The Evolution of Microfinance

Overview

Microfinance is widely used to refer to a relatively recent phenomenon: among its iconic
champions Grameen became a bank in 1983, BancoSol in 1992 and K-Rep 1987 (as an NGO)
and in 1999 (as a bank). However, if defined as financial services for relatively poor people then
of course it has a much longer history. For example, its recent history echoes a nineteenth
century proliferation of financial initiatives and innovations from friendly societies to Raiffeisen
cooperatives to help poor working people in the aftermath of European and North American
industrialization (Roodman, 2012).

Microfinance also evolved out of earlier forms of government sponsorship of credit for small
businesses and farms, and shares many characteristics with them (Anderson and Khambata,
1985; Von Adams and Von Pischke, 1992). While the first Microcredit Summit in Washington
of 1997 can be viewed as symbolic of the arrival of microfinance as a global phenomenon, the
G20 adoption of the Global Partnership for Financial Inclusion in Seoul on 10th December 2010
can be viewed as heralding its eclipse. Rhyne (2014) puts it as follows: -

“Through microfinance, hundreds of millions of clients who had previously been ignored by the
mainstream financial institutions have access to products that most of us take for granted in our
daily lives. Now, building on the success of microfinance, the financial inclusion movement has
created a vision of a world where everyone has financial services to help them achieve their
goals... new providers and new technologies are making it possible.”

The spread of microfinance and the success of MFIs in various countries around the world
prompts a question: -

Who served the poor before the microcredit revolution? It is well known that conventional
banks, which act as creditors to most entrepreneurial activity in the modern world, have largely
avoided lending to the poor. Instead, credit to the poor has been provided mostly by local
moneylenders, often at abnormally high interest rates. Consequently, moneylenders are typically
perceived as being exploitative, taking advantage of poor villagers who have no other recourse to
loans. Therefore, it is not surprising that microfinance has been welcomed by most as an
alternative to the abusive practices of village moneylenders.

a) However, this common perception requires a more careful study: -

b) Why don’t mainstream banks lend to the poor?
c) In the banks’ absence, do local moneylenders have monopoly power?
d) More importantly, are these high interest rates charged by money lenders welfare
reducing?

Lending to the poor is usually challenging and this can be explained as follows.

1) Early studies believed that poor people often lack the resources needed to invest their
borrowings to the most productive use. The poor borrow mostly to finance consumption
needs (Bhaduri, 1977; Aleem, 1990);
2) Even if loans could be earmarked for investment purposes, commercial banks would find
it difficult to lend. This is due to lack of credit histories and documented records on small

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 entrepreneurs or farmers make it difficult for the bank to assess the creditworthiness of
the borrower; and
3) There is the inability of the poor to provide collateral on the loans. This reduces the
bank’s recourse to a saleable asset once the borrower defaults on the loan.

On the other hand, it is believed that local moneylenders could mitigate the problems faced by
outside banks in lending to the poor. Local moneylenders are arguably better informed of
borrower quality and have more effective means of monitoring and enforcing contracts than
outside banks. In short, because of their social ties, information and location advantage, these
money lenders are in a unique position to lend to the poor.

Some observers argue that exceptionally high interest rates in these markets can be explained by
this “monopoly” that the local money lenders have at their disposal. However, there are other
reasons why money lenders charge high interest rates.

1) They have to compensate for the high transaction costs of issuing and servicing a small
loan;
2) The funds have high “opportunity costs” whereby it can earn high returns by investing in
other high yielding investment ventures; and
3) Despite their local informational advantage, moneylenders face some of the same
problems as commercial banks in identifying risky borrowers and securing collateral,
particularly in poor rural areas.

2.0 Stages of Development of Micro-Financing

Micro-financial activities in the world have a slightly different trajectory:

1) Strong social feeling appearing by the expressive ‘bottom-up’ activity. The active attitude
of the poor smallholders, fishermen, craftsmen, businessmen and other population of the
very poor countryside;
2) Poverty in rural areas; and
3) Period in which micro-financial activities of the Micro Financial Institutions (MFI’s)
become evident with attainment of political independence, in the 1970’s of the last
century.

The development of the MFI’s accelerated right in the period of decolonization when new states
originated. The banks of the newly independent states created environment for the MFI’s and
gave rise in providing basic micro financial services to the rural poor. The poor rural areas in
were not reinforced, it was rather the urban centres.

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Development of MFI’s can be divided into some important periods which overlap each other as
shown below.

1970-1980 1980-1990 1990-2000 2000-Present

Period Period Period
- - - Transformation
Expansion Growth Commercialization Secularization

-Poverty reduction -significant financial dualism -growth of formal -transformation of informal to

-Prevalent support -considerable support “top- MFI’s formal MFI’s of international,
down” -support of NGO’s, state & private org.
“bottom-up”
-rapid growth in number of Govt. -financial business
-most informal MFI’s & served clients -support prevail the charity
MFI’s

The development of micro-financial activities depends on many factors, amongst which: -

1) Stable economic environment guaranteed;

2) Permanently functional liberal programmes;
3) Governments support and cooperation with the private sector; and
4) Stable exchange rate (e.g open international trade, know-how, mutual understanding,
tolerance etc.).

First period

The first period is characterized mainly by (Book review 2008): -

 Providing social benefits and taking priority over the raising of the MFIs’ profitability;
 Loaned (start-up) money is paid back, but without dividends (interest, profit);
 The principle of mutual guarantee in terms of Peering Groups, Self-Help Groups or in the
initiative informal micro-financial activities;
 Micro-financial activities are characterized as: self-sustaining, self-expanding and self-
perpetuating;
 Different voluntary groupings are established (e.g Grameen Groups, ROSCA (Rotating
Savings and Credit Associations), ASCRA (Accumulating Savings and Credit
Associations));
 High level of enthusiasm among persons who were at the beginning of this movement
(e.g Muhammad Yunus);
 Appeal on poverty reduction.

Poor countryside is an entrepreneur environment for the MFIs. These institutions influence not
only poverty reduction and debt relief of the heavily indebted but currently they are one of the
decisive factors to maintain or completely change the living environment. Formal MFIs can very

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easily come under the endeavour to make profit at the expense of the mainly sustainable
environment and poverty reduction (Sherr 2002). Besides, the proof that microfinance influence
poverty reduction is Professor Muhammad Yunus who was awarded the Nobel Peace Prize, and
the fact that the year 2005 was declared the Year of Microcredit (in terms of the UN’s
Millennium Development Goals).

Second period

The second period is characterized by a rapid development of the formal MFIs. Different types
of formal MFIs began to evolve in the second half of 80s of the last century.

The coexistence of formal and informal microfinance system commonly used in LDCs is the so-
called ‘financial dualism’. The modern and transparent formal system dominates but is less
accessible to the poor clients. The informal system is more spread in rural areas where it is
accessible to the very poor clients and it is cheap but not quite transparent. The formal system is
commonly much more known than the informal one in which the understanding is obvious from
the financial relations between creditors and debtors. These relations are mostly based on
historical, tribal, familiar and traditional relationships. The principle of these relations is honour
and promise which is stronger than a written agreement or pledge.

In the financial markets, formal and informal MFIs work parallel but just formal MFIs are
distinguished by a larger scope of activities and are governed and controlled by the given public
institutions. Poverty in these countries is solved from the point of view of financing in two basic
directions: -

1) the initiative ‘bottom-up’; informal self-help groups, profit and non-profit MFIs; and
2) the initiative ‘top-down’; profit organizations (formal MFIs or middle and large scale
financial.

As for the poor people, all categories are beneficial. However, it is not so from the standpoint of
the needs of the middle and large-scale investors, especially in the implementation of the
developing programmes.

Third period

This period is characterized not only by the ongoing growth of microfinance activities, but
mainly by the acceleration of transformation of the informal types of MFIs to formal ones.

The main scientific question in this period was an assessment of the objective framework: ‘When
is the informal MFI suitable for a transformation?’

The conditions and suitability for transformation of informal MFIs to formal ones are highlighted
in the scheme of the three triangles. The institution has to meet three requirements: -

1) Stability maintenance in the environment in which the MFIs operate; the critical triangle
2) Outside sustainable development of the MFI; out-side institution’s stability; the triangle
of outside economic stability (Zeller, Meyer 2002); and
3) Inside economic sustainability of MFI, inside institution’s stability; the triangle of inside
economic stability.

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Critical triangle (stability of the region) characterizes a space in which it is rational for formal
MFIs to develop their activities. Actually, it concerns a balance keeping in solution of the most
serious needs in the given regions: sustainable environment development, the necessity to
remove hunger and the need of poverty reduction in the region.

Triangle of professor Zeller (outside economic stability of MFI) describes the outside
stability results from the scope and quality of the provided financial and other services. These
services have to fulfil three following requirements: financial stability which ensures sustainable
development of the institution, sufficient scope and quality (to hold out with the competition, to
be able to spread its provided services) and the necessity of an effective impact on the clients’
rising economic stability and prosperity.

The inside economic stability of MFI (Triangle of MFI’s inside economic stability) concerns
the coincidence of three factors which are expressed in bigger financial institutions on the base
of business cash flow. The factors are the following: -

1) Profitability of MFI, i.e its management in the way in which the yield is higher than costs
and the MFI reaches profit;
2) Liquidity – the ability of MFI to transform its financial deposits into the liquid assets (the
ability to pay off to the clients their deposits when required – from their own reserves,
property converted into money or deconsecrating of its actives); and
3) Solvency – the ability to reimburse from their usual income, eventually by releasing their
common reserves, the costs and obligations even in the cases when losses happen (this
enables continuing activities and does not transfer the negative economic results to the
clients).

Fourth period: Business or Charity

Microfinance creates financial markets and builds up civilization structures in isolated and
remote regions: that is why some banks buy at present the whole portfolios or even the whole
institutions. Initially, microfinance had the character of self-help and charity. In the 21 st century,
microfinance more and more attract the attention of small and middle-sized investors.

Small informal MFIs are mostly of the self-help character with the charity support (‘charity
Model’) and the formal MFIs with a significant support of NGOs (as a financial intermediary),
middle- and large-scale banks as well as other large organizations (‘Business Model’). Both
informal and formal MFIs work side by side.