What is... | October 7, 2014

What is microfinance?

Microfinance is a way of providing financial services to people on low incomes who don’t have access to mainstream banks. But the concept is not without controversy.

Pioneered in the 1970s and 1980s, microfinance is credited with benefiting borrowers, reducing poverty and creating a feel-good factor for society as an alternative way for lenders to support causes they believe in.
While some studies indicate it can battle poverty, others argue that on occasion interest rates on loans take advantage and that over-lending can lead borrowers to take on more debt than they can afford to pay off.

Reversed conventional banking wisdom
The pioneer of modern microfinance is widely considered to be Nobel Peace Prize recipient Muhammad Yunus and his Grameen Bank, which, as UNESCO writes, “reversed the conventional banking wisdom” by basing loan agreements in Bangladesh on trust, supervision, accountability and other factors rather than collateral.
Then head of rural economics at the University of Chittagong, Yunus aimed to extend banking to the poor and eliminate exploitation by money lenders. Yunus’ scheme offered small loans to people previously deemed too poor or insufficiently creditworthy to qualify for traditional bank loans. UNESCO writes that Grameen Bank’s growth is large and has successfully helped “a substantial number” of clients overcome poverty.
The movement gained so much support that 2005 was dubbed the International Year of Microcredit by the United Nations.

Too commercialised?
However, Yunus detailed in a column for the New York Times in 2011 how commercialisation saw microfinance “give rise to its own breed of loan sharks” when some lenders that were trying to make profits from microfinance hiked rates and increased marketing.
A 2012 London School of Economics study suggests the thinking trap known as “projection bias” – the tendency for current experience to inaccurately influence views of the past and the future – maybe a factor in over-borrowing among some microfinance clients.

The new challenge for microfinance
In the September 2014 economic update video for eZonomics, ING senior economist Gerben Hieminga gives insights from the Billion to Gain 2014 report he co-authored. It followed Billion to Gain editions in 2006, 2008 and 2012.
The 2014 report demonstrates positive benefits for the mental and physical health of microfinance clients as well as benefits for their wealth. But, like Yunus, it gives a nod to potential dangers when it says “the history of microfinance has shown that over-borrowing can put households into a debt spiral, making them worse off than before credit was provided. The sector must keep a close eye on this possibility.”
Hieminga says in the video that both banks and the poor can be better off when financial services are more widely available. The sector now faces the challenge to extend  efforts to reach  the rest of the 2.5 billion people excluded from formal financial services.
Roy Budjhawan, Head of ING Microfinance and board member of NpM, Platform for Inclusive Finance advocates to be selective in providing loans to the poor and provide additional education and coaching to prevent over-indebtedness. “Not everybody is a natural born entrepreneur, some benefit more from employment or need assistance to become an entrepreneur”.  

Microfinance in the United States and elsewhere
Microfinance is not confined to developed countries only. Former Federal Reserve chairman Ben Bernanke laid out in a 2007 speech the microfinance movement in the United States, which shares similar goals and core values as microfinance in developing countries despite operational differences.
On the flipside, people in developed countries are also lending money via microfinance non-profits, such as Kiva. Under these arrangements, lenders loan small sums to projects in dozens of countries as diverse as funding education, homes and businesses. 

Lessons for all of us
Microfinance proved to be a very effective tool to financially include the poor.
It shows how access to loans can help build income and growth but also the importance of not borrowing more than can be repaid and of keeping close watch on the terms and conditions (including the interest rate or APR).
Used responsibly, microfinance has been shown to make positive change and empower. 

Personal finance

eZonomics team
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