Why do microfinance?
Microfinance gives the poor the opportunity to become financially included, self-sufficient and gives them control over their own economic situation. Loans are provided at commercial terms and carry interest. The loan amounts are set at sustainable levels; where customers are comfortably able to both service the loan and pay the interest.
The microfinance institutions must run efficient and commercial operations to acquire customers and manage their loan portfolios. These systems are often based on close personal relationships between the institutions and the borrowers, with regular face to face interaction. A combination of relatively broad loan portfolios, short loan durations and small initial loan amounts reduces the loss exposure of the lending institutions, even in circumstances where collateral is hard to secure.
The sums involved in microfinance are typically much smaller than with regular banks. A first-time loan may be a low as NOK 250 and very rarely higher than NOK 4000.
The trust between institution and the customer develops over time, and as loans are repaid the borrower may usually borrow a larger amount the next time. In this way, the borrower becomes increasingly financially literate and builds up a credit history.
The loan duration is usually between six months to a year. The effective interest rate is 11% to 35%. This interest covers the administrative costs of establishing the loan (which is high given the need for personal interaction, and given the size and duration of the loans granted compared to normal banks); the financial education/ training of customers; the administration of collateral deposits; and a default rate that is a little higher than for conventional bank loans.
Who can get a loan?
In principal anyone who has a good business idea may apply for a loan: a craftsman buying tools, a shopkeeper buying stock, a peasant buying animals or tools that make the farm work more efficient. The only prerequisite is that the business they run generates positive financial results or an income stream that allows the borrower to service the debt, with a margin of safety. The loans are intended for the poor who are not financial included and not for those that are catered for by conventional banks.
Why can’t the poor use regular banks?
Regular banks often require collateral in property or fixed chattel, as well as proof of regular income or salary, to provide them the assurance that the borrower is creditworthy. Property registers in most development countries typically both manual and incomplete. This means that even families that have owned and lived on a property for generations may find they are unable to provide the documental proof needed to allow them to pledge the property as collateral. This, combined with the absence of individual credit history, effectively excludes huge proportions of the world’s poor from the regular banking system.
Why charge interest when lending to the poor?
History has shown time and again that «free money» does little to help businesses flourish in the long term. Learning financial discipline, and the economic training that the micro finance institutions provide to their customers, increase financial literacy and creates an environment for sustainable economic development. Requiring businesses to be both able to support loan interest and repayments, as well as making a return for the owner, is a good way of ensuring the business case stacks up and is a viable investment. Charging interest will, therefore, ensure investments in tools, equipment and inventories and so forth only made if they make economic sense. Good investments generate better economy and living conditions over time.
Meeting the poor on a normal, commercial basis also means treating them (and them feeling treated) as an equal, with the respect and dignity that simply giving gifts never can achieve.
When is microfinance not relevant?
Microfinance as a tool has been developed to support those poor that don’t have access to regular banking services, but is not suitable in all circumstances. There are people that are unable to service loans, even from micro finance institutions.
This could be because they are innumerate or lack the knowledge of how to run a business profitably, or simply because the environment they live in is so poor that there is no available market for the goods or service they want sell. It is still the case that people living in such extreme poverty, and who don’t have the necessary knowledge and qualifications, primarily are in need of aid and education rather than access to financial services.