1 MICROFINANCE Orrick, Herrington & Sutcliffe Type: Published: Last Updated: Keywords: Legal guide Microfinance; lending; development.
2 This document provides general information and comments on the subject matter covered and is not a comprehensive treatment of the subject. It is not intended to provide legal advice. With respect to the subject matter, viewers should not rely on this information, but seek specific legal advice before taking any legal action Any opinions expressed in this document are those of the author and do not necessarily reflect the position and/or opinions of A4ID Advocates for International Development 2012
3 Background Microfinance is a broad term that describes banking and financial services provided by poverty-focused financial institutions (often referred to as microfinance institutions or "MFIs") to poor populations that are not being served by mainstream financial organizations. MFIs take many forms and include savings and loan cooperatives, local or international NGOs, village banks and programs set-up by international institutions. Commercial banks support microfinance operations directly (by providing financing or equity investment to existing MFIs) and indirectly (by creating branches or a range of microfinance products and services). Since its inception in the 1970s, microfinance has been based on the principal that the working poor, particularly women, need alternatives to what had previously been the only source of borrowed funds, namely informal lenders who charge excessive interest. MFIs primarily provide small loans to their clients (although some MFIs also offer additional services, including include micro-deposit and micro-insurance products). Unlike commercial banks, MFIs typically do not require borrowers to provide collateral for their loans. Some apply a creditworthiness standard based on the performance of a group of borrowers by initially extending a loan to an individual and then lending money to additional members of the group if that individual proves to be a reliable borrower. In effect, the MFIs create incentives for each individual within the group to repay their loans, as the failure to do so will jeopardize the ability of the rest of the group to obtain credit. Others lend directly to individuals without tying credit to group performance. Objectives of Microfinance Microfinance providers seek to serve poor populations that have traditionally been unable to obtain access to credit by enabling them to secure loans and other financial services. The primary goal of microfinance is the reduction of poverty in developing countries by providing poor people with basic financial services that will enable them to earn more, accumulate assets and protect themselves from unexpected setbacks.
4 With the assistance of microcredit, recipients are expected to be better able to transition from everyday survival to planning for the future, and investing in better nutrition, housing, health, and education. The Consultative Group to Assist the Poor, a consortium of 31 public and private development agencies, private foundations and international financial institutions whose goal is to expand access to financial services for the poor, developed the following set of key principles1 of microfinance, which were endorsed by the Group of Eight leaders at the G8 Summit on 10 June Poor people need a variety of financial services, not just loans. Like everyone else, the poor need a range of financial services that are convenient, flexible, and affordable. Depending on circumstances, they want not only loans, but also savings, insurance, and cash transfer services. Microfinance is a powerful tool to fight poverty. When poor people have access to financial services, they can earn more, build their assets, and cushion themselves against external shocks. Poor households use microfinance to move from everyday survival to planning for the future: they invest in better nutrition, housing, health, and education. Microfinance means building financial systems that serve the poor. In most developing countries, poor people are the majority of the population, yet they are the least likely to be served by banks. Microfinance is often seen as a marginal sector a development activity that donors, governments, or social investors might care about, but not as part of the country s mainstream financial system. However, microfinance will reach the maximum number of poor clients only when it is integrated into the financial sector. Microfinance can pay for itself, and must do so if it is to reach very large numbers of poor people. Most poor people cannot get good financial services that meet their needs because there are not enough strong institutions that provide such services. Strong institutions need to charge enough to cover their costs. Cost recovery is not an end in itself. Rather, it is the only way to reach 1 Source: 4
5 scale and impact beyond the limited levels that donors can fund. A financially sustainable institution can continue and expand its services over the long term. Achieving sustainability means lowering transaction costs, offering services that are more useful to the clients, and finding new ways to reach more of the unbanked poor. Microfinance is about building permanent local financial institutions. Finance for the poor requires sound domestic financial institutions that provide services on a permanent basis. These institutions need to attract domestic savings, recycle those savings into loans, and provide other services. As local institutions and capital markets mature, there will be less dependence on funding from donors and governments, including government development banks. Microcredit is not always the answer. Microcredit is not the best tool for everyone or every situation. Destitute and hungry people with no income or means of repayment need other kinds of support before they can make good use of loans. In many cases, other tools will alleviate poverty better for instance, small grants, employment and training programs, or infrastructure improvements. Where possible, such services should be coupled with building savings. Interest rate ceilings hurt poor people by making it harder for them to get credit. It costs much more to make many small loans than a few large loans. Unless microlenders can charge interest rates that are well above average bank loan rates, they cannot cover their costs. Their growth will be limited by the scarce and uncertain supply soft money from donors or governments. When governments regulate interest rates, they usually set them at levels so low that microcredit cannot cover its costs, so such regulation should be avoided. At the same time, a microlender should not use high interest rates to make borrowers cover the cost of its own inefficiency. The role of government is to enable financial services, not to provide them directly. National governments should set policies that stimulate financial services for poor people at the same time as protecting deposits. Governments 5
6 need to maintain macroeconomic stability, avoid interest rate caps, and refrain from distorting markets with subsidized, high-default loan programs that cannot be sustained. They should also clamp down on corruption and improve the environment for micro-businesses, including access to markets and infrastructure. In special cases where other funds are unavailable, government funding may be warranted for sound and independent microfinance institutions. Donor funds should complement private capital, not compete with it. Donors provide grants, loans, and equity for microfinance. Such support should be temporary. It should be used to build the capacity of microfinance providers; to develop supporting infrastructure like rating agencies, credit bureaus, and audit capacity; and to support experimentation. In some cases, serving sparse or difficult-to-reach populations can require longer-term donor support. Donors should try to integrate microfinance with the rest of the financial system. They should use experts with a track record of success when designing and implementing projects. They should set clear performance targets that must be met before funding is continued. Every project should have a realistic plan for reaching a point where the donor s support is no longer needed. The key bottleneck is the shortage of strong institutions and managers. Microfinance is a specialized field that combines banking with social goals. Skills and systems need to be built at all levels: managers and information systems of microfinance institutions, central banks that regulate microfinance, other government agencies, and donors. Public and private investments in microfinance should focus on building this capacity, not just moving money. Microfinance works best when it measures and discloses its performance. Accurate, standardized performance information is imperative, both financial information (e.g., interest rates, loan repayment, and cost recovery) and social information (e.g., number of clients reached and their poverty level). Donors, investors, banking supervisors, and customers need this information to judge their cost, risk, and return. 6
7 Main Features There are various methods of providing funds to microfinance borrowers, although there are common themes among them. Community-based organizations, social pressure to repay borrowed funds, participation in the administration of loans and encouraging borrowers to save are among the hallmarks of microfinance lending. The following is an overview of some of the structures employed within the microfinance framework. Solidarity Lending Solidarity lending consists of lending to "solidarity groups", which are very small groups of individuals who are permitted to choose the other members of the group as long as they are not related. Solidarity groups typically include approximately five individuals, often women and usually in tightly knit rural areas, who are considered a unit for purposes of obtaining a loan. Membership in a solidarity group is intended to give each individual an incentive to repay the loan as well as a source of support. The group approves each member's loan request, which effectively makes the group collectively responsible for the behavior of the others and emphasizes the communitybased approach that is frequently utilized in microfinance. Although some microfinance providers impose joint liability on all members of a solidarity group if an individual's loan becomes delinquent, others place responsibility for delinquent loans on a committee made up of several solidarity groups. This preserves the social leverage employed by individual solidarity groups and, because the groups comprising the committee are collectively responsible for unpaid loans, distributes the burden more widely and helps prevent the disintegration of a smaller group unable to repay the loan of one of its members. It also reduces the cost of evaluating, monitoring and collecting loans to microfinance providers, which can increase the availability of funds for additional loans. 7
8 Village Banking A village bank is not a financial institution, but a self-managed and informal group of approximately individual participants who meet periodically to monitor loans made by NGOs or microfinance institutions to its members. Borrowers are primarily women and are typically extremely poor. The loans are small (usually U.S. $50- $100) and are linked to savings, allowing borrowers who save more to obtain additional credit. Village banks rely upon solidarity lending, whereby each member is liable for the debts of each other member. The system depends on social pressure to motivate borrowers to repay their loans and village banks enjoy a strong track record of repayment. Village banks receive funds and supervision from their credit providers, but oversee expenditures, meetings and managerial functions themselves. CVECAs A CVECA is a village savings and credit bank operated by its members, most of whom are subsistence farmers with minimal non-farm income. CVECas typically have less than 250 members, but form regional consortia to realize economies of scale and obtain funds from commercial banks. They are found primarily in West Africa, are operated by voluntary staff and function as intermediaries within the microfinance sphere by interacting with larger banks and individual borrowers. CVECAs do not require borrowers to provide collateral, but use substitutes that usually do not have significant material value, but the loss of which will considerably inconvenience defaulting debtors. CVECAs actively encourage their members to deposit their savings, which are then used to collateralize loans obtained from traditional financial institutions. Microfinance Providers The term "microfinance" encompasses a broad range of services, many of which are sufficiently informal to be excluded from studies attempting to quantify the scale of providers of credit to the poor. However, it has been estimated that there are over 700 8
9 MFIs and over 3,000 microcredit NGOs serving clients throughout the developing world, although the majority are located in Asia. There are four basic types of microfinance providers: Informal providers (including moneylenders, informal groups of individual borrowers and pawnbrokers; available credit is typically short-term and expensive). Member-owned organizations (including self-help groups, credit unions and hybrid organizations, including CVECAs; operational costs are low and access to and the cost of credit varies). NGOs (usually funded by donors; NGOs have been instrumental in developing techniques that include solidarity lending and village banking). Formal financial institutions (including commercial, state, agricultural development, savings and rural banks and non-bank financial institutions; due to the high cost of their operations, profitability concerns and internal credit restrictions, they are not significant providers of microcredit). Positive and Negative Aspects Microfinance has enabled numerous people who would otherwise have little or no access to credit to borrow money and, in some instances, to acquire insurance and accumulate savings. Borrowers who have identified an economic opportunity and have the ability to capitalize on it by with the assistance of a small loan can acquire funds that, without microfinance, would have been unobtainable or prohibitively expensive. It is this type of scenario that microfinance was developed to support. In addition to providing a means for the poor to borrow money, microfinance has begun to introduce mechanisms to encourage savings in vulnerable populations. By developing savings regimes that match the particular needs and cash flow cycles of the poor, microfinance institutions are attempting to assist their clients in insulating themselves from financial shocks and preparing for future uncertainties, both of which 9
10 can devastate an already poor family. As microfinance develops beyond simply providing micro loans to small segments of the poor population, it will uncover further opportunities to educate and provide financial services to its clients. Microcredit is not a panacea and there are circumstances under which other types assistance are more appropriate. Destitute people with insufficient resources to sustain themselves and no means of repayment need other types of aid before they can make good use of credit. Loans to individuals who lack the ability to repay them may not benefit from credit and risk being in debt on a long-term basis. In many cases, other means will better serve poor populations, including grants, training programs, healthcare and infrastructure improvements. Geographically dispersed or nomadic populations, individuals with severe health problems, communities that rely on barter rather than cash transactions and those that depend on a single economic activity or agricultural crop may not be appropriate candidates for microfinance. Other barriers, including the presence of hyperinflation, absence of the rule of law and legal regimes that limit the ability of lenders to charge an appropriate rate of interest, can challenge the sustainability of microfinance programs. Some critics of microfinance object to the use of charitable funds in for-profit enterprises and point to the relatively high rates of interest charged by lenders in this sphere. However, the costs associated with providing microfinance loans must be taken into account in this respect. It is much more expensive for a lender to make many small loans than a few large loans. Consequently, microlenders must charge interest rates that are significantly higher than average bank loan rates in order to cover their costs. If microlenders are unable to cover their costs, they require infusions from donors or governments, both of which are inherently scarce and uncertain. Microfinance must be self-sufficient if it is to sustain itself and reach large numbers of poor people. A financially solvent institution can continue and expand its services over the long term. Achieving sustainability also allows microfinance providers to lower transaction costs, offer services that are more useful to the clients, and find new ways to reach larger numbers of clients. Another debate focuses on the appropriate target group for microfinance services. One view is that the most important form of microfinance is credit extended to poor people 10
11 who are also gifted entrepreneurs. If such people are able to obtain credit, they can expand their businesses, stimulate local economic growth and generate employment opportunities by hiring others in their community as their businesses grow. This approach has been successful in urban areas, but has failed to reach the majority of poor people, who are generally rural subsistence farmers with little, if any, other source of income. As income inequities between urban and rural areas continue to grow in developing countries, this result is increasingly the subject of criticism. Case Studies Grameen Bank Grameen Bank is the best known, and among the oldest, microfinance providers. Founded in Bangladesh by Muhammed Yunus as a project funded by commercial banks to provide microcredit in the 1970s, Grameen Bank is best known for developing the solidarity lending system, which is now utilized in over 43 countries. In 2006, Muhammad Yunus & Grameen Bank were awarded Nobel Peace Prize for their efforts to create economic and social development from below. The Nobel Committee cited micro-credit as one way in which large population groups could potentially break out of poverty, thereby increasing the likelihood of peace and lasting stability for such people, as well as advancing democracy and human rights Grameen Bank lends to groups of five borrowers, none of whom are responsible for the others debt, but if a member of a solidarity group defaults, no further loans will be made to any member of the group. The bank does not require its borrowers to provide collateral, but does compel them to save small amounts on a regular basis for emergencies, group needs, etc., as a form of insurance against unexpected contingencies. Few women in Bangladesh borrow money from large commercial banks, but 97% of Grameen Bank s customers are women. The bank has an impressive track record, claiming 98% repayment rates, and currently has outstanding loans to almost 13 million households. It is also the model for most microfinance providers that extend loans to solidarity groups. 11
12 The general consensus among scholars of microfinance is that access to microcredit has significantly reduced the vulnerability of the poor in Bangladesh. They are better able to plan for seasonal income shortfalls, unanticipated natural disasters and other problems, and their children are more likely to attend school and have better nutrition and healthcare. The social mobilization effect of borrower group meetings and the increase in income through microfinance have both been credited with such improvements. Bank Rakyat Indonesia (BRI) Units BRI Units were established in the 1980s in Indonesia and BRI is currently among the largest and most successful microfinance institutions in the world. BRI Units provide standardized banking products and services to approximately 30 million clients (with average deposits of US $100), including close to 3 million borrowers (with average loans of US $500). BRI has a large-scale operation which is based on locally sourced savings and does not receive government or donor funds. The bank was initially formed to make loans to borrowers in the agricultural sector through government subsidized credit. After the Indonesian government decided to terminate its loan subsidies through the bank, BRI formed a rural banking network consisting of geographically based units, each of which operates individually on a forprofit basis. BRI Units offer passbook savings accounts, demand and time deposits, savings plans for children, small loans and other products tailored to its primarily rural clientele. Borrowers are required to provide sufficient collateral, but are also given incentives (including to a partial refund of interest payments) to repay their loans on a timely basis. By its sixth year of operation in 1989, the BRI Unit system was both profitable and self-sufficient and since then, deposits have been larger than outstanding loan amounts in both number and volume. BRI Units target the working poor who engage in viable economic activities; they have not traditionally loaned money to the population below the poverty line and remain focused on traditional banking activities with a view to helping an underserved 12
13 but not destitute segment of the population. Recent studies have indicated that BRI Unit borrowers are relatively better off than others (including savers without BRI Unit loans and non-customers) in terms of income and wealth. Moreover, the BRI Units successfully weathered the Asian financial crisis of the late 1990s, demonstrating that providing banking services to the disadvantaged can remain a profitable enterprise even during an economic downturn in which other commercial banks are struggling. Equity Building Society Equity Building Society was formed in Kenya in 1983 to provide financial services to low-income borrowers who lacked access to traditional banks. The bank initially struggled to attract customers and was on the brink of insolvency by the early 1990s as a result of poor management practices, inadequate lending controls and various other problems. After restructuring itself with the assistance of outside experts, Equity eventually sought the assistance of several international partners and refocused its efforts to provide banking services to poor and low-income households. Today, Equity offers a wide range of financial services, including loans, money transfers and other products typically provided by a traditional commercial bank. The majority of Equity s clients are small farmers, low-salaried workers and very small businesses. Equity offers education and medical loans at lower rates if funds are paid directly to the provider. The bank also offers savings accounts specially tailored for children s education and has developed a series of programs and products to serve its various niche markets. Its clients have reported that they use Equity s services to invest in their businesses, save for future expenses, manage cash flows, invest in assets and pay for unexpected expenses. Conclusion The primary goal of microfinance is help the poor to increase their income, build businesses and acquire a financial cushion to reduce their vulnerability to financial shocks in the future. Research has shown that each of these factors lead to other 13
14 improvements in the lives and conditions of the poor, including increased access to healthcare and education, better nutrition, personal empowerment for women and a safety net from unanticipated financial crises that can otherwise destroy families ability to break the poverty cycle. Microfinance can also help build permanent local financial institutions that attract domestic savings, which can be used to make loans, and provide other services to the poor. Different types of microfinance providers focus on different segments of the underserved population. Local circumstances and needs are among the most important factors that determine the appropriate form of microlending; however, empirical evidence has shown that the availability of microfinance has, in many cases, improved the lives and economic condition of the populations it serves. 14