INTRODUCTION

Microfinance is the provision of financial services to low-income clients, including consumers

and the self-employed, who traditionally lack access to banking and related services.

More broadly, it is a movement whose object is "a world in which as many poor and near-poor
households as possible have permanent access to an appropriate range of high quality financial
services, including not just credit but also savings, insurance, and fund transfers." Those who
promote microfinance generally believe that such access will help poor people out of poverty.

THE CHALLENGE

Traditionally, banks have not provided financial services, such as loans, to clients with little or
no cash income. Banks incur substantial costs to manage a client account, regardless of how
small the sums of money involved. For example, the total profit for a bank from delivering 100
loans worth $1,000 each will not differ greatly from the revenue that results from delivering one
loan of $100,000. But the fixed cost of processing loans of any size is considerable as assessment
of potential borrowers, their repayment prospects and security; administration of outstanding
loans, collecting from delinquent borrowers, etc., has to be done in all cases. There is a break-
even point in providing loans or deposits below which banks lose money on eachtransaction they
make. Poor people usually fall below that breakeven point.

In addition, most poor people have few assets that can be secured by a bank as collateral. As
documented extensively by Hernando de Soto and others, even if they happen to own land in
the developing world, they may not have effective title to it. This means that the bank will have
little recourse against defaulting borrowers.

Seen from a broader perspective, the development of a healthy national financial system has long
been viewed as a catalyst for the broader goal of national economic development (see for
example Alexander Gerschenkron, Paul Rosenstein-Rodan, Joseph Schumpeter, Anne Krueger ).
However, the efforts of national planners and experts to develop financial services for most
people have often failed in developing countries, for reasons summarized well by Adams,
Graham & Von Pischke in their classic analysis 'Undermining Rural Development with Cheap
Credit'.
Because of these difficulties, when poor people borrow they often rely on relatives or a
local moneylender, whose interest rates can be very high. An analysis of 28 studies of informal
moneylending rates in 14 countries in Asia, Latin America and Africa concluded that 76% of
moneylender rates exceed 10% per month, including 22% that exceeded 100% per month.
Moneylenders usually charge higher rates to poorer borrowers than to less poor ones.[4] While
moneylenders are often demonized and accused of usury, their services are convenient and fast,
and they can be very flexible when borrowers run into problems. Hopes of quickly putting them
out of business have proven unrealistic, even in places where microfinance institutions are
active.

Over the past centuries practical visionaries, from the Franciscan monks who founded the
community-oriented pawnshops of the 15th century, to the founders of the European credit union
movement in the 19th century (such as Friedrich Wilhelm Raiffeisen) and the founders of
the microcredit movement in the 1970s (such as Muhammad Yunus) have tested practices and
built institutions designed to bring the kinds of opportunities and risk-management tools that
financial services can provide to the doorsteps of poor people. While the success of the Grameen
Bank (which now serves over 7 million poor Bangladeshi women) has inspired the world, it has
proved difficult to replicate this success. In nations with lower population densities, meeting the
operating costs of a retail branch by serving nearby customers has proven considerably more
challenging. Hans Dieter Seibel, board member of the European Microfinance Platform, is in
favour of the group model. This particular model (used by many Microfinance institutions)
makes financial sense, he says, because it reduces transaction costs. Microfinance programmes
also need to be based on local funds. Although much progress has been made, the problem has
not been solved yet, and the overwhelming majority of people who earn less than $1 a day,
especially in the rural areas, continue to have no practical access to formal sector finance.
Microfinance has been growing rapidly with $25 billion currently at work in microfinance
loans. It is estimated that the industry needs $250 billion to get capital to all the poor people who
need it. The industry has been growing rapidly, and concerns have arisen that the rate of capital
flowing into microfinance is a potential risk unless managed well.

BOUNDARIES AND PRINCIPLES

Poor people borrow from informal moneylenders and save with informal collectors. They receive
loans and grants from charities. They buy insurance from state-owned companies. They receive
funds transfers through formal or informal remittance networks. It is not easy to distinguish
microfinance from similar activities. It could be claimed that a government that orders state
banks to open deposit accounts for poor consumers, or a moneylender that engages in usury, or a
charity that runs a heifer pool are engaged in microfinance. Ensuring financial services to poor
people is best done by expanding the number of financial institutions available to them, as well
as by strengthening the capacity of those institutions. In recent years there has also been
increasing emphasis on expanding the diversity of institutions, since different institutions serve
different needs.

Some principles that summarize a century and a half of development practice were encapsulated
in 2004 by Consultative Group to Assist the Poor (CGAP) and endorsed by the Group of
Eight leaders at the G8 Summit on June 10, 2004:

1. Poor people need not just loans but also savings, insurance and money transfer services.
2. Microfinance must be useful to poor households: helping them raise income, build up
assets and/or cushion themselves against external shocks.
3. "Microfinance can pay for itself." Subsidies from donors and government are scarce and
uncertain, and so to reach large numbers of poor people, microfinance must pay for
itself.
4. Microfinance means building permanent local institutions.
5. Microfinance also means integrating the financial needs of poor people into a country's
mainstream financial system.
6. "The job of government is to enable financial services, not to provide them."
7. "Donor funds should complement private capital, not compete with it."
8. "The key bottleneck is the shortage of strong institutions and managers." Donors should
focus on capacity building.
9. Interest rate ceilings hurt poor people by preventing microfinance institutions from
covering their costs, which chokes off the supply of credit.
10. Microfinance institutions should measure and disclose their performance – both
financially and socially.
Microfinance is clearly distinguishable from charity. Families who are destitute, or so poor they
are unlikely to be able to generate the cash flow required to repay a loan, should be recipients of
charity. Others are best served by financial institutions.

DEBATES AT THE BOUNDARIES

There are several key debates at the boundaries of microfinance.

Practitioners and donors from the charitable side of microfinance frequently argue for restricting
microcredit to loans for productive purposes–such as to start or expand a microenterprise. Those
from the private-sector side respond that because money is fungible, such a restriction is
impossible to enforce, and that in any case it should not be up to rich people to determine how
poor people use their money.

Perhaps influenced by traditional Western views about usury, the role of the traditional
moneylender has been subject to much criticism, especially in the early stages of modern
microfinance. As more poor people gained access to loans from microcredit institutions however,
it became apparent that the services of moneylenders continued to be valued. Borrowers were
prepared to pay very high interest rates for services like quick loan
disbursement, confidentiality and flexible repayment schedules. They did not always see lower
interest rates as adequate compensation for the costs of attending meetings, attending training
courses to qualify for disbursements or making monthly collateral contributions. They also found
it distasteful to be forced to pretend they were borrowing to start a business, when they were
often borrowing for other reasons (such as paying for school fees, dealing with health costs or
securing the family food supply).[10] The more recent focus on inclusive financial systems (see
section below) affords moneylenders more legitimacy, arguing in favour of regulation and efforts
to increase competition between them to expand the options available to poor people.

Modern microfinance emerged in the 1970s with a strong orientation towards private-sector
solutions. This resulted from evidence that state-owned agricultural development banks in
developing countries had been a monumental failure, actually undermining the development
goals they were intended to serve (see the compilation edited by Adams, Graham & Von
Pischke). Nevertheless public officials in many countries hold a different view, and continue to
intervene in microfinance markets.
There has been a long-standing debate over the sharpness of the trade-off between 'outreach' (the
ability of a microfinance institution to reach poorer and more remote people) and its
'sustainability' (its ability to cover its operating costs—and possibly also its costs of serving new
clients—from its operating revenues). Although it is generally agreed that microfinance
practitioners should seek to balance these goals to some extent, there are a wide variety of
strategies, ranging from the minimalist profit-orientation of Banco Sol in Bolivia to the highly
integrated not-for-profit orientation of BRAC in Bangladesh. This is true not only for individual
institutions, but also for governments engaged in developing national microfinance systems.

Microfinance experts generally agree that women should be the primary focus of service
delivery. Evidence shows that they are less likely to default on their loans than men. Industry
data from 2006 for 704 MFIs reaching 52 million borrowers includes MFIs using the solidarity
lending methodology (99.3% female clients) and MFIs using individual lending (51% female
clients). The delinquency rate for solidarity lending was 0.9% after 30 days (individual
lending—3.1%), while 0.3% of loans were written off (individual lending—0.9%). Because
operating margins become tighter the smaller the loans delivered, many MFIs consider the risk
of lending to men to be too high. This focus on women is questioned sometimes, however. A
recent study of microenterpreneurs from Sri Lanka published by the World Bank found that the
return on capital for male-owned businesses (half of the sample) averaged 11%, whereas the
return for women-owned businesses was 0% or slightly negative.

Microfinancial services are needed everywhere, including the developed world. However, in
developed economies intense competition within the financial sector, combined with a diverse
mix of different types of financial institutions with different missions, ensures that most people
have access to some financial services. Efforts to transfer microfinance innovations such
assolidarity lending from developing countries to developed ones have met with little success.

FINANCIAL NEEDS OF POOR PEOPLE

FINANCIAL NEEDS AND FINANCIAL SERVICES.

In developing economies and particularly in the rural areas, many activities that would be
classified in the developed world as financial are not monetized: that is, money is not used to
carry them out. Almost by definition, poor people have very little money. But circumstances
often arise in their lives in which they need money or the things money can buy.

In Stuart Rutherford’s recent book The Poor and Their Money, he cites several types of needs:

Lifecycle Needs: such as weddings, funerals, childbirth, education, homebuilding,

widowhood, old age.

Personal Emergencies: such as sickness, injury, unemployment, theft, harassment or death.

Disasters: such as fires, floods, cyclones and man-made events like war or bulldozing of
dwellings.

Investment Opportunities: expanding a business, buying land or equipment, improving
housing, securing a job (which often requires paying a large bribe), etc.

Poor people find creative and often collaborative ways to meet these needs, primarily through
creating and exchanging different forms of non-cash value. Common substitutes for cash vary
from country to country but typically include livestock, grains, jewellery and precious metals.

As Marguerite Robinson describes in The Microfinance Revolution, the 1980s demonstrated that
"microfinance could provide large-scale outreach profitably," and in the 1990s, "microfinance
began to develop as an industry" (2001, p. 54). In the 2000s, the microfinance industry's
objective is to satisfy the unmet demand on a much larger scale, and to play a role in reducing
poverty. While much progress has been made in developing a viable, commercial microfinance
sector in the last few decades, several issues remain that need to be addressed before the industry
will be able to satisfy massive worldwide demand. The obstacles or challenges to building a
sound commercial microfinance industry include:

Inappropriate donor subsidies

Poor regulation and supervision of deposit-taking MFIs

Few MFIs that meet the needs for savings, remittances or insurance

Limited management capacity in MFIs

Institutional inefficiencies

Need for more dissemination and adoption of rural, agricultural microfinance methodologies
WAYS IN WHICH POOR PEOPLE MANAGE THEIR MONEY

Rutherford argues that the basic problem poor people as money managers face is to gather a
'usefully large' amount of money. Building a new home may involve saving and protecting
diverse building materials for years until enough are available to proceed with construction.
Children’s schooling may be funded by buying chickens and raising them for sale as needed for
expenses, uniforms, bribes, etc. Because all the value is accumulated before it is needed, this
money management strategy is referred to as 'saving up'.

Often people don't have enough money when they face a need, so they borrow. A poor family
might borrow from relatives to buy land, from a moneylender to buy rice, or from a microfinance
institution to buy a sewing machine. Since these loans must be repaid by saving after the cost is
incurred, Rutherford calls this 'saving down'. Rutherford's point is that microcredit is addressing
only half the problem, and arguably the less important half: poor people borrow to help them
save and accumulate assets. Microcredit institutions should fund their loans through savings
accounts that help poor people manage their myriad risks.

Most needs are met through mix of saving and credit. A benchmark impact assessment
ofGrameen Bank and two other large microfinance institutions in Bangladesh found that for
every $1 they were lending to clients to finance rural non-farm micro-enterprise, about $2.50
came from other sources, mostly their clients' savings. This parallels the experience in the West,
in which family businesses are funded mostly from savings, especially during start-up.

Recent studies have also shown that informal methods of saving are unsafe. For example a study
by Wright and Mutesasira in Uganda concluded that "those with no option but to save in the
informal sector are almost bound to lose some money – probably around one quarter of what
they save there."

The work of Rutherford, Wright and others has caused practitioners to reconsider a key aspect of
the microcredit paradigm: that poor people get out of poverty by borrowing, building
microenterprises and increasing their income. The new paradigm places more attention on the
efforts of poor people to reduce their many vulnerabilities by keeping more of what they earn
and building up their assets. While they need loans, they may find it as useful to borrow for
consumption as for microenterprise. A safe, flexible place to save money and withdraw it when
needed is also essential for managing household and family risk.
CURRENT SCALE OF MICROFINANCE OPERATIONS

No systematic effort to map the distribution of microfinance has yet been undertaken. A useful
recent benchmark was established by an analysis of 'alternative financial institutions' in the
developing world in 2004. The authors counted approximately 665 million client accounts at
over 3,000 institutions that are serving people who are poorer than those served by the
commercial banks. Of these accounts, 120 million were with institutions normally understood to
practice microfinance. Reflecting the diverse historical roots of the movement, however, they
also included postal savings banks (318 million accounts), state agricultural
and development banks (172 million accounts), financial cooperatives and credit unions (35
million accounts) and specialized rural banks (19 million accounts).

Regionally the highest concentration of these accounts was in India (188 million accounts
representing 18% of the total national population). The lowest concentrations were in Latin
American and the Caribbean (14 million accounts representing 3% of the total population)
and Africa (27 million accounts representing 4% of the total population). Considering that most
bank clients in the developed world need several active accounts to keep their affairs in order,
these figures indicate that the task the microfinance movement has set for itself is still very far
from finished.

By type of service "savings accounts in alternative finance institutions outnumber loans by about
four to one. This is a worldwide pattern that does not vary much by region."

An important source of detailed data on selected microfinance institutions is the MicroBanking

Bulletin. At the end of 2006 it was tracking 704 MFIs that were serving 52 million borrowers
($23.3 billion in outstanding loans) and 56 million savers ($15.4 billion in deposits). Of these
clients, 70% were in Asia, 20% in Latin America and the balance in the rest of the world.

As yet there are no studies that indicate the scale or distribution of 'informal' microfinance
organizations like ROSCA's and informal associations that help people manage costs like
weddings, funerals and sickness. Numerous case studies have been published however,
indicating that these organizations, which are generally designed and managed by poor people
themselves with little outside help, operate in most countries in the developing world.
Help can come in the form of more and better qualified staff, thus higher education is needed for
microfinance institutions. This has begun in some universities, as Oliver Schmidt describes.Mind
the management gap

"INCLUSIVE FINANCIAL SYSTEMS"

The microcredit era that began in the 1970s has lost its momentum, to be replaced by a 'financial
systems' approach. While microcredit achieved a great deal, especially in urban and near-urban
areas and with entrepreneurial families, its progress in delivering financial services in less
densely populated rural areas has been slow.

The new financial systems approach pragmatically acknowledges the richness of centuries of
microfinance history and the immense diversity of institutions serving poor people in developing
world today. It is also rooted in an increasing awareness of diversity of the financial service
needs of the world’s poorest people, and the diverse settings in which they live and work.

Brigit Helms in her book 'Access for All: Building Inclusive Financial Systems', distinguishes
between four general categories of microfinance providers, and argues for a pro-active strategy
of engagement with all of them to help them achieve the goals of the microfinance movement.

INFORMAL FINANCIAL SERVICE PROVIDERS

These include moneylenders, pawnbrokers, savings collectors, money-guards,
ROSCAs, ASCAs and input supply shops. Because they know each other well and live in the
same community, they understand each other’s financial circumstances and can offer very
flexible, convenient and fast services. These services can also be costly and the choice of
financial products limited and very short-term. Informal services that involve savings are also
risky; many people lose their money.
MEMBER-OWNED ORGANIZATIONS
These include self-help groups, credit unions, and a variety of hybrid organizations like 'financial
service associations' and CVECAs. Like their informal cousins, they are generally small and
local, which means they have access to good knowledge about each others' financial
circumstances and can offer convenience and flexibility. Since they are managed by poor people,
their costs of operation are low. However, these providers may have little financial skill and can
run into trouble when the economy turns down or their operations become too complex. Unless
they are effectively regulated and supervised, they can be 'captured' by one or two influential
leaders, and the members can lose their money.

NGOs
The Microcredit Summit Campaign counted 3,316 of these MFIs and NGOs lending to about
133 million clients by the end of 2006. Led by Grameen
bank and BRAC inBangladesh, Prodem in Bolivia, and FINCA International, headquartered in
Washington, DC, these NGOs have spread around the developing world in the past three
decades; others, like the Gamelan Council, address larger regions. They have proven very
innovative, pioneering banking techniques like solidarity lending, village banking and mobile
banking that have overcome barriers to serving poor populations. However, with boards that
don’t necessarily represent either their capital or their customers, their governance structures can
be fragile, and they can become overly dependent on external donors.
FORMAL FINANCIAL INSTITUTIONS
In addition to commercial banks, these include state banks, agricultural development banks,
savings banks, rural banks and non-bank financial institutions. They are regulated and
supervised, offer a wider range of financial services, and control a branch network that can
extend across the country and internationally. However, they have proved reluctant to adopt
social missions, and due to their high costs of operation, often can't deliver services to poor or
remote populations. The increasing use of alternative data in credit scoring, such as trade
credit is increasing commercial banks' interest in microfinance.

With appropriate regulation and supervision, each of these institutional types can bring leverage
to solving the microfinance problem. For example, efforts are being made to link self-help
groups to commercial banks, to network member-owned organizations together to achieve
economies of scale and scope, and to support efforts by commercial banks to 'down-scale' by
integrating mobile banking and e-payment technologies into their extensive branch networks.

MICROCREDIT AND THE WEB

Due to slow progress in developing quality savings services for poor people, peer-to-
peer platforms have developed to expand microlending through individual lenders in the
developed world. The volume channeled through Kiva's peer-to-peer platform is about $87
million as of August 2009 (Kiva facilitates approximately $5M in loans each month). In
comparison, the needs for microcredit are estimated about 250 bn USD as of end 2006.

Most experts agree that these funds must be sourced locally in countries that are originating
microcredit, to reduce transaction costs and exchange rate risks.

There have been problems with disclosure on peer-to-peer sites, with some reporting interest
rates of borrowers using the flat rate methodology instead of the familiar banking Annual
Percentage Rate.[26]. The use of flat rates, which has been outlawed among regulated financial
institutions in developed countries, can confuse individual lenders into believing their borrower
is paying a lower interest rate than, in fact, they are.

EVIDENCE FOR REDUCING POVERTY

Some proponents of microfinance have asserted, without offering credible evidence, that
microfinance has the power to single-handedly defeat poverty. This assertion has been the source
of considerable criticism. In addition, research on the actual effectiveness of microfinance as a
tool for economic development remains slim, in part owing to the difficulty in monitoring and
measuring this impact. At the 2008 Innovations for Poverty Action/Financial Access
Initiative Microfinance Research conference, economist Jonathan Morduch of New York
University noted there are only one or two methodologically sound studies of microfinance's
impact.

The BBC Business Weekly program reported that much of the supposed benefits associated with
microfinance, are perhaps not as compelling as once thought. In a radio interview with
Professor Dean Karlan of Yale University, a point was raised concerning a comparison between
two groups: one African, financed through microcredit and one control group in the Philippines.
The results of this study suggest that many of the benefits from microcredit are in fact loaned to
people with existing business, and not to those seeking to establish new businesses. Many of
those receiving microcredit also used the loans to supplement the family income. The income
that went up in business was true only for men, and not for women. This is striking because one
of the supposed major beneficiaries of microfinance is supposed to be targeted at women.
Professor Karlan's conclusion was that whilst microcredit is not necessarily bad and can generate
some positive benefits, despite some lenders charging interest rates between 40-60%, it isn't the
panacea that it is purported to be. He advocates rather than focusing strictly on microcredit, also
giving citizens in poor countries access to rudimentary and cheap savings accounts.

Sociologist Jon Westover found that much of the evidence on the effectiveness of microfinance
for alleviating poverty is based in anecdotal reports or case studies. He initially found over 100
articles on the subject, but included only the 6 which used enough quantitative data to be
representative, and none of which employed rigorous methods such as randomized control trials
similar to those reported by Innovations for Poverty Action and the M.I.T. Jameel Poverty
Action Lab. One of these studies found that microfinance reduced poverty. Two others were
unable to conclude that microfinance reduced poverty, although they attributed some positive
effects to the program. Other studies concluded similarly, with surveys finding that a majority of
participants feel better about finances with some feeling worse.

MICROFINANCE AND SOCIAL INTERVENTIONS

There are currently a few social interventions that have been combined with micro financing to
increase awareness of HIV/AIDS. Such interventions like the "Intervention with Microfinance
for AIDS and Gender Equity" (IMAGE) which incorporates microfinancing with "The Sisters-
for-Life" program a participatory program that educates on different gender roles, gender-based
violence, and HIV/AIDS infections to strengthen the communication skills and leadership of
women [32] "The Sisters-for-Life" program has two phases where phase one consists of ten one-
hour training programs with a facilitator with phase two consisting of identifying a leader
amongst the group, train them further, and allow them to implement an Action Plan to their
respective centres.

Microfinance has also been combined with business education and with other packages of health
interventions. A project undertaken in Peru by Innovations for Poverty Action found that those
borrowers randomly selected to receive financial training as part of their borrowing group
meetings had higher profits, although there was not a reduction in "the proportion who reported
having problems in their business".

OTHER CRITICISMS
There has also been much criticism of the high interest rates charged to borrowers. The real
average portfolio yield cited by the a sample of 704 microfinance institutions that voluntarily
submitted reports to the MicroBanking Bulletin in 2006 was 22.3% annually. However, annual
rates charged to clients are higher, as they also include local inflation and the bad debt expenses
of the microfinance institution.[35] Muhammad Yunus has recently made much of this point, and
in his latest book argues that microfinance institutions that charge more than 15% above their
long-term operating costs should face penalties.

The role of donors has also been questioned. The Consultative Group to Assist the Poor (CGAP)
recently commented that "a large proportion of the money they spend is not effective, either
because it gets hung up in unsuccessful and often complicated funding mechanisms (for
example, a government apex facility), or it goes to partners that are not held accountable for
performance. In some cases, poorly conceived programs have retarded the development of
inclusive financial systems by distorting markets and displacing domestic commercial initiatives
with cheap or free money."

There has also been criticism of microlenders for not taking more responsibility for the working
conditions of poor households, particularly when borrowers become quasi-wage labourers,
selling crafts or agricultural produce through an organization controlled by the MFI. The desire
of MFIs to help their borrower diversify and increase their incomes has sparked this type of
relationship in several countries, most notably Bangladesh, where hundreds of thousands of
borrowers effectively work as wage labourers for the marketing subsidiaries of Grameen Bank or
BRAC. Critics maintain that there are few if any rules or standards in these cases governing
working hours, holidays, working conditions, safety or child labour, and few inspection regimes
to correct abuses. Some of these concerns have been taken up by unions and socially responsible
investment advocates. Microfinance in India started in the early 1980s with small efforts at
forming informal self-help groups (SHG) to provide access to much-needed savings and credit
services. From this small beginning, the microfinance sector has grown significantly in the past
decades. National bodies like the Small Industries Development Bank of India (SIDBI) and the
National Bank for Agriculture and Rural Development (NABARD) are devoting significant time
and financial resources to Experiences, Options, and Future

UNDERSTANDING MICROFINANCE
Robinson (2001) defines microfinance as “small-scale financial services—primarily credit and
savings—provided to people who farm, fish or herd” and adds that it “refers to all types of
financial services provided to low-income households and enterprises.”

In India, microfinance is generally understood but not clearly defined. For instance, if an SHG
gives a loan for an economic activity, it is seen as microfinance. But if a commercial bank gives
a similar loan, it is unlikely that it would be treated as microfinance. In the Indian context there
are some value attributes of microfinance:

1: Microfinance is an activity undertaken by the alternate sector (NGOs). Therefore, a loan

given by a market intermediary to a small borrower is not seen as microfinance. However when
an NGO gives a similar loan it is treated as microfinance. It is assumed that microfinance is
given with a laudable intention and has institutional and non-exploitative connotations.
Therefore, we define microfinance not by form but by the intent of the lender.

2. Second, microfinance is something done predominantly with the poor. Banks usually do not
qualify to be MFOs because they do not predominantly cater to the poor. However, there is
ambivalence about the regional rural banks (RRBs) and the new local area banks (LABs).

3. Third, microfinance grows out of developmental roots. This can be termed the “alternative
commercial sector.” MFOs classified under this head are promoted by the alternative sector and
target the poor. However these MFOs need not necessarily be developmental in incorporation.
There are MFOs that are offshoots of NGOs and are run commercially. There are commercial
MFOs promoted by people who have developmental credentials. We do not find commercial
organizations having “microfinance business.”

4. Last, the Reserve Bank of India (RBI) has defined microfinance by specifying criteria for
exempting MFOs from its registration guidelines. This definition is limited to not-for-profit
companies and only two MFOs in India qualify to be classified as microfinance companies.
Microfinance in India
NGOs in India perform a range of developmental activities; microfinance usually is a sub-
component. Some of these NGOs organize groups and link them to an existing provider of
financial services. In some cases NGOs have a “revolving fund” that is used for lending. But in
either of these cases, microfinance is not a core activity for these NGOs. An example is the Aga
Khan Rural Support Programme India (AKRSP-I). For AKRSP-I, the microfinance component is
incidental to its work in natural resource management.
Examples like MYRADA and the Self-Employed Women’s Association (SEWA) fall in the
same category. However, as their microfinance portfolios grew, both organizations decided to
form separate entities for microfinance. MYRADA set up an MFO called Sanghamitra Rural
Financial Services (SRFS), while SEWA
set up the SEWA Cooperative Bank. At the next level, we find NGOs helping the poor in
economic activities. Their purpose is developmental. They see microfinance as an activity that
feeds into economic activities. For instance, the South Indian Federation of Fishermen’s
Societies (SIFFS) started as a support organization for fishermen, providing technical and
marketing support. It then arranged for loans to its members throughbanks. When the
arrangement was not effective, it started providing loans itself. At the third level, we have
organizations with microfinance at the core. They have developmental roots, but are diverse in
their operational details, orientation, and form of incorporation. This paper focuses on
organizations that have microfinance at the core. It also examines NGOs that have created new
MFOs to deal with the specialized function of microfinance. It deals with issues of
transformation of these organizations, moving from a developmental root to a commercial
sprout.
ISSUES THAT TRIGGER TRANSFORMATION
We examine five significant issues that trigger the transformation of NGOs into MFOs.

SIZE
The most significant issue that triggers a transformation is growth. This affects the promoters as
well as the providers of microfinance. With organizations like MYRADA and SIFFS that
promoted credit groups, banks were unwilling to provide loans at the pace at which microfinance
customers needed them. It was not easy for
MYRADA or SIFFS to deal with the attitudes of people manning these organizations. In several
instances it was an enthusiastic bank manager who made the difference; but this was not
institutionalized. In such situations, NGOs tend to get into action by opening a microfinance
division or by setting up a separate MFO. The origins of several Indian MFOs are rooted in the
failure of banks to meet the needs of the poor.
DIVERSITY
Another trigger for transformation is the diversity of financial services that an MFO wants to
offer. In most cases, NGOs start with credit but soon realize the need to provide other support
services. While MFOs have reduced their own lending risks through group guarantees and
addressed the issue of willful default, they have not been able to grapple with the situation where
the underlying economic activity fails and the borrower faces a genuine problem. This can be
tackled with a combination of savings and risk mitigation products. But, MFOs realize that the
NGO format is not suited carrying out these activities, owing to stringent regulations. They
necessarily have to look at transformation options.

SUSTAINABILITY
Sustainability is closely linked to growth. Beyond a certain level, MFOs have to seek external
funds for keeping the credit activity going. When MFOs seek funds from financial institutions,
issues like ownership structure and capital adequacy become critical. For an MFO to survive in
the long run, it has to transform itself into an institution with transparent systems and
accountability. In most cases the promoters of MFOs do not have sufficient capital to invest and
therefore the main constraint is that they are dealing with “other people’s money.” NGOs have
no clear-cut ownership structure, and making people liable under this format is a problem. If they
wish to be sustainable, the only option is to deal with mainstream institutions.
FOCUS
NGOs need to maintain focus on their original mandate. Undertaking microfinance is transaction
intensive and requires distinct orientation and skills. For NGOs, there is always a conflict
between microfinance, which earns returns and is therefore “commercial,” and other activities
that are “developmental.” This is one reason for NGOs to spin off their microfinance activities.
The entity that emerges to carry out microfinance should be
understood by the mainstream and therefore it should have an appropriate institutional form.
TAXATION
When an NGO carries out commercial activities (microfinance) on a large scale, it could lose its
“tax free” status, and this might jeopardize other activities. Even grants may become taxable.
This is a major concern for NGO-MFOs. This also triggers a search for an alternative where
microfinance could be kept isolated.

TRANSFORMATION OF INSTITUTIONS
The transformation process in India is still at a nascent stage. Microfinance has not grown to the
size that warrants a full-scale study on the transformation processes. There are a large number of
small initiatives being carried out at various places. . The number of public societies and trusts is
likely to be an underestimate, whereas the figures for other forms are more realistic. The
transformation options under each regulatory category.
OPTION 1: IN GOOD COMPANY
If we treat setting up “for-profit companies” to mean transformation, not much has happened in
the field. We examine a few examples of transformation from the limited experiences that the
Indian microfinance sector has had. Let us look at instances of MFOs that have registered as
NBFCs. Here, there are two approaches: one taken by Share and Cashpor Financial and
Technical Services (CFTS), and the other by BASIX.
Share and CFTS are similar in orientation and focus. Both are inspired by Grameen and focus on
reaching the poorest. Share operated as a public society for a long time before setting up a
NBFC. CFTS started as an NBFC and is still trying to grapple with the norms applicable to
NBFCs. When Share set up an NBFC, it transferred a portion of grants received from C-Gap to
poor customers and encouraged them to reinvest those grants as equity in the new NBFC. This
ensured adequate capital for Share to start an NBFC. This was similar to the Bolivian approach.
However, an important difference is that it was possible for the Bolivian NGO to invest in an
FFP (a similar arrangement was with K-Rep, Kenya). In the case of Share, it had to transfer all
the clients to a new legal entity, slowly and gradually winding down the operations in the NGO
and transferring the clients to the NBFC branch by branch (Sriram, 2001). This posed some
problems for Share. First, being governed by the prudential norms.An NBFC is prohibited from
accepting savings till it gets an investment grade rating. Even if Share gets the rating, its
flexibility of offering savings services to clients will be very restricted. Share found an
innovative solution where it also promoted a cooperative (Share India MACS) to collect savings.
This cooperative in turn would lend to the NBFC. But this has limitations, as both entities are
incorporated under different laws and have different governance structures.
In the case of CFTS, the incorporation itself was a process of transformation. Cashpor is an NGO
operating in multiple countries. When CFTS set up its operations in India, it was registered as a
company. However, unlike Share it did not have prior operations in India as an NGO. It was,
therefore, difficult to raise the start-up capital. Local laws make it difficult for small international
investments to come in the form of equity in the financial sector. For a long time, CFTS did not
have adequate domestic capital to be registered as an NBFC. CFTS had to go through the process
of raising capital, by finding donor money that could go to the clients and then be re-invested in
the company to reach a size that gained economies of scale and recognition. The Activists for
Social Alternatives is another organization that follows the Grameen model and is trying to
transform itself as a company. It is attempting an innovative route of forming private mutual
benefit trusts of clients. The trusts would seek donor grants and in turn hold equity in the NBFC.
However, the scheme has yet to take a concrete shape.
The path followed by BASIX was different. BASIX had a design that looked at mainstreaming
microfinance right from inception. The structuring of BASIX was complicated. BASIX sought a
mix of developmental and commercial funding for its operations and had a separate vehicle
through which the operating entity was adequately capitalized. This involved setting up a holding
company that had large external borrowings from donor organizations. The holding company
was heavily leveraged. As the formality of getting clearances for setting up an NBFC was going
on, BASIX carried on its operations for a year through an existing NGO-Indian Grameen
Services. BASIX represents a mix of developmental capital flowing in on the promise of
sustainability and commercial capital flowing in from the developmental windows of large
financial institutions. While Share and BASIX have similar institutional investors, the
shareholding in BASIX is not spread as widely as in Share. The laws have become more
stringent since BASIX was established and it is now impossible to replicate that model of
financing. All three institutions have faced barriers in incorporation and
operation. The major constraints pertain to regulations, as listed below:
• Steep entry norms to register NBFCs. If the promoters have a development background, it is
difficult for them to raise commercial capital to start an NBFC. Routing donor money into
commercial organizations is not easy, though BASIX did it with a lot of innovative thinking.
• Restrictions placed on the type of activity that can be undertaken by these companies—
especially on accepting savings from clients and on the financial services that can be provided.
• Restrictions on accessing finance from outside the country.
These restrictions mostly take the form of requiring clearances and permissions, and they have
eased over time. However matters get complicated if domestically raised capital is insufficient.
OPTION 2: LET US COOPERATE
As debates continue in the microfinance world on issues of mainstreaming, initial capital norms,
and incorporation, there is silent revolution in parts of Andhra Pradesh, particularly in the
districts of Karimnagar and Warangal. There are nearly 250 small thrift cooperatives, each with
an average membership of around 500, carrying on successfully and offering all the services
offered by MFOs for more than a decade. While there are a good number of women’s
cooperatives, there have been an equally large number of men’s cooperatives, all promoted by
CDF. The microfinance world usually does not recognize traditional banking or credit union
movement as “microfinance,” unless it has adopted some of the symbolisms. Even by that note,
these thriftcooperatives qualify to be called MFOs. About a decade ago, CDF was working
exclusively with agricultural finance cooperatives. State interference in cooperatives was one of
the major problems. The interference culminated in the nation-wide loan pardon scheme of 1989,
resulting in the impairment of the portfolio of many a cooperative. At that point CDF thought it
was time to spin off the thrift and credit activity out of the cooperative fold and actively started
promoting informal mutual benefit groups. Simultaneously, CDF also lobbied for a change in
legislation, seeking greater autonomy for cooperatives in the state. This culminated in the
Mutually Aided Co-operative Societies (MACS) Act. This act gives ample autonomy for
cooperatives, provided they do not seek state funding. After the legislation was passed, the
mutual benefit groups promoted by CDF were registered under the new act. Simultaneously
other NGOs encouraged their groups to be formally registered as MACS.The transformation of
small groups to cooperatives has been painless. The advantage of a cooperative is that it can
access various types of savings from its members besides providing credit like other MFOs. It
can also easily get its stakeholders in the governance structure by the use of democratic
processes. Besides, cooperatives can grow organically by setting up federations as and when they
have a need to wield clout and negotiate on matters of policy. However, until now, the
federations have played a limited role in the context of CDF cooperatives. One major drawback
of cooperatives is the geographic limitation. State and not federal legislation governs
cooperation, and even within that, usually the area of operations of a cooperative is demarcated.
Cooperatives also experience problems in accessing mainstream finance, because of their poor
image. Nevertheless, they seem to be a good mechanism to get the informal groups into a formal
incorporation when the groups reach the limit of size. But it is also important to note that no
single cooperative has grown big enough to cross Rs. 10 million in outstanding loans. The
success of the new generation of cooperatives is limited to Andhra Pradesh, even though other
states have passed similar legislation. The only exception to this is the SEWA Cooperative Bank
based in Ahmedabad. SEWA Bank is increasingly being recognized as one of the oldest MFOs
in India—having been in existence for over 25 years. While there have been several urban
cooperative banks across the country, none is recognized as an MFO. SEWA Bank did not go
through the pains of transformation, because the moment its parent, SEWA, decided that the
poor women of Ahmedabad needed a financial service institution of their own, SEWA lost no
time in promoting a women’s bank independent of the NGO. SEWA proves the point that if the
client group and geographical focus exist, there is no need to go through the painful process of
starting as an NGO and moving towards mainstream. However, under current norms, an urban
cooperative bank can only be set up with a start-up capital of Rs. 5 million .Though this is less
than the amount needed for setting up a commercial bank, it is still a steep amount if it were to
be contributed by poor women to run as a self-governed institution.
OPTION 3: BANKING ON INNOVATION
The third alternative is setting up a local area bank (LAB). We have only one instance that can
be classified as “microfinance”—the case of BASIX. The setting up of this bank was not a
transformation but was part of the design of the BASIX group. BASIX started the Krishna
Bhima Samruddhi LAB (KBSLAB) in 2001 and is the only instance of how microfinance
principles can be adopted by the banking sector. The entry norms for LABs are more stringent
than for NBFCs. While NBFCs are expected to bring in a start-up initial capital of Rs. 50
million. There are further restrictions on LABs—they can only operate in a geographical area
limited to three contiguous districts. Every branch of the LAB has to be opened with the
permission and license of the Reserve Bank of India (RBI). This is stifling. While there is
tremendous flexibility in launching savings products, it comes with inflexibility in expansion and
growth. Recently, RBI has decided not to issue further LAB licenses (Business Line, 2003).
Other possibilities include RRBs contributing for the promotion of microfinance and setting up
cooperative banks. Some RRBs are doing an excellent job of linking SHGs and thereby bringing
them to the mainstream banking sector. Harper (2002) has studied the case of a commercial bank
active in microfinance. If commercial banks and RRBs do adopt some microfinance methods, it
is possible to replicate the Indonesian experience in India. The other area where microfinance
could happen is in the cooperative banking sector. Cooperative banks in India have lower entry
norms compared to mainstream banks and LABs . SEWA Bank is one example of how an NGO
promoted a cooperative bank to offer an array of services. However, we do not have many other
examples. A possible reason for the banking option not gaining popularity is the urban focus.
While there are several cooperative societies in rural areas, banking has been restricted to the
urban sector. However, recently there have been a series of bankruptcies in urban cooperative
banking and therefore it is likely that there might be regulatory tightening.

TRANSFORMATION OPTIONS AND THEIR IMPLICATIONS

If we consider the view taken by Robinson (2001) on what should be treated as MFOs, we will
address the issue head on. She has classified the institutions that are “expected” to operate in the
microfinance realm under the following categories:
• Institutions that provide microcredit but are not permitted to mobilize savings from the public
(most institutions that are not regulated and publicly supervised)
• Institutions that do well in lending but poorly in mobilizing savings (such as Bangladesh’s
Grameen Bank)
• Institutions that do well in savings but poorly in lending (India’s RRB and China’s Rural Credit
cooperatives)
• Institutions that fail in both (most microfinance institutions that provide subsidized credit are
permitted to raise public savings, particularly state-owned banks).
Considering this view, microfinance could happen not only by the transformation of small NGOs
into bigger institutions, but also by the transformation of larger financial institutions embracing
the microfinance methodology and microfinance clients. In brief, we do not have an optimal
route for the transformation of NGOs into mainstream MFOs. NBFCs that could operate across
the country will have to go through a steep entry hurdle and registration process. LABs have a
double disadvantage of steep entry norms and limited operational area. This option is also not
available with the recent decision of RBI. With the concerns that most MFOs have for
community involvement and with the existing legislation in India, the obvious choice for
microfinance initiatives is a cooperative. This involves the clients in governance because of its
democratic nature. Even though cooperatives seem to be an obvious alternative, they are not so
across the country because only a few states have passed liberal cooperative legislation. Besides,
the major disadvantage of cooperatives is their geographic limitations. Further, the cooperative
institutions, owing to historical baggage, do not make glamorous MFOs. The credit union
movement represents more of an individual banking model in India with formal systems, while
microfinance focuses on groups, social collateral, and social capital. Few cooperatives use the
microfinance methodology in providing financial services.