Collaborators

Microfinance: Possibilities & Prospects

INSTITUTE: NITIE Mumbai

Rohit Batra (+919967678896)

(batrarohit@gmail.com)

Tarun Pahwa (+919833092402)

(tarunpahwa@gmail.com)
(Team Leader)
 Executive Summary

The last two decades have witnessed a powerful opening up of the world of microfinance.
Despite the improvements in financial access, two-thirds of the world’s adults still do not have a
basic bank account. The impact is only limited to only moderate poor and extreme poor are
rarely reached by microfinance. The new vision recognizes that “access for all” can be achieved
only if financial services for the poor are integrated into all three levels of a financial system:
micro, meso, and macro. The total microfinance industry is characterized by a schism between
two camps and that has crucial implications for the future of microfinance and its impact on the
poor.

Moreover, improvements in health care, nutritional advice and education can be sustained only
when households have increased earnings and greater control over financial resources.
Financial services thus reduce poverty and its effects in multiple concrete ways.

This paper has outlined the changing global trends in the field of microfinance and showed how
access points for poor are multiplying and borders of microfinance are blurring. Commercial
microfinance holds the most promise for sustainably expanding the microfinance frontier.
Commercial MFIs will help in expanding the outreach and enhancing the access to Demand-
Driven Rural Microfinance. While some commercial MFIs have managed to overcome some
constraints, many more barriers must be overcome to significantly expand commercial
microfinance in rural areas.

Wireless technology will revolutionize the way financial institutions and other businesses offer
financial services to low-income people. This will spark the interest of domestic banks because
the costs of executing low-value transactions can be lowered substantially. Also, new
international players and foreign investment will further boost the efficiency and reduce cost.
The paper has identified the major challenges for the microfinance and also the role of
government, donors and investors in the primary goal of rural development.
“A world in which poor people everywhere enjoy permanent access to a wide range of quality
financial services, delivered by different types of institutions through a variety of convenient
mechanisms.” - Vision for inclusive financial system

Microfinance: An Introduction

To most, microfinance means providing very poor families with

very small loans (microcredit) to help them engage in productive
activities or grows their small businesses. The last two decades
have witnessed a powerful opening up of the world of
microfinance. Beginning in the early 1990s, the development
community came to realize that microcredit providers could
recover loans to poor and low-income people and cover their costs,
and thus reach large numbers of people. At that time, donors and
microfinance providers alike focused primarily on a single product
(credit) for a particular client group (micro entrepreneurs). Over
time, the notion of microcredit broadened first from microcredit
into microfinance (credit, savings, insurance, etc.) then into the
concept of building entire financial systems that serve their poor
and low-income populations—financial systems that are
“inclusive.” This new, more ambitious and complex vision has
captured the attention of governments, financial institutions, social
investors, bankers, and even some celebrities.

Despite the improvements in financial access, two-thirds of the world’s adults still do not have a
basic bank account. Access to a bank account is only one dimension of financial inclusion, but it
is an important one. A basic bank account is the entry point that allows customers to save money
outside the household, make loan or premium payments, or transfer funds within their country or
across borders. More than 80 percent of households have bank accounts in high-income
countries, compared to well below 20 percent in low-income countries. In countries like
Bangladesh or Sudan, that number hovers just above zero.
So the assessment of an impact of microfinance on life of poor
people and their standard of living is as important as providing Objectives of Microfinance:
them with micro financial services. It has been seen that - Eradicating Poverty
impact is limited to only moderate poor and those who are - Promoting children education
vulnerable non poor. As shown in the graphic, most - Improving health outcomes
- Empowering women
microfinance clients today fall in a band around the poverty - Reaching those in extreme
line. The extreme poor are rarely reached by microfinance. poverty

P
o
v
e Factors to measure impact:
r - Outreach
Destitute Extremely Moderate t Vulnerable Non Poor Wealthy - Product characteristics count
Poor Poor y Non Poor - The Assets base of clients
- Sustainability with MFI’s
L - Country context
i
n
e

The new vision for microfinance recognizes that “access for

all” can be achieved only if financial services for the poor are
integrated into all three levels of a financial system: micro,
meso, and macro. However, financial services may not be the
best and only solution for all poor people. Retail financial
institutions and other suppliers that provide services directly to
clients are the backbone of inclusive financial systems (micro
level). In addition, locally available market infrastructure is
required to reduce transactions costs, increase outreach, build
capacity, and foster transparency among retail institutions
(meso level). Finally, conducive, stable macroeconomic and
policy environments provided by the appropriate government
entities are necessary to underpin a pro-poor financial system.
“The stark reality is that most poor people in the world still lack access to sustainable financial services,
whether it is savings, credit, or insurance. The great challenge before us is to address the constraints that
exclude people from full participation in the financial sector…. Together, we can and must build inclusive
financial sectors that help people improve their lives.”
- Kofi Annan, United Nations Secretary General, 2003

The Rift between two Camps

The microfinance industry is characterized by a "schism," or

debate, between two camps that represent broadly different
approaches to microfinance: the institutionists and the
welfarists. How this debate is resolved has crucial
implications for the future of microfinance-its guiding
principles, its objectives, its clients, and its impact on the poor
and poverty in general. The institutionist approach, with its
emphasis on financial self-sufficiency and institutional scale,
appears to have gained ascendancy over the welfarist
approach, with its emphasis on direct poverty alleviation
among the very poor. The institutionists, however, base their
arguments on a number of debatable assertions and
questionable empirical methodologies.
The stated ultimate goal of both camps is poverty reduction.
Yet the objectives each camp has set for itself diverge. Each The rift between the two
has defined "poor" differently, and each has articulated reminds a quote by George
Bernard Shaw: “Great Britain
different visions of how the poor can be helped by increased
and the United States are ‘two
access to microfinance services. The practical implications of nations divided by a common
differences between the two camps are at least threefold: language’."

 Differences in the population segments served

 Differences in the designs for service delivery to these
populations.
“Estimates put the total
 Differences in the institutional structures and financing demand for microcredit at $25
to support these services bn by 2010 and $90 bn by 2025
(or 10 and 30 % respectively of
The conflict between the two camps is driven by the belief that the world's low-income
the alternative approach threatens the fulfillment of the entrepreneurs, or at between
movement's broadly shared goal-poverty reduction. 100 and 200 mn persons. By
comparison, the total micro
Institutionists believe that successful poverty reduction
lending portfolio today is
requires massive scale. But massive scale in turn requires estimated at only $2.5 bn”
massive financial resources-far beyond the ability of donors to
provide. It is from this "recognition of scarcity" that springs
the institutionists' concern for financial self-sufficiency.
Moreover, the only way to attract the requisite financial
resources is by tapping into private sources of capital. But
widespread access to private capital in turn requires that MFIs
be well run, operate efficiently, and, most important, be
profitable. Finally, to satisfy the demand for microfinance
services, and thus make a dent in poverty, it is not sufficient
that a relatively small number of MFIs tap into private capital.
It is necessary to create an entirely new financial system
consisting of a large number of privately financed, large-scale
financial intermediaries that provide services to the poor.
“The concept of microfinance is not new. Savings and credit groups that have operated for centuries include the
"susus" of Ghana, "chit funds" in India, "tandas" in Mexico, "arisan" in Indonesia, "cheetu" in Sri Lanka,
"tontines" in West Africa, and "pasanaku" in Bolivia, as well as numerous savings clubs and burial societies
found all over the world.”

Microfinance: The Journey so far

Microfinance is not a recent development, and neither is the

development of regulation and supervision of microfinance
institutions (MFIs). Every now developed country has its own
history of microfinance. It is important to recognize this because it
presents a view different from that of many in the microfinance
community who associate microfinance with credit NGOs and
believe that microfinance was invented in Bangladesh some 20-
odd years ago. Attributing the origin of microfinance to recent
initiatives misses not only the historical depth and scale of
microfinance, but also centuries of experience.

In the 1800s, various types of larger and more formal savings and
credit institutions began to emerge in Europe, organized primarily
among the rural and urban poor. These institutions were known as
People's Banks, Credit Unions, and Savings and Credit Co-operatives. In the early 1900s, various
adaptations of these models began to appear in parts of rural Latin America. The goal of such
rural finance interventions was usually defined in terms of modernizing the agricultural sector.
Between the 1950s and 1970s, governments and donors focused on providing agricultural credit
to small and marginal farmers, in hopes of raising productivity and incomes.

Meanwhile, starting in the 1970s, experimental programs in Bangladesh, Brazil, and a few other
countries extended tiny loans to groups of poor women to invest in micro-businesses. This type
of microenterprise credit was based on solidarity group lending in which every member of a
group guaranteed the repayment of all members. These "microenterprise lending" programs had
an almost exclusive focus on credit for income generating activities targeting very poor (often
women) borrowers. In 1972 the Self Employed Women's Association (SEWA) was registered as
a trade union in Gujarat (India), with the main objective of
"strengthening its members' bargaining power to improve “In 1990s the two features - high
income, employment and access to social security." In 1973, repayment and cost-recovery
interest rates - permitted some
to address their lack of access to financial services, the
MFIs to achieve long-term
members of SEWA decided to found "a bank of their own".
sustainability and reach large
Through the 1980s, the policy of targeted, subsidized rural numbers of clients. Another
credit came under a slow but increasing attack as evidence flagship of the microfinance
mounted of the disappointing performance of directed credit movement is the village banking
unit system of the Bank Rakyat
programs, especially poor loan recovery, high administrative
Indonesia (BRI), the largest
costs, agricultural development bank insolvency, and accrual microfinance institution in
of a disproportionate share of the benefits of subsidized credit developing countries. This state-
to larger farmers. owned bank serves about 22 mn
micro savers with autonomously
It was not until the mid-1990s that the term "microcredit" managed micro banks.”
began to be replaced by a new term that included not only
credit, but also savings and other financial services.
"Microfinance" emerged as the term of choice to refer to a
range of financial services to the poor, that included not only
credit, but also savings and other services such as insurance.

Practitioners and donors are increasingly focusing on “Today, the microfinance

industry and the greater
expanded financial services to the poor in frontier markets
development community share
and on the integration of microfinance in financial systems the view that permanent poverty
development. The recent introduction by some donors of the reduction requires addressing
financial systems approach in microfinance which the multiple dimensions of
poverty. For microfinance, this
emphasizes favorable policy environment and institution-
means viewing microfinance as
building - has improved the overall effectiveness of an essential element in any
microfinance interventions. But numerous challenges remain, country's financial system.”
especially in rural and agricultural finance and other frontier
markets.
“The microfinance field has come a long way based on the successes of a few microfinance institutions (MFIs) in
simultaneously expanding outreach and improving financial self-sufficiency.”

Microfinance: Global Trends

Financial Institutions for poor in all shapes and sizes: More than 800 million
accounts in “social” financial institutions and number growing at very fast rate.

Access Points are multiplying: Financial institutions are leveraging on existing

and new infrastructure to offer multiple access point to clients.

Commercial
Banks
State Banks MFI’S

Self Help
Loan Groups PC
Service Kiosks
Agents

POS
Lottery Networks
Agents

ATM’s
Trades & Clients
Processors
 The Borders of Microfinance are blurring

MFI clients access

international ATM
“The Classical MFI business model
Networks
Unregulated MFI’s
is changing. Now MFI’s have
12 Mainstream Rating
Report to National Agencies Rate MFI’s partnership with technology
Financial System
Credit Bureaus (Peru) providers, Commercial Banks,
Investors and Retail partners to
Financial Services for provide services to clients. ”
the Poor

62 Linkages between
MFI bank issues VISA
Bank and MFI’s in 36
Debit Card
countries
50 countries discussing and Today leaders in MFI segment
implementing Microfinance are making great progress.
Policies - ROE of 32.3% for financially
sustainable MFI’s.
- Avg. 25% growth in borrowers
Financing for Microfinance - Money transfers, automated
credit approval using credit
scoring.

Public Private

Intl.
Donors Private
Financial
Funds
Institutions

- Donors: US $ 500 million – 1.5 billion per annum

- Public investors (IFI’s): US $ 648 + 484 million

invested in funds.

- Private Funds (Social Investment Funds): US $

511 million

Source: CGAP-MIX-ADA Survey

“How can the international community—public and private—contribute to the greatest possible increase in
financial service access for underserved people?”

Microfinance: The Road Ahead

The main challenge faced by the microfinance field is to

increase the outreach for a significant number of underserved
micro entrepreneurs and poor households. Commercial
microfinance may hold the most promise for sustainably
expanding the microfinance frontier. Commercialization
means “the application of market-based principles to
microfinance” or “the expansion of profit-driven
microfinance operations.” The commercialization will allow
MFIs greater opportunity to fulfill their social objectives of
expanding access of the poor to an array of demand-driven
microfinance products and services on a sustainable basis.

At the micro level, MFI commercialization can be considered as progress along a continuum:

 Adoption of a professional, business-like approach to MFI administration and operation,

such as developing diversified, demand-driven microfinance products and services and
applying cost-recovery interest rates.
 Progression toward operational and financial self-sufficiency by increasing cost recovery
and efficiency, as well as expanding outreach.
 Use of commercial sources of funds; for example, non-subsidized loans from apex
organization or commercial banks, voluntary savings or investor equity.
 Operation as a for-profit, formal financial institution that is subject to prudential \
regulation and supervision and able to attract equity investment.

At the macro level, the extent of commercialization of the microfinance industry depends on
factors like the degree to which the policy environment and the legal framework are conducive to
the development of commercial MFIs, the availability and access of commercial MFIs to market-
based sources of funds, and the existence of industry support institutions.
Commercial Microfinance will expand Outreach: The key to achieving substantial levels of
outreach is building a sound financial institution essentially means that the MFI needs to charge
cost covering interest rates and continually strive for increasing operational efficiency. As an
MFI’s interest and fee revenue covers first its operating costs and then the cost of its loanable
funds, it may be considered to be increasingly operating on a commercial basis. To balance
outreach considerations with achieving financial self-sufficiency, pricing decisions are key. MFI
profitability enables expansion of operations out of retained earnings or access to market-based
sources of funds. As profitability improves, so does the ability of the institution to leverage
commercial sources of funds to achieve increasing levels of outreach. The process of
commercialization lead to increased competition as existing MFIs will expand their outreach
over time. In addition, the profitability that commercial MFIs will demonstrate will attract some
new entrants to the market.

Commercial MFIs Enhance Access to Demand-Driven Rural Microfinance (RMF): The

extent to which commercial MFIs target rural areas for market expansion depends on two main
issues: i) the degree of focus on the rural poor in a commercial MFI’s mission statement; and ii)
the extent of competitive pressures in the environment. For MFIs whose commercial missions
outweigh their social objectives, exploitation of the lowest cost, most highly profitable market
niches will naturally occur first. Some people have expressed concern that increased
commercialization will cause MFIs to drift from their missions. In fact, increasing competition in
highly populated areas can push the market frontiers in several directions including serving
harder to reach clients in more sparsely populated rural areas. Competition will bring significant
benefits to clients as MFIs become more customer-oriented and interest rates become more
attractive. Also, competition brings innovation in products, lower prices and better service.
 Using Technology to extend access

Over the next decade, the most significant technological change

that could open up access to finance for large numbers of Constraints of Commercial RMF:
excluded people is pervasive extension of wireless access, even - Unsound microeconomic policy
in poorer countries. Wireless technology revolutionizes the way - Restrictive financial policies
financial institutions and other businesses offer financial - Insufficient institutional capacity
within MFIs to achieve high level
services to low-income people. Hundreds of millions of poor
of outreach in sustainable manner.
and unbanked clients gain access to cell phones, either by - Underdeveloped legal systems.
owning their own or using someone else’s. This sparks the - Inadequate prudential regulation
interest of domestic banks because the costs of executing low- and supervision of financial
intermediaries.
value transactions can be lowered substantially. Because
- Poor governance, corruption and
international banks are capturing most of the corporate clientele, other political factors.
domestic banks turn more to retail business. They invest in
delivery systems that can reach more people at lower cost, thus
improving access for lower-income clients. In addition, they see
wireless technology as a fast and transparent way to track
transactions, making it easier, among other things, to comply
with international standards that combat money laundering and Technology is adopted mainly to
serve the easier-to-reach, wealthy
the financing of terrorism. User-friendly products, some tailored
clients and the substantial middle
for illiterate and semi-literate customers, attract many poor
class. The high fixed cost of
clients. Higher volumes and lower costs allow deeper technology infrastructure allows
penetration. Once deployed, this wireless backbone can handle large banks to push out small
huge numbers of transactions, including not only financial players. The large banks find other
opportunities more attractive than
services but also other development activities. For instance, cell
extending the lower income
phones and wireless Internet kiosks transmit basic health frontier of the retail market, which
education to poor households, market information to remote may leave most of the poor
farmers, and rainfall conditions to holders of weather insurance. outside the system and worsening
the digital divide.
Easy access to information makes it far simpler for those in
developing countries to tap into global best practices.
New International Players & Foreign Investments

Popularity
New international funders bring a fresh perspective and support
innovations and activities that traditional donors cannot easily
handle, such as the application of technology to pro-poor finance.
They bring to bear their expertise in business, technology, and
governance. Their instruments are flexible, and their approach
Foreign investment in MFIs takes
accelerates innovations that lead to hundreds of millions more
the form of:
people accessing financial services. The new entrants understand - Equity—the investor buys stock in
the idea of building, rather than bypassing, domestic funding the MFI, becomes a voting
markets. They structure investments that catalyze rather than shareholder.
- Debt—the investor makes a loan
displace domestic lenders and investors. The private donors are
to the MFI, and occasionally is
less swayed by geo-political considerations than the traditional legally subordinated to the claims
donors have been. They are not as driven by asset-booking of other lenders/depositors.
considerations as traditional social investors. They use subsidies to - Guarantees—the foreign investor
guarantees MFI borrowings from
create new IT networks and payment platforms that reduce
local banks or capital markets.
operating costs and enable new players to enter the market of
providing financial services to poor clients.
“In A Tale of Two Cities, Charles Dickens described the epoch as: ‘It was the best of times, it was the worst of
times.’ The two cities in the Dickens story were not, of course, Frankfurt, Germany and Columbus, Ohio, but the
sentiment related by Dickens may be appropriate to describe the current state of microfinance.”

Microfinance: Challenges

Four of the considerable threats to world of microfinance

are:

 systemic risks,
 increasing competition,
 improper regulation, and
 the return of the state

Microfinance programs struggle to become significant

components of formal financial systems and, with these
systems, MFOs are more vulnerable to systemic risk. New
challenges for microfinance may thus emerge from the increased worldwide volatility of
financial systems. Many MFIs may not be prepared to deal with this new source of risk. Some of
the successful MFIs have shown, however, flexibility and resilience during the recent Asian
crises. For too long, nevertheless, microfinance has ignored the threats of systemic risk.

Increasing competition may also result in threat like:

(a) The arrival of new actors, some of them operating on market terms, some of them not;
(b) The saturation of the original (probably easier) market locations; and
(c) Challenges from the aging of portfolios and the maturing of client relationships,
where established clients have begun to demand additional services, more difficult to
supply.

Inappropriate regulation may result in threat like

(a) Regulatory technologies that are not a good match for the new lending technologies;
(b) Attempts to use the regulatory framework to pursue objectives other than the
avoidance of excessive risk.
“No matter what strategy, donors and investors should complement and not crowd out the market…”

Microfinance: Roles for Government and Donor’s community

The financial systems approach focuses on the

primary goals of rural development: income
expansion and poverty reduction. It is based on the
principle that a commercial approach is most likely
to reach large numbers of clients on a sustained
basis. Governments may play an active role in
establishing a favorable or “enabling” policy
environment to facilitate the smooth functioning of
rural financial markets, but a more limited role in
direct interventions. The financial systems
approach emphasizes three strategic priorities in
rural financial market development:
 Creating a favorable policy environment,
including not only macroeconomic stability
but also reductions in historical biases against the rural sector;
 Strengthening the legal and regulatory framework, including improving the legal basis for
secured transactions and adapting licensing requirements and regulation.
 Building the capacity of commercial MFIs to deliver demand-driven credit, savings and
insurance services in a self-sustaining manner.

Accomplishing these priorities requires governments to focus on three main tasks:

i) Providing an enabling environment;
ii) Improving institutional capacity; and
iii) Supporting innovation and linkage development.

Donors and investors also play an important role in supporting the emergence and evolution of
microfinance. Donors and investors need to recognize that their role is limited to support and that
it is their partners on the ground who actually deliver financial
services. In contrast to the past, today’s donors and investors What does the future hold?
play different roles both vis-à-vis each other and with regard to - Middle income & less developed
the local private sector in countries where they work. Their markets will diverge.
- Commercials and state banks will
individual added value depends on their instruments,
become core providers.
institutional cultures and missions, risk profiles, and staffing. - Major consolidation of MFIs will
As new entrants (private foundations, investment funds, occur through buy outs by banks,
commercial banks, etc.) offer their support, donors need to mergers and partnerships.
continually reassess their position and be ready to fill the - Donors will focus on frontier
markets (very poor and rural).
gaps—such as expanding and deepening access—that the
private financial system may not automatically address. Donor
cannot necessarily work well on all three levels of a financial
system, but each intervention—whatever the level—should
Pathway for the Poorest:
promote the growth of the sector as a whole. Additionally, the
- Better targeting
role of donors at different levels depends on the stage of - More innovations
development of the larger financial system. A fundamental - Smart Subsidies
challenge faced by donors and investors is how to deploy the - Linkages with social protection
programs.
range of instruments at their disposal to best support the
- Focus on a double bottom line
emergence of inclusive financial systems.

Five core elements for Donors effectiveness:

“The future is uncertain, but the prospects suggest some insights into where we can best focus our
efforts to help make the opportunities come true and deflect the risks posed by the threats.”

Conclusion

No single intervention can defeat poverty. Poor people

need employment, schooling, and health care. Some of
the poorest require immediate income transfers or relief to
survive. Access to financial services forms a fundamental
basis on which many of the other essential interventions
depend. Moreover, improvements in health care,
nutritional advice and education can be sustained only
when households have increased earnings and greater
control over financial resources. Financial services thus
reduce poverty and its effects in multiple concrete ways.
And the beauty of microfinance is that, as programs
approach financial sustainability, they can reach far
beyond the limits of scarce donor resources. While some
commercial MFIs have managed to overcome some of the
constraints to providing rural microfinance, many more
barriers must be overcome to significantly expand
commercial microfinance in rural areas. Although the
challenges of expanding RMF provision by commercial
MFIs are formidable, they are not insurmountable. Microfinance practitioners should continue to
build on the achievements made to date by those MFIs that have had encouraging results in
developing innovative products and delivery methodologies. Continued and expanded
government and donor support of commercial MFIs will hasten the learning process and help to
achieve the goal of broadly serving the financial needs of the world’s rural poor.
 References

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Elizabeth Littlefield, Jonathan Morduch, and Syed Hashemi, January 2004.

[2] “Microfinance: Broader Achievements and New Challenges” by Claudio Gonzalez-Vega.

[3] “Expanding Commercial Microfinance in Rural Areas: Constraints and Opportunities” by

Stephanie Charitonenko and Anita Campion, 2005.

[4] “Financial Inclusion 2015: Four Scenarios for the future of Microfinance” by Elizabeth
Littlefield and Brigit Helms, October 2006.

[5] “Good practice guidelines for funders of Microfinance” by CGAP, October 2006, 2nd
Edition.

[6] “Global trends in Microfinance” by Syed M Hashemi, University of Southern California,

April 2006.

[7] “Core Performance Indicators for Microfinance” by Richard Rosenberg, April 2005.

[8] “Helping to Improve Donor Effectiveness in Microfinance” by CGAP, July 2003.

[9] “Beyond good intentions: Measuring the Social Performance of Microfinance Institutions”
by Syed Hashemi, May 2007.

[10] “The market for foreign investment in Microfinance: Opportunities and Challenges” by
Gautam Ivatury and Julie Abrams, August 2005.