Microfinance

Microfinance today serves as an umbrella term for banking and financial services such as loans, bank accounts and insurance for people who do not have access to the financial services sector because they lack financial collateral, often do not have a regular income and live away from the centres. Microfinance received a lot of attention in 2006 when Muhammad Yunus, founder of the Grameen Bank, was awarded the Nobel Peace Prize for his concept of microcredit as “help for self-help”. Private investors have only been able to participate in this concept for a few years through microfinance funds. Funds like the IIV Microfinance Fund grant loans to microfinance institutions in emerging and developing countries. These institutions support small and micro entrepreneurs and offer them real help to help themselves by providing access to financial services.

Microfinance is considered one of the most important instruments of development finance worldwide and is strongly promoted by many countries. Its effectiveness in its entirety is difficult to measure, because microfinance influences many different areas of life and enables numerous synergy effects. Nevertheless, various studies worldwide have shown the positive effects of microfinance: living conditions are improved and the cycle of poverty is broken. Financial independence allows many families to provide their children with a better education and thus lays the foundation for a better future. Often, microfinance is the only way to escape poverty and become entrepreneurial. However, it is important to note that microfinance alone will not reduce poverty in the world. Other development instruments are also needed to change the accompanying circumstances and to help people who are not reached by microfinance.

A microfinance institution (MFI) provides basic services such as loans, bank accounts and insurance to low-income people without financial collateral who are not served by commercial banks. Socially oriented microfinance is an important instrument of development policy to help low-income households to free themselves from the poverty spiral by their own efforts. MFIs can have different structures: Non-governmental organisations (NGOs), cooperatives, private banks, Non-Bank Financial Institutions (NBFIs) and other organisations that dedicate a line of business to microfinance.

There are various forms of microfinance institutions (MFIs) and the term covers a wide range of different organisational structures. For this reason, it is not possible to speak generally for all MFIs. Many microfinance institutions in emerging and developing countries do not have access to traditional capital markets. They are dependent on investments from abroad as well as on development policy funds. However, the more commercialised and profitable an MFI is, the higher its chances of raising the funds it needs on the capital market. The majority of microfinance institutions with which Invest in Visions cooperates depend on private-sector refinancing in order to be able to successfully pursue their valuable work in the respective emerging and developing countries.

The clients are primarily low-income people in emerging and developing countries who want to improve their standard of living through entrepreneurial activity. Since they often live in rural areas, often do not earn a regular income and cannot offer collateral, they are not attractive to commercial banks as clients and are therefore not served by them. This is where local microfinance institutions come in, offering various banking and financial services to this client group. The microcredit borrowers are people with a realistic business idea with which they want to break out of the poverty spiral. Most of these entrepreneurs work in the informal sector, e.g. in small trade or in the production of simple products. They are self-employed and have no more than 10 employees. They are often one-man/woman businesses. Potential microcredit borrowers often lack the necessary education. Consequently, access to financial services is often linked to business training. This teaches simple rules for good business management to increase the chances of success. The interested persons must present a feasible and promising business idea before a loan is granted. Worldwide, the number of female borrowers is higher than the number of male borrowers. One reason for this is that women – according to the experience of many microfinance institutions – usually make their repayments on time. In addition, they have on average even less schooling and less material collateral. Thus, they have even fewer opportunities to participate in traditional banking services and a higher need for loans to earn a living for themselves and usually also for their children and to invest in their children’s education. Globally, the number of female borrowers is higher than the number of male borrowers. One reason for this is that, in the experience of microfinance institutions, women usually make more punctual repayments. In addition, they have on average even less schooling and less material collateral. Thus, they have even fewer opportunities to participate in traditional banking services and need the loans to earn a living for themselves and usually also for their children and to invest in their children’s education.

Group loans are a special type of lending to micro-borrowers in emerging and developing countries. Here, more or less people who want to obtain a loan join together to form a group. Within the group, they support each other in the successful implementation of the business idea. The group decides for itself which members will be accepted. Trust plays a big role in their success. Group loans are often cited as the reason why the rate of repaid loans is so high. If one person in the group is unable to repay the loan, the other group members will guarantee it. This creates a certain pressure on the group members, which increases their efforts to repay the loans. The sense of community and trusting cooperation within communities are thus strengthened. Often, group members get to know solidarity outside the family in the context of these group loans. Women in particular experience unaccustomed recognition here and take on leading positions. However, group credits are not useful in all cases. Their application varies according to region and situation.

Interest rates in emerging and developing countries are not comparable to those in industrialised countries, because microfinance is a very small-scale and therefore cost-intensive business. In contrast to commercial banks, client advisors often travel to rural areas themselves to serve their clients locally. In addition, many countries have high double-digit inflation rates and much higher market interest rates. Annual interest rates of 18-30 per cent can be within reasonable limits, depending on the region or country. Many micro-entrepreneurs in emerging and developing countries already generate high percentage returns with low capital investment. As a result, they are often able to repay loans within 6-9 months. For more information on interest rates in microfinance, please visit our blog.

The high repayment rates of 98 percent on average show impressively that most borrowers succeed in developing their entrepreneurial potential. Properly applied, microfinance can reduce poverty and help people to improve their standard of living through their own efforts.

Microcredit borrowers are primarily microentrepreneurs who, with the help of a loan from a microfinance institution, are given the opportunity to become active in business. Initial investments in entrepreneurial activities lead to high profit increases when successfully implemented. For a seamstress, for example, investing in her first sewing machine means an incredible increase in productivity and thus in profits. Increases of 20 percent and more are not uncommon. Micro-entrepreneurs can expand their business and increase their profits accordingly. This makes it comparatively easy for borrowers to pay higher interest rates for their loans. The amount of interest can be explained by the often high inflation, the high expenses in the operational area as well as the higher risk (see question: What are appropriate interest rates?). For more information on interest rates in microfinance, see our blog.