Microfinance Definition: Benefits, History, and How It Works (2024)

What Is Microfinance?

Microfinance, alsocalledmicrocredit​, is a type of banking service provided to low-income individuals or groups who otherwise wouldn't have access to financial services.

While institutions participating in microfinancemost often provide lending—microloans can range from as small as $50 to under $50,000. But many banks offer additional services such as checking and savings accounts as well as micro-insurance products, and some even offer financial and business education. The goal of microfinance is to ultimately give impoverished people an opportunity to become self-sufficient.

Understanding Microfinance

Microfinance services are provided to unemployed or low-income individuals because most people trapped in poverty, or who have limited financialresources, don't have enough income to do business with traditional financial institutions.

Despite being excluded from banking services, however, people who live on as little as $2 a day do attempt to save, borrow, or acquire credit or insurance, and they do make payments on their debt. Thus, many poor people typically look to family, friends, and even loan sharks (who often charge exorbitant interest rates) for help.

Microfinance allows people to take on reasonable small business loanssafely, and in a manner that is consistent with ethical lending practices. Although they exist all around the world, the majority of microfinancing operations occur in developing nations, such as Bangladesh, Cambodia, India, Afghanistan, Democratic Republic of Congo, Indonesia, and Ecuador. Manymicrofinance institutions, sometimes referred to as MFIs,focus on helping women in particular.

Microfinancing organizations support a large number ofactivities, ranging from providing the basics—like bank checking and savings accounts—tostartup capitalfor small business entrepreneurs andeducational programs that teach the principles of investing. These programs can focus on such skills as bookkeeping, cash-flow management, andtechnical or professional skills, like accounting.

In many instances, people seeking help from microfinance organizations are first required to take a basic money-management class. Lessons cover understanding interest rates,the concept of cash flow, how financing agreements and savings accounts work, how to budget, and how to manage debt.

Once educated, customersmay apply for loans. Just as one would find at a traditional bank, a loan officer helps borrowers with applications, oversees the lending process,and approves loans.The typical loan, sometimes as little as $100, may not seem like much to some people in the developed world, but for many impoverished people, this figure often is enough to start or sustain a business or engage in other profitable activities.

Microfinance Loan Terms

Like conventional lenders, microfinanciers must charge interest on loans, and they institute specific repayment plans with payments due at regular intervals. Some lenders require loan recipients to set aside a partof their income in a savings account, which can be used as insurance if the customer defaults. If the borrower repays the loan successfully, then they have just accrued extra savings.

Because many applicants can't offercollateral, microlenders often pool borrowers togetheras a buffer. After receiving loans, recipients repay their debts together. Because the success of the program depends on everyone's contributions, this creates a form of peer pressure that can help to ensure repayment.

For example, if an individual is having trouble using their money to start a business, that person can seek help from other group members or from the loan officer. Through repayment, loan recipients start to develop a good credit history,which allows them to get larger loans in the future.

Although these borrowers often qualify as "very poor," repayment rates on microloans are often higher than the average repayment rate on more conventional forms of financing. For example, the Grameen Bank in Bangladesh, one of the original microlenders, reports an average repaymentrate of 98%.

History of Microfinance

Microfinance isn't a new concept. Small operations of this type have existed since the 18th century. The first occurrence of microlending is attributed to the Irish Loan Fund system, introduced by Jonathan Swift, which sought to improve conditions for impoverished Irish citizens. In its modern form, microfinancing became popular on a large scale in the1970s.

The first organization to receive attention was the Grameen Bank, started in 1983 by Muhammad Yunus in Bangladesh. In addition to providing loans to its clients, the Grameen Bank also suggests that its customers subscribe to its "16 Decisions," a basic list of ways that the poor can improve their lives. The 16 Decisions touch upon a wide variety of subjects, ranging from a request to stop the practice of issuing dowries upon a couple's marriage, to keepingdrinking watersanitary. In 2006, the Nobel Peace Prize was awarded to both Yunus and the Grameen Bank for their efforts in developing the microfinance system.

There are other microfinance operations around the world. Some larger organizations work closely with the World Bank, while other smaller groups operate in different nations. Some organizations enable lenders to choose exactly who they want to support, categorizing borrowers with criteria such as level of poverty, geographicregion, and type of small business.

Benefits of Microfinance

Millions of people have directly or indirectly benefited frommicrofinance-relatedoperations. The Consultative Group to Assist the Poor, a Washington-based global nonprofit organization, estimates that, as of 2021, more than 120 million people had directly benefited from microfinance-related operations. However, these operations are only available to some of the world's poor, while an estimated 1.7 billion people lack access to establishing basic financial accounts.

The For-Profit Controversy

Although there are countless heartwarming success stories, microfinance has sometimes been the target of criticism. As microfinance interest rates are generally higher than conventional banks', critics have charged that these operations are making money off the poor.

In fact, some non-profit microlenders have converted to being for-profit as they've grown. One of the largest, and most controversial, is Mexico'sBanco Compartamos.The bank was started in 1990 as a nonprofit. However, 10 years later, management decided to transform the enterprise into a traditional, for-profit company. In 2007, it went public on the Mexican Stock Exchange, and its initial public offering (IPO) raised more than $400 million.

Like most other microfinance companies, CompartamosBancomakes relatively small loans, serves a largely female clientele, and pools borrowers into groups. The main difference lies in how it uses the funds it nets in interest and repayments. Like any public company, it distributes them to shareholders. In contrast, nonprofit institutions take a more philanthropic stance toward profits, using them to expand the number of people they help or tocreate more programs.

Concerns About For-Profit Microfinancing

In addition toCompartamosBanco, many major financial institutions and other large corporations have launched for-profit microfinance departments, includingCitigroup and Barclays,for example. Other companies have created mutual funds that invest primarily in microfinance firms.

CompartamosBanco and its for-profit peers have been criticized by many, including the grandfather of modern microfinance himself, Yunus. The immediate, pragmatic fear is that, out of a desire to make money, largemicrofinancebankers will charge higher interest rates that may create a debt trap for low-income borrowers.

ButYunus and others also have a more fundamental concern: that the incentive for microcredit should be poverty alleviation, not profit. By their very nature—and their obligation to stockholders—these publicly traded firms work against the original mission of microfinance: helping the poor above all else.

In response, Compartamos and other for-profit microfinanciers counter that commercialization allows them to operate more efficiently, and to attract more capital by appealing to profit-seeking investors. By becoming a profitable business, their argument goes, a microfinancebankis able to extend its reach, providingmore money and more loans to low-income applicants. For now, though, charitable and commercialized microfinanciers do co-exist.

Other Criticisms of Microfinance

In addition to the divide between the nonprofit and for-profit microfinance enterprises, other criticisms exist. Some say that individual microloans of $100 aren't enough money to provide independence—rather, theykeep recipients working in subsistence-level trades, or just cover basic needs, like food and shelter.

A better approach, these critics maintain, is to createjobs by constructing new factories and producing new goods. They cite the examples of China and India, where the development of large industries has led to stable employment and higher wages, which in turn has helped millions to emerge from the lowest levels of poverty.

Other critics have said that the presence of interest payments is a burden. Despite the healthy repayment rates, there still are borrowers who can't, or don't, repay loans, because of the failure of their ventures, personal catastrophe, or other reasons. So, this added debt can make recipients of microcrediteven poorer than when they started.

The Bottom Line

Microfinance is a form of banking service provided to low-income individuals or groups who otherwise wouldn't have access to financial services. Institutions most often lend amounts of $50 to under $50,000, but they may also offer checking and savings accounts, and some deliver financial and business education. The goal of microfinance is to ultimately give impoverished people an opportunity to become self-sufficient.

Some criticisms of the microlending industry as it's grown include excessively high interest rates charged on the small loans extended, profit motives at odds with the original intent of helping the poor, and loans so limited they can't really make their impoverished borrowers self-sufficient.