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Micro Finance, Theoretical Study

Sankar Ganesh 
on 19 January 2008


MICRO FINANCE, A SCOPE 1. Introduction Mostly Micro Finance is the term used for funding poor families with very small loans to improve their livelihood but its activities grow more than providing small loans and it discusses a broad range of services which includes credits, savings, insurance, etc. Since poor families are not accustomed to the traditional form of financial institutions and hence they hesitate to approach and by that they are lacking in financial support and hence the scope of micro finance is very wide and its scope is highly essential to the welfare of poor family. Micro-credit came to prominence in the 1980s, although early experiments date back 30 years in Bangladesh, Brazil and a few other countries. The important difference of micro-credit was that it avoided the pitfalls of an earlier generation of targeted development lending, by insisting on repayment, by charging interest rates that could cover the costs of credit delivery, and by focusing on client groups whose alternative source of credit was the informal sector. Emphasis shifted from rapid disbursement of subsidized loans to prop up targeted sectors towards the building up of local, sustainable institutions to serve the poor. Micro-credit has largely been a private (non-profit) sector initiative that avoided becoming overtly political, and as a consequence, has outperformed virtually all other forms of development lending. Microfinance refers to loans, savings, insurance, transfer services and other financial products targeted at low-income clients. Micro-credit refers to a small loan to a client made by a bank or other institution. Micro-credit can be offered, often without collateral, to an individual or through group lending. Traditionally, microfinance was focused on providing a very standardized credit product. The poor, just like anyone else, need a diverse range of financial instruments to be able to build assets, stabilize consumption and protect themselves against risks. In India, Micro-credit programs are run primarily by NABARD in the field of agriculture and SIDBI in the field of Industry, Service and Business (ISB). The success of Micro-credit program lies in diversification of services. In the 1970s, a new wave of microfinance initiatives introduced many new innovations into the sector. Solidarity lending emerged as a distinctive new methodology, made famous by Dr. Muhammad Yunus, the founder of Grameen Bank, who was awarded, together with Grameen Bank, the Nobel Peace Prize in 2006. 2. MICRO FINANCE IN INDIA In india nance traces its roots to mid 1970s when some prominent Indian NGO like Myrada & Pradan started using the Self Help Group (SHG) model. The SHG is used as a platform for social mobilization and finance is one of the various services provided to the grassroot community through this model. It was widely replicated across other developmental NGOs. It is a community driven and managed microfinance model where the NGO plays the role of a facilitator, for instance providing capacity building services to the groups and building relationships with banks. During the late 1990s, the Grameen model promoted by Muhammad Younus of Grameen Bank and the ASA model promoted by the Association for Social Advancement, both from Bangladesh, found rapid acceptance amongst the newer breed of microfinance institutions in India. This was due to the models' capability for rapid scaling in terms of client outreach. Also these models are less dependent on donor funds and passes the actual service charge to the clients while retaining a margin for its own growth. These models have proven to be robust revenue models. Slowly a distinct trend of shifting from non profit, grant-supported organizations to for profit institutions (non-banking financial corporations) became visible in Indian microfinance sector Micro Finance Scheme of SIDBI is under operation since January, 1999 with a corpus of Rs. 100 crore and a network of about 190 capacity assessed rated MFIs/NGOs. Under the programme, total amount of Rs. 191 crore have been sanctioned upto 31st December, 2003, benefiting over 9 lakh beneficiaries. Under the programme, NGOs/MFIs are supposed to provide equity support in order to avail SIDBI finance. But they find it difficult to manage the needed equity support because of their poor financial condition.The problem has got aggravated due to declining interest rate on deposits. The Office of the Development Commissioner (Small Scale Industries) under Ministry of SSI is launching a new scheme of Micro Finance Programme to overcome the constraints in the existing scheme of SIDBI, whose reach is currently very low. It is felt that Government’s role can be critical in expanding reach of the scheme, ensuring long term sustainability of NGOs / MFIs and development of Intermediaries for identification of viable projects. The Scheme of Micro-Finance Programme, the following activities would be undertaken. i. Arranging Fixed Deposits for MFIs/NGOs: The SIDBI is already running a Micro-Credit Programme with a network of capacity assessed rated MFIs/NGOs. The scheme of Micro-Finance Programme has been tied-up with SIDBI by way of contributing towards security deposits required from the MFIs/NGOs to get loans from SIDBI as per details given under: The Government of India will provide funds for Micro-Finance Programme to SIDBI, which shall be called ‘Portfolio Risk Fund’ (PRF). This fund would be used for security deposit requirement of the loan amount from the MFIs/NGOs and to meet the cost of interest loss. At present, SIDBI takes fixed deposit equal to 10% of the loan amount. The share of MFIs/NGOs would be 2.5% of the loan amount (i.e. 25% of security deposit) and balance 7.5% (i.e. 75% of security deposit) would be adjusted from the funds provided by the Government of India. The MFIs/NGOs may avail the loan from the SIDBI for further on lending on the support of the security deposit. The Government would provide the needed fund in four years of the Xth Plan and release the fund on half-yearly basis based on demands for security deposit. By contributing an amount of Rs.6 crore during the Xth Plan under Micro-Finance Programme, SIDBI can provide loan of Rs.80.00 crore to MFIs/NGOs. This would benefit approximately 1.60 lakhs beneficiaries, assuming an average loan of Rs. 5,000/- per beneficiary. The SIDBI will pay interest to the Govt. on the fixed deposit made available by the Government at the same rate as allowed to NGOs. Other terms and conditions will be fixed mutually by SIDBI and GOI. The recovery of loan/interests will be the sole responsibility of the SIDBI. In case of non recovery of loan, SIDBI would first adjust fixed deposit and interest accrued thereon for 2.5% security deposit of the loan pledged by the MFIs / NGOs and thereafter adjust 7.5% security deposit of the loan amount provided by the Government of India and the interest accrued thereon with the approval of Committee of Govt. of India. After full recovery of loan from the MFIs/NGOs, the 7.5% security deposit of the loan amount provided by Govt. of India and interest accrued thereon would be rotated further as a security deposit for MFIs/NGOs with the approval of Committee of the Govt. of India or the same will be returned to the Govt. of India. As SIDBI is already running the Micro-Credit Programme, they will monitor the scheme. They would also provide the monthly/ quarterly progress report along with details of beneficiaries, utilization of funds provided by Government of India and loan sanctioned/ utilized by the beneficiaries. The activities covered under the scheme are manufacturing, service sector and non-farming activities. Training and Studies on Micro-Finance Programme: The Government of India would help SIDBI in meeting the training needs of NGOs, SHGs, intermediaries and entrepreneurs and also in enhancing awareness about the programme. This task would be performed through National Level Entrepreneurship Development Institutes (EDIs) and Small Industries Service Institutes (SISIs). The Research Studies would also be arranged through reputed agencies. Institution Building for ‘Intermediaries’ for identification of viable projects: The Government of India would help in institution building through identification and development of ‘intermediary organization’, which would help the NGOs/SHGs in identification of product, preparation of project report, working out forward and backward linkages and in fixing marketing/ technology tie-ups. The SISIs would help in the identification of such intermediaries in different areas. Recent research and technical assistance activities have focused on the relationship between, on the one hand, deposit mobilization and lending technologies and, on the other, the inclusion or exclusion of specific client types in microfinance loan portfolios. The program has also addressed the difficulties of measuring the poverty status of clients of microfinance organizations. In this connection, the program has examined the levels and sources of the costs of rural financial intermediation as well as the role of learning in addressing imperfect information and in reducing transaction costs. Components of successful lending technologies (signaling, screening, monitoring, and contract design and enforcement) have been identified for different microfinance organizations. Elements of the lending technology have been matched to features of target clienteles and the results have been tested with surveys of loan officers and of clients of organizations in Bolivia, El Salvador, Mali and Russia. 3. how it helps the poor Experience shows that microfinance can help the poor to increase income, build viable businesses, and reduce their vulnerability to external shocks. It can also be a powerful instrument for self-empowerment by enabling the poor, especially women, to become economic agents of change. Poverty is multi-dimensional. By providing access to financial services, microfinance plays an important role in the fight against the many aspects of poverty. For instance, income generation from a business helps not only the business activity expand but also contributes to household income and its attendant benefits on food security, children's education, etc. Moreover, for women, who, in many contexts, are secluded from public space, transacting with formal institutions can also build confidence and empowerment. Recent research has revealed the extent to which individuals around the poverty line are vulnerable to shocks such as illness of a wage earner, weather, theft, or other such events. These shocks produce a huge claim on the limited financial resources of the family unit, and, absent effective financial services, can drive a family so much deeper into poverty that it can take years to recover. Providing financial services to poor people is quite expensive, especially in relation to the size of the transactions involved. This is one of the most important reasons why banks don't make small loans. A 10000 rupees loan, for example, requires the same personnel and resources as a Rs. 20,000 one thus increasing per unit transaction costs. Loan officers must visit the client's home or place of work, evaluate creditworthiness on the basis of interviews with the client's family and references, and in many cases, follow through with visits to reinforce the repayment culture. It can easily cost Rs.2, 500 to make a microloan. While that might not seem unreasonable in absolute terms, it might represent 25% of the value of the loan amount, and force the institution to charge a “high” rate of interest to cover its cost of loan administration. The microfinance institution could subsidize the loans to make the credit more "affordable" to the poor. Many do. However, the institution then depends on permanent subsidy. Subsidy-dependent programs are always fighting to maintain their levels of activity against budget cuts, and seldom grow significantly. They simply aren't sustainable, especially if other microcredit operations have shown that they can provide credit and grow on the basis of “high” rates of interest—and along the way serve far greater numbers of clients. Evidence shows that clients willingly pay the higher interest rates necessary to assure long term access to credit. They recognize that their alternatives—even higher interest rates in the informal finance sector (moneylenders, etc.) or simply no access to credit—are much less attractive for them. Interest rates in the informal sector can be as high as 20 percent per day among some urban market vendors. Many of the economic activities in which the poor engage are relatively low return on labor, and access to liquidity and capital can enable the poor to obtain higher returns, or to take advantage of economic opportunities. The return received on such investments may well be many times greater than the interest rate charged. Moreover, the interest rate is only a small part of their overall transaction cost of credit, and if microfinance institutions offer credit on a more accessible basis, substantial costs in terms of time, travel, paperwork, etc. can be reduced, thus benefiting the poor. A long series of studies has shown that many programs that charge subsidized interest rates end up using rationing mechanisms to distribute credit in response to excess demand. These mechanisms cause the borrower to have to “jump through hoops”, increasing the time and money s/he must put out to get the loan. In fact, these transactions costs are frequently higher than the interest costs, which take away the advantage to the borrower of the interest rate subsidy. However, while increased access to credit for the poor on a long term and sustainable basis can bring significant benefits, MFIs must continue to work to improve efficiency levels, and to increase scale. This will bring down the cost of providing loans, and the benefits transferred to the poor in terms improving loan products, better access to loans, and lower borrowing costs. The poor already save in ways that we may not consider as "normal" savings--- investing in assets, for example, that can be easily exchanged to cash in the future (gold jewelry, domestic animals, building materials, etc.). After all, they face the same series of sudden demands for cash we all face: illness, school fees, need to expand the dwelling, burial, weddings. These informal ways that people save are not without their problems. It is hard to cut off one leg of a goat that represents a family's savings mechanism when the sudden need for a small amount of cash arises. Or, if a poor woman has loaned her "saved" funds to a family member in order to keep them safe from theft (since the alternative would be to keep the funds stored under her mattress), these may not be readily available when the woman needs them. The poor need savings that are both safe and liquid. They care less about the interest rates that they can earn on the savings, since they are not used to saving in financial instruments and they place such a high premium on having savings readily available to meet emergency needs and accumulate assets. These savings services must be adapted to meet the poor’s particular demand and their cash flow cycle. Most often, the poor not only have low income, but also irregular income flows. Thus, to maximize the savings propensity of the poor, institutions must provide flexible opportunities--- both in terms of amounts deposited and the frequency of pay ins and pay outs. This represents an important challenge for the microfinance industry that has not yet made a concerted attempt to profitably capture tiny deposits. 4. Can microfinance be profitable Microfinance is profitable only. According to the sources from Micro Banking Bulletin reports that 63 of the world's top MFIs had an average rate of return, after adjusting for inflation and after taking out subsidies programs might have received, of about 2.5% of total assets. This compares favorably with returns in the commercial banking sector and gives credence to the hope of many that microfinance can be sufficiently attractive to mainstream into the retail banking sector. Many feel that once microfinance becomes mainstreamed, massive growth in the numbers of clients can be achieved. Others worry that an excessive concern about profit in microfinance will lead MFIs up-market, to serve better off clients who can absorb larger loan amounts. This is the “crowding out” effect. This may happen; after all, there are a great number of very poor, poor, and vulnerable non-poor who are not reached by the banking sector. It is interesting to note that while the programs that reach out to the poorest clients perform less well as a group than those who reach out to a somewhat better-off client segment, their performance is improving rapidly and at the same pace as the programs serving a broad-based client group did some years ago. More and more MFI managers have come to understand that sustainability is a precursor to reaching exponentially greater numbers of clients. Given this, managers of leading MFIs are seeking ways to dramatically increase operational efficiency. In short, we have every reason to expect that programs that reach out to the very poorest microclients can be sustainable once they have matured, and if they commit to that path. The evidence supports this position. 5. CONCLUSION The World Bank estimates that of approximately 1.2 billion people who subsisted on less than US$1 a day in 2003, 850 million lived in rural areas. There is increasing recognition that poor people can and do save informally at home -- but lose much of their savings because home is a risky place to save. There is also recognition that before rural farmers will have the confidence to start businesses, they must be able to gain more control over other household risks such as hunger, disease and natural disaster. This requires access to safe, flexible small-balance savings accounts. 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. It is not widely known that interest rates charged to borrowers frequently range from 2.5% to a 4% a month (about 31% to 50% a year), depending on the country This is justified to pay staff salaries and technical assistance from rich countries. Microfinance institutions argue that rates are not really high compared with those charged by local money lenders (often over 10% a month). They also point out that if their interest rates were not fair, they would have fewer borrowers and more delinquencies than in fact, they do. But it is quite controversial that they charge such high interests to poor individuals, with money that is often donated. Furthermore, the experience of microfinance organizations shows that interest rate has usually secondary significance for microborrowers. The factors of more significance are access to credit, processing time, level of bureaucratic requirements, collateral requirements, etc. Thus the clients can prefer an institution even if the interest rate is very high but the level of bureaucratic requirements is low to an institution charging much lower interest rate but with higher bureaucratic requirements (for instance traditional banks). The level of interest rate charged by microfinance institutions can be justified by high margins achieved by microentrepreneurs. For instance, a cloth trader in Central Asia can easily have margins of 100% with high rotation of working capital. That means that additional cash circulating in the business generates additional profit that easily allows for loan repayment A new microfinance paradigm is taking shape, with the goal of developing full-service for-profit banks for all poor people. This approach is exemplified by the transformations at Grameen Bank (referred to as 'Grameen II') since 2000 and has been championed by practitioners such as Stuart Rutherford, Graham Wright, Madeleine Hirschland and Marguerite Robinson. The Consultative Group to Assist the Poor (CGAP) has also published extensively on the new microfinance. These banks will be able to support their clients' efforts to control family risks as well as capitalize on business opportunities. They will offer savings, insurance, remittance services, and personal and business loans, to help clients grow their assets while increasing their incomes.

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