‘The ability of these institutions to lend effectively beyond the “frontier” of those who have collateral to offer, when those safely behind the frontier make much bigger losses lending to more prosperous people, is one of the most extraordinary achievements of development policy in our time.’
Paul Mosley, University of Reading, England, 1995
Microfinance services, established and operated by non-profit organizations (NPOs), are an ingenious way of giving ‘the poor’ of the world access to affordable financial resources. A 1996 World Bank survey found that 206 institutions had about US$17 billion in outstanding small loans to more than 13 million individuals and groups as of September 1995. Yet these impressive figures did not gain real attention until the Microcredit Summit held in Washington DC early in 1997 made the topic the subject of headline news and worldwide development euphoria.
Why all the excitement?
Why is microfinance considered to be today’s ‘development revolution’? Why are donors now paying serious attention to what countless NPOs around the South are achieving in terms of amounts of money lent, loan recovery rates, numbers of clients reached, incomes increased and new jobs created?
The answers to all of these questions is, amazingly, only one. Microfinance services, successfully operated, provide – literally – millions of households with financial resources that without doubt contribute to improving their economic situation. And – what is most noteworthy – this is achieved at a significantly lower cost, in terms of development funds, when compared to most other poverty alleviation and income-generation interventions tried before. As was recognized by an official of a major international cooperation agency, the UNDP, ‘microcredit is one of the most powerful development assistance tools we have’.
What is microfinance?
Simply put, microfinance services are usually started by NPOs as a solution to problems related to two conditions:
- a chronic lack of cash to support or start economic or income-generating activity by individuals or groups living in poverty;
- the absence of private and public formal sources of credit for low-income populations.
By providing access to the cash that is needed, these programmes have shown dramatically that the poor are credit-worthy, that they repay the loans received, and that they do so at interest rates that are usually higher than those available at commercial banks. This access to loans results in thriving microenterprises and other economic activities managed by ‘the poor’, improved incomes, new sources of employment, and improvements in the living conditions of those receiving the loans.
From the point of view of the organizations behind the programmes, successful services result in growth for the organizations themselves: growth in resources, in outreach capacity, and in self-sustainability.
How can you lend to the very poor?
None of this would be possible if there were any doubts about the clients’ ability to repay the loans. It is an undeniable fact that lending to the poor makes excellent business sense. Loans given on affordable terms to poor people show excellent repayment rates, and when economies of scale are exploited in order to make the operations cost-effective, the making of such loans is profitable. The benefits are therefore twofold and reinforcing: as more clients receive more loans and repay them, the pool of funds available for the implementing organization increases, allowing it to give out even more loans.
‘Affordable terms’ does not mean cheap or subsidized. The programmes would end very quickly if such were the case, because processing and managing many very small loans is expensive. In order for the operation to make economic sense, the interest rates must reflect this expense and as such may be higher than rates in the banking sector. But it is clear now that what poor people need is access to loans. And the economic activities serviced by these programmes need credit that is available long enough to allow the clients’ economic activities to grow. Access and continuity depend on programme growth and sustainability, and this in turn depends, for the most part, on income gained from interest rates. The cost (interest rate) of obtaining the loans is therefore a secondary consideration for clients: they know that lower interest rates may be available elsewhere, but from institutions (banks) that do not service them.
Starting up a microfinance programme
Even assuming one has the necessary funding to begin, the establishment of a microfinance programme is no simple matter. In addition to having some basic knowledge of credit methodologies and procedures, the implementing organization must consider certain other issues before initiating a programme.
Knowledge of the sector receiving the loans is the first priority. The sector’s previous experience with credit, if any, must be taken into account. Understanding the formal financial and legal context is also important. Finally, and very importantly, in most countries inflation requires these programmes to adopt measures to maintain the value of their funds.
Of course, there may be sectors of the poor – perhaps the ‘poorest of the poor’ – who will not benefit from credit at all but need other types of support. The impressive results of some microfinance programmes, coupled with a justified donor impatience for poverty eradication, have perhaps led to over-enthusiasm about microfinance as a blanket solution. This in turn can distort facts and create false expectations that will be harmful in the long run. Microfinance programmes must be very clear at the outset about the ‘target group’ they expect to work with and if credit is the best way to support that group.
How much funding is needed?
Initial financial resources vary between programmes. Some started with major donations from international donors, foundations, private enterprise, etc, while others were begun with very little financial and/or external technical assistance. The Trickle-Up Program in the United States, for example, started with only US$1,000 of the founders’ own money, some computer equipment on the dining room table and a part-time secretary.
But financial resources for the lending operations and for acquiring technical assistance in microfinance know-how are very important. Successful programmes have generally moved along a continuum from being totally dependent on donor funds to increased levels of self-sustainability, where income equals or exceeds expenditures. We have learned from these programmes that the process of development has two phases:
- a start-up or institution-building phase, which requires significant amounts of non-refundable funds or grants;
- a consolidation phase of expansion of activities towards self-sufficiency, where other sources of funds – usually refundable – must be tapped.
Donor funds and sustained support from international cooperation agencies for these programmes are specially crucial during the start-up phase.
How long will the start-up phase last?
How long the programme operates on donated funds depends on those involved having the business sense, even as a non-profit, to work towards self-sustainability. The only way to approach microfinance is to realize early on that income gained through increased volumes of operations will bring a programme to a break-even point. Working towards this goal will afford the programme credibility and prestige in the local lending market and open doors to new sources of funds.
At this stage the programme is ready to borrow funds, usually at market rates, either from local commercial banks or from specialized agencies within international cooperation institutions. Many of these agencies now have credit lines for microfinance as part of their regular operations.
Donor agencies that have been following the results of microfinance programmes now point out that grants for equity are of strategic importance in enabling organizations to build a capital base for increased outreach and sustainability. These grants for equity can be used to generate investment income, build the loan portfolio, and leverage funds from local banks. They help lower the overall cost of funds during the period it takes to build efficient operations and reach economies of scale.
The future for microfinance
It was hard to imagine where this work would lead when non-profit microfinance programmes started. As an immediate solution to lack of access to sources of credit for poor populations, it was thought that the trend would point to formal financial institutions taking on this clientele, while the NPOs implementing the programmes moved into other needed areas of work. ‘Graduating’ poor clients to banks was often a stated goal of these programmes. But … the formal financial institutions did not open their doors to the microborrower – or were too slow to see the financial potential of doing so – and governments and other donors alike began to realize the opportunity for channelling development funds to these programmes.
Why not encourage and support these programmes to transform themselves into formal microfinance institutions? This was the question being asked, and measures to make this possible were set in motion. Financial legislation is changing in many countries and, where this is happening, the door is now open for NPOs working in microfinance to become formal financial institutions. Formalizing entails many new challenges, most important of which is being able to offer a new service to the clients: savings.
Mobilizing savings – the key to sustainability
From the point of view of the clientele savings, like credit, meets a felt need. The rural poor, in particular, need a secure place to place their small savings and the assurance that they can withdraw these savings when needed. Commercial banks usually do not have offices in remote rural areas where the poor live, but microfinance NPOs do.
From the point of view of the institution, savings is the key to long-term sustainability. This is because being able to access savings, from big and small depositors alike, provides the institution with a new and easier-to-access source of funds for its lending programme. But this requires legal authorization. Microfinance NPOs are authorized to offer credit services, as NPOs, because the risk lies with the NPOs themselves and the institutions that provide them with funds. Savings mobilization, on the other hand, requires government authorization and supervision because the institution will be dealing with funds from the ‘public at large’ – the many hundreds of thousands of small savers who trust the institutions where they deposit their savings. It is essential, therefore, that institutions collecting savings are properly supervised and legally authorized to offer the service.
Two-thirds of the world’s population live in poverty, and the majority survive through extremely small-scale economic activities that put food on the table for themselves and their families. Providing financial resources for those activities, by way of credit, allows these families also to obtain clothing, education, housing, health services, and an evident improvement in their working and living conditions. No wonder, then, that development practitioners, policy-makers and donors are looking seriously at what is happening with microfinance in the world today.
FIE – an example from Bolivia
FIE, in Bolivia, is a typical success story. Started in 1985 as an NPO dedicated to providing credit for low-income individuals and groups in the so-called ‘urban informal sector’, FIE began with very little funding and hardly any international support. A staff of almost 200 now works in 14 FIE branches; so far the organization has lent over US$65 million, in loans averaging less than US$700 each. Its current loan portfolio is US$12.2 million, servicing over 22,500 clients, 60 per cent of whom are women. This excellent performance and amazing growth have encouraged FIE to transform into a financial institution. FIE, Private Financial Fund opened its doors to the public in March 1998, offering its clientele savings services as well as loans. No small achievement for what started as a small non-profit servicing very low-income clients and their microenterprises.
What explains this success? From the very beginning, even as a non-profit, FIE’s approach was highly business-oriented. Its guiding principles are cost recovery, capitalization and full pricing.
Even the institution-building phase emphasized these principles, with the organization devoting itself to perfecting its individual lending methodology, acquiring knowledge of the clientele, improving the loan officers’ performance, and perfecting the software for loan portfolio control and daily performance indicator reports. FIE’s rapid yearly growth, in volume of loans, allowed it to reach break-even point during the seventh year of its credit programme. This performance – together with an enviable rate of arrears of as low as 2.9 per cent – qualified it for commercial loans from local banks to increase its lending funds. These results, and its capacity to access market-rate loans, forced the attention of both the local banking authorities and the international cooperation agencies, which agreed to support the NPO’s transformation into a formal financial institution.
Pilar Ramirez is an FIE board member. In 1985 she encouraged four other women to join with her in starting FIE, the first urban microfinance NPO in Bolivia.
1 Paul Mosley and D Hulme, Finance Against Poverty, Chapter 3, Routledge, 1995.
2 World Bank, ‘A Worldwide Inventory of Micro-finance Institutions’, The Sustainable Banking with the Poor Study, Washington DC, July 1996.
3 James Gustave Speth, UNDP Administrator, in Microcredit Summit draft Action Plan, 1996.
4 New York Times, 12 November 1997.
5 Marguerite S Robinson, Harvard Institute for International Development.