More than three decades ago, the unassuming Bangladeshi Professor Muhammad Yunus institutionalized the concept of lending to the poorest of the poor and created what would eventually become the worldwide industry of Microfinance. His Grameen Bank — the pioneer microfinance model established in 1983 — had the clear objective of poverty alleviation by providing those excluded from the financial sector with small amounts of credit called Microcredit.
Central to the Grameen approach was an outright rejection of traditional banking and the idea of a more inclusive financial sector that served the needs of the people who needed it the most yet could access it the least. The goal was to decrease the poor’s vulnerability to informal financial networks charging exorbitant amounts of interest that brought them deep into debt via providing alternative financial products and services suitable and favorable to their conditions. This entailed a big double challenge: first, proving that the poor were credit worthy by redefining and recreating standards and situations of credit worthiness, and second, illustrating that such new forms of credit could actually alleviate poverty.
Generally praised for many years despite scandals here and there, Microfinance has found itself having an identity crisis as of late, evident in the fact that we observe a clear evolution in the business models of the Microfinance Institutions (MFIs) that eventually led to their survival. This evolution concerns an increasing dominance of the need to prioritize financial sustainability. Proponents claim that MFIs should be able to cover their costs without depending mainly on subsidies and donors, reduce transaction costs, and address the problem of borrower default to serve a large number of borrowers. This presents a strong critique: has microfinance lost touch with the poorest of the poor? Have we failed in inclusive finance when we now have standards on inclusivity?
A review of the academic literature leads us to posit that Microfinance in developing countries has followed three key trends: 1.) A shift in lending methods: from group to individual lending; 2.) A change in the purpose of loans, broadening of product offerings, and the use of new technologies; and, 3.) The diversification of funding sources and changes in organization type. Today’s column looks at this in brief.
Group lending is one of the key innovations that characterize traditional microfinance. This method consists in providing loans to self-formed groups that assume a joint liability for repayment. The idea is to use peer pressure as a collateral substitute. However, the individual-based lending approach has featured more and more predominantly within the sector, just as it has been in a traditional bank. Similarly, some research suggest that younger MFIs begin with group-lending and move toward individual-lending when they grow, illustrating that moving towards individual lending may have less impact on outreach, less financial literacy and entrepreneurship training, and evidences a change in the MFIs philosophical orientation toward a prioritization of financial sustainability in order to achieve a social mission.
When microfinance appeared in the 1970s, its borrowers were mainly farmers who took out loans to raise crops or to purchase animals to raise and sell. In the 1980s, we observed a shift towards a more urban population and entrepreneurs of small businesses, and of women in particular. It is in the 2000s that Microfinance began veering away from merely funding microenterprises and began targeting heterogeneous groups of poor households with a diversity of financial needs. Today, Microcredit is now but one of an array of offerings under Microfinance. MFIs today offer micro-savings and micro-insurance, among other products and services. These developments come in tandem with the burgeoning of technological innovation in the sector. Banking through mobile phones is taking off in many developing countries and is experiencing real success in places like here in the Philippines.
Finally, most MFIs commence their businesses using subsidies in the form of grants or donations. Most of these come from international organizations, local public authorities, foundations, and aid agencies allowing them to charge lower interest rates despite the high cost of lending to the poor. However, an increasing number of MFIs have turned towards the capital market for funding. The diversification of funding sources and ownership largely influences the MFI’s strategies and policies, consequently leading to a change in firm type from non-profit to for-profit — by transforming from NGOs to Non-Bank Financial Institutions (NBFIs). Now, MFIs are able to distribute profits to their shareholders and have better access to technology. In parallel, many commercial banks have expanded their activities to engage in microfinance, either by directly entering the market with the expansion of their retail operations through an internal unit, or by launching a separate specialized company.
Whether such trends reduce the social impact is up for debate, but what is undeniable is that institutionalization and commercialization are underway in a sector that once claimed to be the antithesis of traditional exclusion.
Notes: This article is based on a co-authored working paper originating from the Master Thesis of Hélène Laherre under the supervision of the author at the IÉSEG School of Management (Catholic University of Lille) in Paris, France. References are available upon request.
Daniela “Danie” Luz Laurel is a business journalist and anchor-producer of BusinessWorld Live on One News, formerly Bloomberg TV Philippines. Prior to this, she was a permanent professor of Finance at IESEG School of Management in Paris and maintains teaching affiliations at IESEG and the Ateneo School of Government. She has also worked as an investment banker in The Netherlands. Ms. Laurel holds a Ph.D. in Management Engineering with concentrations in Finance and Accounting from the Politecnico di Milano in Italy and an MBA from the Universidad Carlos III de Madrid.