Microfinance Management

by
Pradeep Kumar Mishra
Cengage Learning (2019)

Chapter – 2
Basic Concepts of Microfinance
Learning Objectives
• To provide an idea of various perspectives from which microfinance is
studied
• To provide an overview of poverty and its linkages with microfinance
• To provide a discussion of market failure and its related concepts
• To discuss how market failure is addressed through microfinance
Perspectives from which Microfinance is
studied
• Development perspective
• Grant based
• SHG-Bank Linkage Programmes are the major interventions
• Facilitating Agency (SHPI) plays an important role
• Primarily funded by government, requires huge public investment
• Market Perspective
• Assumes that poor are creditworthy, and grants are not required
• A win-win situation, where poor pay relatively less interest rate and access
institutional funds
• Followed by MFIs/SFBs through JLG/Grameen Group/SHGs.
• Pros and Cons
• Development perspective of microfinance is benevolent and not disruptive,
however, it has its limit due to grant dependency

• Market based microfinance has unlimited potential for expansion, however

sometimes, there has been mission drift of MFIs
Approaches to Microfinance
• Minimalist Approach
• Assumes that poor need capital, and it is enough to provide microcredit
• But there were risks associated with enterprise development
• Clients often lacked technical expertise. While many would be good in
production, they could not deal with marketing aspects.
• Integrated Approach
• Here a range of services (financial and non-financial) are provided
• The idea is that with support services the borrower would be in a better
position
Poverty
• Absolute Poverty
• Defined in terms of poverty line
• Based on income (say $1.25/day) or nutrition (calorie consumption)
• Relative Poverty
• A person is compared to others in the society
• Based on the comparison it is determined whether he/she is poor
• Subjective Poverty
• Judgemental
• Based on perception
Measurement of Poverty
• Income Approach (Headcount ratio)
• Based on poverty line (income based)
• It does not measure distribution of income
• Biological Approach
• Based on nutrition-based poverty line
• Inequality Approach
• Based on relative poverty
• Deprivation Approach
• Under certain conditions, a group is deprived of opportunity and income
Drewnowsky (1977)
Another Classification (Streeten, 1981)
• Basic Needs Approach
• Considers material and non-material deprivation

• Capability Approach (A. Sen)

• Deprivation from capabilities and commodities
• Entitlement failure
Causes of Poverty
• Lack of Resource Base
• Poor technology
• Lack of Market Access
• Structural Inequality
• Lack of Social Security
• Business Cycles
Dimensions of poverty that microfinance can
address
• Low income
• Through financing of income generating activities
• Material deprivation
• Through financing poor for acquiring assets
• Capability deprivation
• Through capacity building and institution building
Market Failure
• Economic theories relate demand, supply and price
• These relation should hold in market
• This also steers the booms, recessions
• Sometimes market principles does not work
• For example
• Poor require funds (say loans), there is a huge demand
• They pay very high interest rate also
• There should be an effort in market to match the demand
• But that never happens, and price always remain high
• Reasons for Market Failure
• Information Asymmetry
• Transaction Cost
• These two factors distort the market and hence market fails
• Information Asymmetry leads to
• Adverse Selection
• Moral Hazard
• Ex-ante
• Ex-post
Dealing with Risky Borrowers
• Banks /FIs lend to all kinds of borrowers
• Safe borrowers: 100% guarantee of successful repayment
• Risky borrowers: certain percent do go bad
• When you know that a certain borrower is ‘safe’, you can simply lend
at a rate equal to
k
Where k= cost of capital including the principal
In order to break even
e.g. suppose 100 (principal) + 10 (interest)= 110
Importance of information
• When you know that a certain borrower is ‘risky’, and there is a
probability of p of successful repayment the bank lend at a rate equal to
k/p
In order to break even
e.g. 110/90%=122.22 or say at an interest rate of 22.22%
• But suppose you do not know who is a risky and who is a safe borrower
• However from the past experience you have an idea that
• Proportion of safe borrower= q
• Proportion of risk borrower = (1-q)
Breakeven cost
• Now breakeven cost say ‘Rb’ • Or
Þ[q+(1-q)p)]x Rb=k k (1-q) (1-p)
ÞRb=k/ [q+(1-q)p)] A= q+(1-q)p
ÞRb-k=[k/ {q+(1-q)p)}]- k
ÞRb-k=k x [1/ {q+(1-q)p)}]- 1 Armendariz ad Morduch (2010).
ÞRb-k=k x [{1-q-(1-q)p}]/ {q+(1-q)p)}
ÞRb-k=k x [{)1-q)(1-q)}]/ {q+(1-q)p)}
ÞSay, Rb-k=A
ÞOr Rb=k+A
Group Lending
• It works because of
• Peer pressure
• Decrease in transaction cost (saving in number of transaction due to dealing
with group)
• Decrease in adverse selection (local people know who is a risky borrower)
• Decrease in moral hazard (other members would have a fair assessment of
this risk)
Cash-flow based financing
• In asset-based financing the concerned asset remain as collateral
• In case the borrower does not repay, at least a part of the loan can be
recovered by selling the collateral
• In microfinance this does not work
• There is no collateral
• If collateral is asked for, not many will get loans
• Hence loans are given based on project cash flows
Thank You