Microfinance, the concept
The concept of microfinance is to reach a large portion of the poor people who do not have access to regular banks either because such banks do not exist in their territory or even if they did they would not lend money to them as no suitable collateral assets exist.
A suitable collateral has to have a market value but also be easily tradable. Nobody can imagine your next-door banker going around trying to rescue a cow or farming tools to recover their investment, it would just be let die or stolen and then written off.
In absence of finance would be entrepreneurs turn to the family or friends, but often the entourage is poor as well or reluctant to put at risk what they have. Here is why unofficial or, worse, illegal channels, including usury, have so much success and can dictate their terms.
If not banks, who does it then?
In order to tackle this problem, government institutions, NGOs and charity organisations have come up with the concept of microfinance, whereby some money is provided to poor entrepreneurs in absence of collateral, but under certain conditions.
Managing microfinance loans is expensive
The interest rate charged by microfinance institutions, usually around 25% above inflation, is higher than regular banks, but still much better than unofficial channels. The reason for that is not the default rate, as one would think – it is in fact quite low -, but because managing the loan is expensive. First of all, the principal is low and therefore the management relative importance is high. Besides, in order to increase the chances of success, the control is quite strict and frequent. Sometimes basic management education courses are involved. For instance, in many uneducated populations the concept of saving for future bad times is rather blur or non-existent. Income volatility has a direct impact on their life. Another concept hard to break is that power and income is directly proportional to the number of children. It is here that microfinance is believed to be more effective than simple donations or subsidies. A principle that could be valid for tackling Western unemployment as well, perhaps?
How microfinance works
The way it is managed is rather interesting: the loan is usually granted to the main female member of the family because she has a stronger motivation to spend the profit of her business to feed the rest of the family and make them survive long-term. Sadly, an uneducated man is more likely to waste principal and revenues onto drinks, playing or betting. More importantly, the loan is organised around a ‘self-help’ group (moderated by a representative of the lender organisation) which shares the responsibility for the loan and its repayment. The group meets regularly and ensures that each one contributes to the success of the ‘venture’ and has a vested interest on it. A strong group usually succeeds more frequently than individuals also in this area. This might remind you some job design concepts like self-autonomous workgroups applied to quite a different environment. Finally, I would like to mention an interested development which tries to address an aspect of the cost of finance in microfinance and that is money raising and transaction cost. An organisation like www.kiva.org collects money directly from lenders on behalf of lending institutions on the field, thus bypassing a number of passages and associated costs. In that ‘marketplace’ the not-for-profit money provider provides funds directly and even chooses the target borrower by analysing profiles, projects and situations; bear in mind that the lender individual shall expect the payback of the principal only, which can then be granted again to another entrepreneur. Involved sums are capped.
Conclusion?
Statistics show that this approach is working better than other instruments in lifting poverty and raising education levels in certain areas of the world, but it cannot be the only mean for such an extremely large problem. I welcome views and experiences that readers might have on microfinance.