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The development of the microfinance sector is based on the assumption that the poor possess the capacity to accomplish income-generating economic activities but are limited by lack of access to and inadequate provision of savings, credit, and insurance facilities. The micro financial services capture the various financial needs of the poor, and currently microfinance is a major component of poverty reduction and economic regeneration strategies around the world. As a concept, microfinance pays close attention to the incentives that drive efficient performance in the context of small transactions and large numbers of clients. Most of the institutions in microfinance are based on group-based lending approaches and thus reduce the administrative costs of gathering information, contract design, and enforcement of credit transactions, including loan recovery. Recently, the microfinance sector has come more into the domain of commercial organizations and the idea of sustainable microfinance has become an integral part of the development of financial markets in many countries.

Microfinance activities usually involve (1) small loans, (2) informal appraisal of borrowers and investments, (3) collateral substitutes such as group savings or compulsory savings, (4) access to repeat and larger loans, based on repayment performance, (5) streamlined loan disbursements and monitoring, and (6) secure savings products.

According to the Consultative Group to Assist the Poor (CGAP), the key principles of microfinance are (1) the poor need a variety of financial services, not just loans; (2) a powerful instrument against poverty; (3) the need to build financial systems that serve the poor; (4) financial sustainability; (5) the need to build permanent local financial institutions; (6) requires more than microcredit; (7) interest rate ceilings can damage poor people’s access to financial services; (8) the role of government as an enabler of financial services; (9) donor subsidies should complement private sector capital; (10) the lack of institutional and human capacity; and (11) the importance of financial and outreach transparency. These principles are generic and provide a broad foundation to the core idea of enhancing access to finance.

The CGAP principles suggest the need for a wide range of financial services that are suitable, flexible, and reasonably priced. The financial diaries prepared by poor households in urban and rural areas in Bangladesh and in India reveal that the respondents patch together a wide array of informal arrangements with semiformal and formal services. These diaries reveal that poor people want reliable, convenient, and flexible ways to store and retrieve cash and to turn their capacity to save into spending power, in the short, medium, and long term on a continuing basis.

The ideas of sustainability in microfinance allow the continued operation of the microfinancial services without subsidies and help from the donor. Financial sustainability helps to reduce transaction costs, which leads to client-based products and services. The idea of the poor as a heterogeneous group of vulnerable households with complex livelihoods demonstrates the need for client-based microfinancial services. In some cases nonfinancial services are essential for the effective use of financial services, and many microfinance institutions integrate both services in their operations. According to CGAP, microfinance combines banking with social goals, and capacity needs to be built at all levels, from financial institutions through the regulatory/supervisory bodies and information systems, to government entities and donor agencies.

New Institutions

There is an increasing level of interest from formal sector financial institutions in microfinance activities. For instance, Bank Rakyat Indonesia’s (BRI) experience shows that with attractive savings and credit products, appropriate staff incentives, and an effective system of internal regulation and supervision, the microfinance operation can be highly profitable. The flexibility in saving services, an important part of Unit Desa Scheme of BRI, offers convenient banking hours, a friendly atmosphere, unconstrained withdrawals, and a range of incentives such as bonuses and raffles.

In India, the Self Help Group (SHG) program, a distinctive microfinance program, is based on the existing banking network in delivering financial services. The formal financial sector institutions extend loans to highly performing SHGs in certain multiples of the accumulated savings of each SHG. The Reserve Bank of India (RBI) has instructed all commercial banks to participate and extend financing to SHGs, extending this to cooperative banks and regional rural banks. However, by the early 21st century, microfinance institutions have become a vast global industry involving large numbers of governments, banks, aid agencies, nongovernmental organizations (NGOs), cooperatives, and consultancy firms and directly employing hundreds of thousands of branch-level staff. The presence of more players in microfinance has raised certain concerns about the quality and sustainability of the services for several reasons.

The higher number of players attracts competition and brings high levels of professionalism to the industry. But there are concerns about more players targeting the same market, which questions the absorptive capacity limits on the part of both lenders and of borrowers. Irrespective of the successful citations of microfinance, there is a view that microfinance has failed to see the slippery slope toward consumerism. This type of concern goes back to the ages of the previous debates on whether microfinance is a successful tool to address poverty alleviation. It is beyond doubt that microfinance raises the prospects for low-income households, and some poor people, to achieve their goals—in business, consumption, education, health, and other areas—and is not a magic bullet that automatically lifts poor people out of poverty through microenterprise. The time has come for microfinance institutions as well to take up the challenge to develop diversified financial services while maintaining financial sustainability.

Bibliography:

Arun and D. Hulme, eds., Microfinance: A Reader (Routledge, 2008);
Arun, D. Hulme, I. Matin, and S. Rutherford, “‘Finance for the Poor: The Way Forward?” in Finance and Development: Surveys of Theory, Evidence and Policy, C. J. Green, C. H. Kirkpatrick, and V. Murinde, eds. (Edward Elgar, 2005);
Arun and P. Mosley, “SHGs in India: A Magic Bullet for Poor Rural Women,” Paper presented to the ESRC Seminar Series on Finance and Development, University of Manchester (October 30, 2003);
Consultative Group to Assist the Poor (CGAP), “Key Principles of Microfinance,” cgap.org (cited March 2009);
Alex Counts and Alex Counts, Small Loans, Big Dreams: How Nobel Prize Winner Muhammad Yunus and Microfinance Are Changing the World (John Wiley & Sons, 2008);
Dichter, “Can Microcredit Make an Already Slippery Slope More Slippery? Some Lessons
From the Social Meaning of Debt,” in What’s Wrong With Microfinance?, T. Dichter and M. Harper, (Practical Action Publishing, 2007);
Hulme and T. Arun, “The Future of Microfinance,” in Microfinance: A Reader, T. Arun and D. Hulme, eds. (Routledge, 2008);
G. Karmakar, Microfinance in India (Sage, 2008);
Daniel Lazar and P. Palanichamy, Micro Finance and Poverty Eradication: Indian and Global Experiences (Pondicherry University, 2008);
Ledgerwood, Microfinance Handbook: An Institutional and Financial Perspective (World Bank, 2000);
Morduch, “The Microfinance Promise,” Journal of Economic Literature (v.37/4, 1999);
Morduch and S. Rutherford, Microfinance: Analytical Issues for India,” Paper Submitted to the World Bank, South Asia Region (2003);
Stuart Rutherford, The Pledge: ASA, Peasant Politics, and Microfinance in the Development of Bangladesh (Oxford University Press, 2009);
D. Seibel, “The Microbanking Division of Bank Rakyat Indonesia: A Flagship of Rural Microfinance in Asia,” in Small Customers, Big Market, M. Harper and S. S. Arora, eds. (ITDG Publishing, 2005);
Rajdeep Sengupta and Craig P. Auchubon, “The Microfinance Revolution: An Overview,” Federal Reserve Bank of St. Louis Review (v.90/1, 2008).

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