It's easy to take bank accounts for granted if you've always had one, but for a lot of the world's population, that's not the case. The World Bank's 2017 Global Findex report, which reviews bank use and accessibility worldwide, estimated that about 1.7 billion people worldwide had no bank account and, therefore, little or no access to financial services. Even among those with bank accounts, access to loans and credit remains shaky for the poor and underemployed.
Microfinance institutions aim to bridge that gap, bringing financial services to people who otherwise wouldn't have them.
No Assets, No Collateral, No Options
In most markets, it's difficult or impossible to get a conventional bank account if you don't have a regular income, any meaningful assets or, in some cases, even a fixed address. If you're looking for a loan, it's even harder. The irony is that even a small loan might be enough to help someone work their way out of poverty by allowing them to purchase goods, supplies or a needed piece of equipment that can then be used to create an entrepreneurial income.
In the absence of a microfinance bank or other microfinance provider, or government programs that fill a similar niche, freelance moneylenders – in other words, high-interest loan sharks – are often the only resource available, leaving borrowers worse off than before.
The Purpose of Microfinance
The purpose of microfinance, then, is to put financial tools in the hands of people who wouldn't otherwise have access to them. There are a few different underlying reasons for doing so.
Governments sponsor microfinance, or even provide it directly, because it reduces poverty and stimulates the economy. Aid groups, non-profits and non-governmental organizations (NGOs) may focus on those who've fallen through the cracks, such as women or ethnic minorities. Microfinance banks or conventional investors may offer microfinance services with a straightforward profit motive.
Microfinance Institutions Operate Under Different Models
As you'd expect, organizations with these distinctly different goals operate with different objectives.
- A for-profit microfinance bank operates much the same way as any other bank, though its criteria for opening accounts and securing loans are different.
- Some institutions operate collectively, as a credit union or through crowdfunding, and profits go back into the lending pool.
- Non-profits and NGOs, unless they have outside funding, also take enough to cover their operating expenses and return the rest to the lending pool.
- Government programs might not need to turn a profit but may be under more pressure to show results lest their funding be cut off.
How Microfinance Works in Practice
To varying degrees, microfinance institutions see themselves as providing a way forward in life, as opposed to just money or services. Often, this means providing new clients or prospective clients with a basic education in financial concepts, money management and business planning before they're eligible for accounts or loans. Networking a number of clients together into a pool – to support each other with shared insights or, if necessary, a bit of assistance in hard times – is another valuable strategy. By giving clients these additional tools and resources as well as funding, microlenders help improve the odds of success.
Microfinance Banks Take Many Forms
The modern model of a microfinance bank is Bangladesh's Grameen Bank, which was awarded a Nobel Peace Prize in 2006 for its pioneering work with the rural poor in that country. It operates as a credit union, with ownership shared by its clients. India's Bharat Financial Inclusion Limited (formerly known as SKS Microfinance Limited) and Mexico's Compartamos Banco began similarly as nonprofits but changed focus and now operate as for-profit entities. Even conventional lenders, from Citigroup to General Electric, now have dedicated for-profit microfinance operations.
The Nigerian Model
Nigeria, which has a large population of unbanked and underserved people, eventually created three distinct tiers of microfinance banks:
- local institutions serving one community
- larger banks operating across one of the country's states
- national banks operating countrywide
A community-based bank requires capitalization of $20 million Nigerian, while a national bank requires $2 billion Nigerian or more. Banks can be nonprofit or for-profit – some were formerly operated as NGOs – but by tightening the standards for capitalization, Nigeria hopes to provide the sector with greater stability and reduce the risk of failures or outright fraud.
Starting up With Existing Capital
Starting up a microfinance bank is simplest, of course, for those with a large quantity of existing capital. When a large conventional institution, such as Citigroup or Barclays, sets up a microfinance subsidiary, the money is carved out of its existing resources and the resulting bank operates and creates profits and losses in the same way as any other subsidiary. Depending on the size of the bank, it could also be created by:
- a single affluent investor,
- a small group of partners, or
- a larger group of investors acting cooperatively
Attracting Outside Investors
A second alternative is to seek outside investment from groups or individuals who will have little to no daily involvement in running the bank. For a bank with a strong business plan and clear prospects of turning a profit, this might take the form of conventional venture capital. Others might turn to firms that combine investment with activism, such as socially responsible mutual funds or investment firms with socially progressive portfolios.
Connecticut-based Developing World Markets, for example, has focused exclusively on "impact investment" since 2007, and 58 of the 62 companies in its portfolio as of 2018 were inclusive financial institutions, meaning microfinance makes up at least a portion of their mandate.
Investment From Governments and Aid Programs
Another key source of capital for some microfinance institutions is international aid programs, funded directly or indirectly by various governments. America's own USAID program, for example, funds banks and credit unions as part of its support of microenterprises worldwide. In the Asia Pacific region, the Asian Development Bank provides funding for microfinance banks and other small-scale enterprises throughout its member countries. The bank itself is funded in part by its own ongoing profits and in part by its member governments, and it also negotiates partnerships with other institutions on a regional or project-by-project basis. Similar organizations operate in other regions.
Bootstrapping Microfinance Institutions
In the absence of any substantial sums of capital, it's entirely possible for a relatively small group to pool their funds and create a microfinance institution of their own. Credit unions use this model, with new members making an initial deposit and receiving an ownership stake – and a small slice of the profits – in return. Microfinance services can also grow organically out of cooperative groups formed by artisans and producers. Indonesia's APIKRI, an association of artisans with over 2,000 members, provides savings programs and microcredit loans as part of the overall benefits of membership.
Yet another model is entirely decentralized, crowdsourcing small individual donations in affluent countries and then distributing those funds in the form of microcredit in underserved areas or to underserved populations. Online crowdsourcing site Kiva takes this approach, providing small-scale loans, sometimes at zero interest, around the world and within the United States.
Yes, But Does it Work?
Over the past few decades, microfinance has grown from a niche product involving small amounts of money to a major industry managing billions. Microfinance institutions naturally paint their impact in rosy colors, with websites and annual reports telling the heartwarming stories of lives that have been changed by their intervention. Economists and other academics increasingly scrutinize the industry, with mixed results. Boosters and detractors can each make a convincing case for their point of view.
The Big Picture
The World Bank's 2017 Findex Database shows financial inclusion rising noticeably since its original 2011 edition, with over 1.2 billion adults obtaining formal banking accounts during that six-year interval. Not all of this improvement is due to microfinance institutions, but – given that the unbanked are primarily among the world's poorest citizens – it's likely they play a disproportionate role.
In a 2017 microfinance essay, privately owned website Infoguide Nigeria contrasted similar villages in that country with and without a microbank, finding more than double the number of entrepreneurs and small enterprises in the village with access to microfinance. Repayment rates for microfinance loans are also excellent, despite their apparently riskier nature, and in fact are higher than repayment rates for conventional loans.
The Bangladesh Experience
Bangladesh's role as a pioneer of microfinance makes it an especially rich source of data on the subject, and a 2014 study drew on 20 years of data from that country to evaluate the results of those small loans and savings. The paper concluded that microfinance had "significant positive effects," increasing families' net worth and tangible assets, creating a greater likelihood of their children being educated and especially increasing opportunities for women.
Access Bank Tanzania
Another paper, from the World Bank's International Finance Corporation, looked at the results of microfinance operations by Tanzania's AccessBank, a full-service bank that provides microfinance services as well as conventional banking. The study showed that customers who'd had and repaid one loan successfully were able to grow their businesses and return for successive loans in larger amounts and on better terms. Over 80 percent of the clients interviewed for the study regarded the experience as a positive for their households and businesses.
It's Not Entirely Clear-Cut
Other studies have found that microfinance may have a much lower impact than its supporters believe. A 2016 paper published in the Review of Development Finance concluded that while increased access to banking reduced national poverty by some measures, that same success couldn't be clearly demonstrated for microfinance institutions. Other critics point to the rigid repayment schedules that are common in the microfinance industry and their sometimes-high fees and interest rates. Another common objection to microfinance is that loans intended for entrepreneurship sometimes go to meet nonbusiness needs, such as repairing a roof or supporting the household during an illness or emergency.
There's Room to Refine the Model
There's reason to believe that a few refinements in the existing microfinance model could improve its outcomes. A 2015 study in the journal Development Studies Research analyzing the Bangladesh market concluded that placing more emphasis on teaching business skills and scalable business planning would increase microfinance's impact.
Other studies point to the need for improved screening of potential entrepreneurs and greater flexibility in repayment terms, especially for those in seasonal occupations. There's also a growing need for products targeted at entrepreneurs who've outgrown traditional microfinance but still aren't large enough to qualify for conventional loans and banking.
The Bottom Line
In the final analysis, while microfinance isn't a magic wand that will make poverty disappear, there's a lot to be said in its favor. After reviewing numerous studies, a 2014 article on the World Economic Forum's website concluded that microfinance – despite the concerns of its critics – shows no evidence of systemic harms to its borrowers and did show specific positives. Microfinance provides a viable source of profit to investors, and demonstrably improves the lives of its users. At the end of the day, that may be enough.