The world's poorest people face a great many barriers to basic financial services. One problem is that the poorest don't own property, so they lack the necessary collateral needed to secure loans. Most have no credit record. Most lack education or a formal employment record. Many live in rural areas, beyond the reach of traditional banks. And many can't read or write or sign their own names. Women are often further deterred in that some societies stipulate that only a man may serve as guarantor to a loan. Furthermore, most banks would not consider allowing loans small enough to be appropriate in those instances, for the simple reason that transaction costs (monitoring and enforcement) would be prohibitive. In the absence of formal access to financial services, the poor traditionally had no choices outside of being exploited by local money lenders.
A trained economist, Yunus saw this reality as a market failure
in his native Bangladesh in the mid-1970s, because by his estimation,
a lack of collateral was not itself a reason to deny financial
services. Bangladesh was suffering through a severe famine at
the time. "I found it difficult to teach elegant theories of economics
in the classroom . . . I felt the emptiness of those theories
in the face of crushing hunger and poverty." (Yunus
2003, 365) Yunus's response was to revisit the assumptions
and goals of contemporary thinking about economics and banking.
He further observed that the poor are not without ability: "Giving
the poor access to credit allows them to immediately put into
practice the skills they already know - to weave, husk rice paddy,
raise cows, peddle a rickshaw. And the cash they earn is then
a tool, a key that unlocks a host of other abilities and allows
them to explore their own potential." (Yunus
1999, 140) In other words, Yunus saw the landless poor not
simply as a cause, but as an economic opportunity.
The result in Bangladesh was the eventual establishment of the Grameen Bank, whose success has spawned countless similar programs worldwide. However, a great many other success stories, including the Bangladesh Academy for Rural Development (BARD), ACCIÓN International (which started in Latin America), and The Foundation for International Community Assistance (FINCA International) in Bolivia, have incorporated business models that are different in certain respects. (Some of the major differences in strategy for microfinance institutions will be explained later.)
But each of these programs has in common loans targeting communities that traditionally lack access to financial services. And each carries the central idea that loans are not charity. Some programs rely on some development aid, but these are generally seen as "startup" costs, not a means to sustain the program in the long run. As such, they rely - as banks do - on the fact that expectations dictate that loans will be paid off, with interest.
How do these programs successfully loan to poor, illiterate people who lack collateral and often lack other characteristics required for a traditional bank loan? Lenders still must seek to manage repayment risk. Four typical features are lending to small groups (as opposed to individuals), targeting women, offering graduated loans, and offering interest rates higher than traditional finance rates. The rationale behind each of these measures is explained below.
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One feature common to many microcredit programs is that loans are only offered to small groups of people, not to individuals. Each member of the peer group has his or her own business plan, but every member of the group (usually a manageable number of about five) is liable if one or more members default on the loan. The joint liability serves as collateral, since even if an individual project fails and some of the borrowers are unable to pay, the group as a whole might still manage the debt. In economic terms, this also cuts down on the need for the bank to monitor its borrowers, since the borrowers will have the incentive to monitor themselves.
One clear advantage to putting borrowers into groups is that it creates a support group mechanism. Group members are encouraged to meet frequently and help each other solve business problems. For entrepreneurs, this can be a particularly useful benefit. Also, individuals by themselves lack sufficient loan collateral, and it has been established that loans are more effectively paid off if small groups are created, and loan responsibility is made a collective responsibility.
But group loans also create a collective action problem. Lending to groups may help insure the borrowers pay back their loans, but individual borrowers' reliance on fellow borrowers also gives each member the incentive to free ride on the repayment of that loan (i.e., rely on other members of the group to repay the loan). In other words, repayment of the loan acts as a public good. So why does group lending outperform individual lending? (Abbink et al., 623)
Social identity theory suggests that cooperation stems from members' identification with and commitment to the group itself. But other research suggests that cooperation is more calculated, borne from extended interaction and reciprocal commitments between group members. Partners prove their trustworthiness to one another over time, enabling group members to commit to the benefits of the whole, a self-reinforcing commitment. (Anthony, 500)
In fact, studies have shown that repayment rates are somewhat better when less-connected community members are grouped together than self-selected groups or same-family and same-church groups. Social ties may be a hindrance if they lead to more "forgivingness" toward defaulters. (Abbink et al., 624; Van Bastelaer and Leathers, 1798) Furthermore, repayment rates are associated with communities characterized by high levels of social capital, where more attention is given to shared values and opinions and where mutual trust levels are higher. (Van Bastelaer and Leathers, 1792)
So peer groups create a mechanism for better enforcement and
more reliable repayment of loans. As a result, many microfinance
programs require the formation of small groups of borrowers from
the same community before money is lent. The groups serve as a
collective source of collateral.
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Another aspect common to successful microfinance models is the practice of loaning exclusively to women. Experience has confirmed that women make the best borrowers, and it has been confirmed that women repay their loans more faithfully than men.
But that is not the only reason to target women. Women are more likely than men to faithfully utilize their loans to improve their businesses. Experience has shown that while men tend to spend disproportionately on themselves, women are more likely to spend on improving the standards of living of their family and children, on health and education, and on household needs. And, because such a high percentage of the world's poor are children, the needs of these children are better met if their mothers and caregivers are given a leg up. (Elson; Van Bastelaer and Leathers, 1798)
Giving loans exclusively to women also helps empower women in developing societies, typically places where women do not enjoy the same benefits as men. Many microcredit organizations have goals beyond poverty alleviation, and social equity and gender justice are consistent with their goals. Programs often claim - and some studies confirm - that involvement in credit programs does empower women by increasing their ability to control family finances and assets and become engaged in the community. (Hashemi et al., 650)
So credit creates economic power, which in turn creates social power. One study of a microcredit program in Senegal that lent exclusively to women found that it empowered women in a rather unintended way. As women disproportionately gained power in the community, a new class of female moneylender emerged: "They recycle their capital as high-interest loans to other farmers, becoming cash patrons to their kin and neighbors. Although only 19 percent of the women interviewed admitted outright to doing this (it is against he rules set forth by the donor agency) most women proclaimed that moneylending is the most popular way for 'other women' to invest their loans." (Perry 31)
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Another common mechanism used by microfinance organizations is a policy of graduated loans. In other words, all borrowers start with small loans, and in paying back those loans, they become eligible for more ambitious loans. While each loan is current, credit is only further available while all members of a group are current in payments. This policy makes it possible to measure each borrower's payment capacity through successive experience. Credit ratings traditionally incorporate evidence of responsibility and stability in their measures, and the use of graduated loans operates using that same philosophy. Lenders perceive current reliability as being indications of future reliability. In other words, in the absence of a credit history, a borrower can build a credit history.
Payment discipline is further encouraged by the incentive for borrowers to gain future access to more credit. It is not uncommon for borrowers to go through many loans over the course of their relationship with the microcredit organization. These borrowers develop a credit history that allows them to take out greater loans for longer periods.
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High interest rates
In order for microfinance institutions to remain viable, in large part due to high administrative costs associated with small loans, they either need to be heavily subsidized or to charge relatively high interest rates. While on the surface, this appears contrary to the operating objectives of microfinance (or, at the very least, of poverty relief), it should be emphasized that while interest rates of 30 percent, 50 percent, or more appear exorbitantly high, they are quite low compared to its alternative, the traditional informal sector lending, which is usually dominated by local elites. And the high rates are necessary, given the fact that there are always overhead costs and transaction costs, and transaction costs must accurately reflect risk.
The Grameen Bank charges a relatively low annual interest rate of 20%. In order to charge a rate that low (for many years, the rate was below cost recovery levels), the bank sustained losses and had to be underwritten through subsidies. (Fernando, 4) However, Grameen is a success story in that it reportedly has not needed to accept donor money since 1998. (Yunus 2006, 16) It is more typical for microfinance institutions to charge an interest rate of 30% to 70% per year.
Interest rates vary depending upon a great number of variables, but ultimately microfinance institutions have to remain economically viable. Lower interest rates are preferred from the standpoint of poverty relief, but they must be made higher when (a) loan sizes are smaller; (b) borrowers are more likely to default; and (c) collection is made more labor intensive. With rural lending programs, all of these factors are often problematic.
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Taken together, these features - requiring group lending, targeting
women, providing incentives through graduated loans, and making
interest rates high enough to cover costs - provide a basic financial
service model for poor communities. The basic model is currently
being tested around the globe, in rural and urban areas, in industrialized
countries, and in the poorest countries. Each of these four features
are a part of the Grameen model, which most estimates have deemed
a success, both as a viable business as well as a social investment.
And the remarkable truth is that loan repayment rates above 90 percent - figures that are comparable to, or an improvement upon, conventional bank loan repayment rates in industrial societies - have become commonplace in the world of microfinance. Not all programs meet with such resounding success, but enough have proven financial successes, at least with respect to loan default rates, to quell any doubts about the efficacy of lending to the poor, in principle.
Furthermore, microfinance, and its overall benefit to a community, has the capacity to go beyond simple business loans. More substantial services can be provided by microfinance organizations as well, and the poor can use financial services not just to invest in business, but also to invest in educating and providing health for their families.
Nevertheless, lending models of microfinance institutions do vary substantially, depending on the characteristics of the target groups, local laws, or organizational philosophies. What works for Grameen in rural Bangladesh may not be necessary or desired in places where community problems are different, where customs and social structures and existing banking practices provide different incentives for organizational modeling. Microfinance programs have emerged in places as different from Dhaka as Chicago and Detroit. Other programs have chosen to make individual loans rather than group loans, and/or to freely loan to men.
And many programs offer - or even require - savings plans. Members who are repaying loans on a weekly basis also are required to save money and deposit it into a group savings plan each week. Programs offering this service include Grameen and the Philippines-based Centre for Agriculture and Rural Development. (Gow, 11) Grameen further provides its members with a package of social welfare services, including family planning education, nutrition and child development programs, and physical exercise programs. (Auwal, 17)
The Bangladesh Rural Advancement Committee (BRAC) mandates that members complete a lengthy awareness and training course before they receive their first loan, and thereafter provides opportunities to participate in other business training programs. The Grameen Bank operates with a different philosophy, offering little instruction. It is not clear which is a superior model, as there have been successes of both types. (Hashemi et al., 649)
So ultimately, the details vary. But the greater insight is that microfinance offers some promise to poor communities. The revolutionary aspect of these programs is that micro-level banking can be a viable business enterprise without the prerequisite of collateral. And for many organizations, these steps are a positive gesture toward alleviating poverty. But how grand a gesture?
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List of Visuals
- Yunus receiving Nobel Prize
MSNBC on the Internet (One Microsoft Way, Redmond, WA 98052)
- Bootstrap Banking All across Central American
The Katalysis Bootstrap Fund (c/o Christina Jennings, Executive Director, 1331 N. Commerce Street, Stockton, CA 95202)
- Women gather to make teak leaf plates, a self-employment project in Purulia, India, a program of Village Earth, an international Non-Governmental Organization
Village Earth (P.O. Box 797, Fort Collins, Colorado 80522)
- Charts showing microfinance expenses and yield by region
The Consultative Group to Assist the Poor (CGAP) (900 19th Street NW, Suite 300, Washington DC 20006)