even provide education in fields like finances and business. The primary intent of microfinance is to ultimately give impoverished people the chance to become self-sustaining.

Microfinance’s main purpose is to allow people to carefully acquire reasonable small business loans. Not only that but do so in a manner that is compatible with ethical lending practices. Operations revolving around microfinancing exist all around the world. However, most of them occur in developing nations, like Uganda, Serbia, Indonesia, and Honduras to name a few. Moreover, many microfinance institutions focus particularly on helping women.

How it works

Microfinancing organizations are supporters of a large number of activities. These can range from providing the basics (i.e. bank checking and savings accounts) to startup capital for small business entrepreneurs. Moreover, there are educational programs that teach the primary principles of investing.

The skills that these programs concentrate on include bookkeeping, cash-flow management, and technical or professional skills, such as accounting. Typical financing situations involve the lender’s main concern being that the borrower has enough collateral to cover the loan. Microfinance organizations, on the other hand, focus on assisting entrepreneurs to reach success.

There are many instances in which there is a specific requirement for people seeking help from microfinance organizations. That being they need to take a basic money-management class. Lessons in these classes cover an array of topics, such as the following:

  • Proper understanding of interest rates
  • The core concept of cash flow
  • Why and how both financing agreements and savings accounts work
  • How to budget
  • The proper ways to manage debt

With this knowledge, customers are able to apply for loans. Similar to how one would find at a traditional bank, a loan officer assists borrowers with various things. They can help with applications, managing the lending process, and approving loans.

The average loan – often as little as $100 – does not seem like much. Especially not to some people who live in more developed areas in the world. The same cannot be said for many impoverished people, though. As a matter of fact, this amount is often enough to start a business or partake in other profitable activities.

microfinance

Loan terms

Similar to conventional lenders, micro-financiers need to charge interest on loans. Furthermore, they appoint specific repayment plans with payments that are due at regular breaks. For some lenders, it is mandatory that loan recipients set aside a part of their income in a savings account. This portion of their income can be for insurance should the customer end up defaulting. If the borrower is able to successfully repay the loan, then they will also be able to accumulate extra savings.

Many applicants are unable to offer collateral, so microlenders frequently pool borrowers together as a buffer. The recipients, after acquiring loans, repay their debts together. The overall success of the program is reliant on everyone’s contributions. Because of this, there is a form of peer pressure that incentivizes repayment.

For example, let’s assume that an individual is having trouble using their money to start a business. In this case, that person can look for assistance from other group members. They can even seek help from the loan officer. Through repayment, loan recipients can begin to develop a good credit history. This will effectively allow them to obtain larger loans in the future.

There is something interesting to note pertaining to the fact that these borrowers often qualify as very poor. Typically, repayment amounts on microloans are noticeably higher than the average repayment rate on more traditional forms of financing. Opportunity International, for example, was reported to have repayment rates of roughly 98.9% in 2016.

The five biggest companies

Microfinance institutions provide their clients with an array of services, such as micro-savings and micro-insurance. Micro-savings accounts give individuals the ability to deposit small amounts of money with a financial institution. They can do so without minimum balance requirements.

The products of micro-insurance range from insurance for crops all the way to life insurance. Moreover, it offers individuals the opportunity to obtain small insurance policies along with correspondingly small premiums.

There are some institutions that are nonprofit organizations. However, there is an increasing trend toward the proliferation of profit-seeking institutions. Specifically, institutions that aim for solid returns for investors. Major banks such as Citigroup Inc. are already entering the business of microfinancing.

Below is a list consisting of five of the largest and most influential microfinance institutions.

1 – 51Give

This is an institution that was founded back in 2007 in Beijing. 51Give offers microfinance solution services for other microfinance institutions. The organization provides its clients with an e-commerce platform, offering both online and mobile technology. The design of this technology was specifically for connecting individuals, companies, organizations, and institutions with local microfinance institutions. This effectively facilitates donations and investments, as well as the delivery of microfinancing services.

As of 2015, there were over 100 charitable organizations that were using 51Give’s platform.

2 – Bank Raykat Indonesia

Alternatively known as Bank Raykat IDR250 (BBRI.JK), this institution is the oldest Indonesian bank. It was founded all the way back in 1896 in Jakarta. Since then, it would establish itself as one of the country’s largest financial institutions. Despite this, Bank Raykat Indonesia still operates primarily as a small-scale and microfinance lender. It has more than 30 million retail banking clients conducting business with the bank by way of many branches and rural service posts. Up to 70% of the bank is owned by the government.

3 – BRAC

This institution is one of the oldest existing microfinance institutions, having been founded in 1972 in Bangladesh. BRAC offers clients a wide range of services in various areas. These include health, human rights, education, and economic development. Moreover, it provides grants and small business loans, housing assistance, and micro-savings services. The operation of BRAC is in a dozen developing countries; these range from Haiti to the Philippines.

As of 2015, its gross loan portfolio was surpassing $1.4 million.

4 – Grameen Bank

This institution was founded in Bangladesh in 1983 and holds the distinction of being a Nobel Peace Prize-winning microfinance institution. The origins of Grameen Bank was a result of the work of its founder, Muhammad Yunus. His research would later pioneer the very concept of providing micro-banking services and non-collateralized loans for the poor. Doing so will help in the alleviation of poverty.

As of 2015, Grameen Bank would have over eight million borrowers and a loan portfolio in excess of $18 billion. Not only does it provide microcredit and other banking services, but in 1998, the bank would launch an award-winning low-cost housing program.

5 – Kiva Microfunds

This institution was founded in 2005 and the location of its headquarters is in San Francisco. Kiva Microfunds is a nonprofit microfinance institution that carries out its operations in the U.S. and over 80 other countries. Kiva’s method for providing microfinance lending is by way of establishing a crowdfunding – or peer-to-peer lending – platform. One that will allow individuals to directly lend to borrowers in other countries who cannot access conventional financing sources. Kiva also offers interest-free financing for small businesses, education, and health services which include distributing clean water.

As of 2016, Kiva has over $850 million microloans in its name. Furthermore, it has a network of approximately 1.5 million lenders and roughly two million borrowers. On a weekly basis, the organization funds an average of $2.5 million in loans.

Does it work?

Right off the bat, we can see that the idea behind microfinancing is a considerably noble one. Its central goal is to mitigate the issue of poverty and unemployment and widen financial inclusion. What’s more, it aims to provide people wanting to start a business the proper chance. Many are lauding microfinance as a way to end the cycle of poverty, as well as decreasing unemployment and increased earning power. Be that as it may, several experts claim that it may not work as well as it should. In fact, some go so far as to say that it’s losing its way.

There are others that make the argument that microfinance simply makes poverty worse. This is largely because many borrowers use microloans to pay for basic necessities, or their businesses fail. This will consequently plunge them further into debt.

In South Africa, for example, 94% of all microfinance loans are primarily for consumption. This basically means that the funds are for basic necessities. So, borrowers are not generating new income with the initial loan. They have to take out another loan in order to pay off that loan and the cycle continues. In the end, this translates into a great amount of debt.

With that being said, there are many experts that claim otherwise. They say that microfinance is capable of serving as a valuable tool for the financially underserved. So long as it is used in a proper manner, anyway. Moreover, they cite the industry’s high repayment rate as concrete proof of its effectiveness.

The overall importance

Regardless of whether you believe that microfinance is effective or not, one cannot deny its impact. Moreover, it’s difficult to ignore its significance. Its importance stems from how it provides resources and access to capital for those in need of it. It helps those who cannot obtain checking accounts, loans, or lines of credit from conventional banks.

Without microfinance, these groups will likely have to resort to using loans or payday advances. Especially those that have extremely high interest rates. Alternatively, they may have to borrow money from those around them. Microfinance allows them to invest in their businesses; in doing so, they can invest in themselves.

All in all, microfinance is incredibly important in the world of finances. If its execution is done correctly, it has the potential to be a powerful tool for many people.

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