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An overview of microfinance: history and evolution, definition and practice.

Abstract

This overview paper has been developed by revisiting literature around the concept of microfinance, and has exhibited basic theoretical dimensions around the concept. It has given the most important features of the evolution, and definition of microfinance. It has shown how the potential for innovation of MFIs can improve the conditions of the microfinance clients who are basically from the low-income and the poor, especially women who are the poorest and least empowered group. A set of products offered by MFIs was shown and considered not yet adequate to satisfy the needs of the poor households over their life-cycle. The paper brought to focus the role that governments and regulatory systems can play in supporting MFIs, and how technological advancements can facilitate the enhancement of the microfinance industry. The paper gives a very brief description of the most recognized success story of the microfinance practice which is the Grameen Bank in Bangladesh.

Introduction:

The idea and aspirations behind microfinance are not new. Small informal savings and credit groups have operated for centuries across the World. Since the early nineties focus began to go deep and expand the concept beyond the relatively narrow practice of microenterprise credit to the more comprehensive concept of microfinance. This came largely in reaction to the shifts in the development paradigms and policies and the claims for participatory, human centered, empowering approaches. The microfinance concept, thus intends to reach the poor, the marginalized and financially excluded groups and mainstream development oriented financial services to replace subsidized credit and donations. Within this perspective the evolution and development of the microfinance concept has gone through many stages and processes, and involved a diverse number of stakeholders such as governments, UN agencies, NGOs, CBOs.... etc. The aim has always been to empower the poor to be able to maintain a decent living and come out of the poverty trap. Microfinance is now perceived as a major tool for poverty reduction and a key contributor to the achievement of the Millennium Development Goals (MDGs), especially MDG1 concerning poverty alleviation. Microfinance is now growing into an industry to which great commitment is manifested by governments and the civil societies alike.

Microfinance defined:

Microfinance has evolved as an economic development approach. It refers to the provision of financial services to low-income clients including the poor and the self-employed. Microfinance is considered as a powerful tool to fight poverty. Poor families and households use financial services provided by the different microfinance institutions (MFIs) to raise income, build their assets, and cushion themselves against external shocks (Helms, 2006).

Microfinance means building inclusive financial systems which integrate specified services tailored to serve the needs of the poor and make them part of the mainstream financial system. The level of coverage and outreach of microfmance services must make it accessible to all those who need it, and to innovatively diversify methods and modalities towards that end. Microfmance institutions, especially formal ones, operate at costs and should be able to pay for themselves and not expect support from governments or donors. So, unless MFIs and service providers charge their clients enough to cover their costs, they will always be limited by the scarce uncertain funds and subsidies from governments and donors. This implies adopting a definition which strongly emphasizes the fact that microfmance is an economic activity which is sensitive to costs, financial profit as well as social gains. Microfmance is about building permanent local financial institutions that can offer the poor a package of financial services, attract domestic deposits, recycle them into loan and support them by insurance and other financial services (ibid).

In some contexts, to operate at its best potential, microfmance needs government support to enable financial service delivery by setting a supporting policy environment. This may imply the integration of government efforts with NGOs and donor support through funds and donor contributions to complement private capital. Donor funds should be temporary start-up support to get MFIs to the point where they can attract, manage and diversify private sources and uses of private capital (ibid).

A brief history of microfinance:

The evolution of the concept of microfmance has gone through different historical landmarks, each of which has its own features, however always focusing on addressing the need of the poor, less capable groups of the population. The following milestones give a picture of the historical development of microfmance as basically established by Helms, B. (2006)

The history of microfinance:

Since the beginning of time

Informal savings and credit groups have operated for centuries across the developing world.

Middle Ages

In Europe, an Italian monk created the first official Pawn shop in 1462 to counter usury practices. In 1515 pope Leon X authorized pawn shops to charge interest to cover their operating costs.

1700s

Jonathan Swift initiates the Irish Loan Fund System, which provides small loans to poor farmers who have no collateral .At its peak; it was lending to 20 Percent of all Irish households annually.

1800s

The concept of the financial cooperative was developed by Friedrich Wilhelm Raffeisen and his supporters in Germany. From 1865 the cooperative movement expand rapidly within Germany and other countries in Europe, North America and eventually developing countries

The 1900s

Adaptations of these models begin to appear in parts of rural Latin America. This historical era can be looked at as different phases as follows:

1950-1970

Efforts to expand access to agricultural credit use state-owned development finance institutions, or farmers cooperative, to channel concessional loans and on-lend to customers at below-market interest rates. These development banks lose most or all of their capital because their subsidized lending rates cannot cover their cost, including the cost of massive default.

Early 1970s

Experimental programs extend loans to groups of poor women to invest in micro-businesses, and microcredit is born Early pioneers include Grameen Bank in Bangladesh, ACCION International, which started out in Latin America, and the Self-Employed Women's Association Bank in India.

1980s

Microcredit programs throughout the world improve on original methodologies. Microlenders, such as Bank Rakayat Indonesia, defy conventional wisdom about financing the poor. Cost-recovery interest rates and high repayment permit them to achieve long-term sustainability and reach large numbers of clients.

Early 1990s

The term 'microcredit 'begins to be replaced by 'microfinance', which includes not credit, but also savings and other services such as insurance and money transfers.

Today

The borders between traditional microfinance and the larger financial system are starting to blur. In some countries, banks and other commercial actors are entering microfmance. Increasing emphasis is placed on building entire financial systems that work for the poor.

Microfinance today:

Over the past 50 years microfinance has accomplished great and astonishing results which accentuate the role it plays in changing people's lives. Microfinance as an industry, mainly focusing on the poor, has demonstrated that poor people are viable customers (Helms, 2006; Hulme and Arun, 2006; Ledgerwood, 1999). Microfinance has created a wide range of financial institutions focusing on serving the financial needs of the poor people, and in some cases offering a package of supportive non-financial services along with the basic financial services. During the past 10 years microfinance has recorded a significant shift in the level and type of focus brought to the concept in response to the global policy frame.

The Millennium Development Goals (MDGs) represent an important component in the global political environment and gained focus and commitment from influential bodies in the Global governance. The MDGs are thought to shape the landscape of the microfinance of today by changing its practice towards integrating the poor within more inclusive financial markets.

The MDGs are committed to eradicate poverty and ensure equitable and sustainable development. Poverty eradication stands as the first goal within this important global policy document. This implies the need to innovate and adopt tools which can facilitate the achievement of the key goals in the MDG document. Accordingly, microfinance is considered as an apparent tool already in operation and all it needs is better tuning to make it a vehicle for poverty eradication. From this platform, governments, UN agencies, NGOs and other national and international institutions started to reconsider microfinance and to mobilize resources towards refining the concept in theory and practice.

Microfinance is now becoming more integrated into the larger financial systems of many countries, though with variation in scope and focus. Central Banks (as in the case of Sudan), commercial banks and other microfinance institutions (MFIs) are moving the wheel of microfinance and adopting strategies that make microfinance move down- market to reach a larger number of ever poorer and remote clients.

Why is microfinance growing?

Recently, the focus on microfinance has led to an expansion in the micro finance industry in all continents. The developed as well as developing countries are showing institutional involvement with the aim of building financial systems which are more inclusive. This is due to many reasons:

1. The promise of facilitating the delivery of financial services to the very poor and low-income segment of the population. This is primarily to support the low-income, poor households through micro-enterprises and income generating activities.

2. The support to MFIs and the technical assistance offered to help build self-supported, locally oriented MFIs.

3. The promise to build on traditional systems and informal channels of credit/savings such as the rotating savings and credit associations (ROSKAS) and integrate them into the broader formal financial system. This will make the financial systems more inclusive of the poor, who are typically considered as unbankable, and allow more flexibility, more affordability by the poor. The intention to integrate traditional methods of microfmance has proved to be more attractive to the poorest and the marginalized, especially women.

4. The contribution of microfinance to strengthening and expanding existing formal financial systems. Microfinance activities (especially the informal ones) can strengthen existing formal institutions by expanding their markets for both savings and credit, and potentially their profitability (Hulme and Arun, 2006).

5. The growing number of success stories, well documented in diverse contexts, such as rural Bangladesh, Urban Bolivia and some African examples, operate as strong incentives and motivation for MFIs at the different levels.

6. The availability of innovative products and modalities of service delivery such as group-based targeting, the use of social capital and peer pressure to solve the repayment problems, and the use of non-conventional collaterals (ibid).

7. The enthusiasm for micro-enterprise development and the growing number of people who believe that entrepreneurship at all levels is an important contributor to economic development.

Microfinance Clients and targets:

Microfinance is fundamentally an economic activity targeting the satisfaction of the financial needs of a vast majority of poor people, those who are perceived as "non-bankable" and not capable of approaching the traditional banking system and microfmance institutions.

An important fact to mention, is that the poor, who are the focus of microfinance services, lack the very basic services that the rest of the society takes for granted. Such services include: (1) access to primary education, (2) access to primary health care and (3) access to training in operating modern tools in day-to-day activities (Sundaresans, 2008). Access to these services is as important, if not even more so,

than access to financial services (ibid). On the other hand it is assumed that access to microfinance will enhance the ability of poor households to reach these important services.This assumption is a key factor for the enthusiasm of many microfinance institutions and practitioners. Some microfinance approaches have already designed a package of these basic needs parallel to the financial services. Most commonly NGOs and development focused MFIs design microfmance service delivery together with literacy education, training in microenterprise development, management and extension programs and health care awareness programs. In such cases, the role of microfmance is perceived as a much more holistic tool that transcends the financial need by intending to change the clients profile and enhance their capability level and turn them into a more interactive group who can benefit from any level and type of microfmance potential services. The financial needs of microfmance clients are to a great extent shaped by the aggregate of the needs of individuals within their households, which is influenced by the household life-cycle. The type of products offered by MFIs should enable poor households to satisfy their needs as indicated by Figure (2) below. The figure shows the needs over the different phases of the individual's life and emphasises the imperfect fit between the products offered by MFIs and clients'/ household needs' (Hulme and Arun, 2005). With little concern over creating a product design and portfolio with the needed flexibility to meet the variety of household needs, microfinance borrowers tend to simply adapt the uses of funds to serve the most appropriate need at the time. Loans ostensibly borrowed for micro-enterprise development are in many times used to meet a multiplicity of other needs (Sebstad and Cohen, 2001, cited in Hulme and Arun, 2005).

[ILLUSTRATION OMITTED]

Marriage ceremony (C.S.)

C. =credit, S. =savings, I. =insurance Bold indicates principle products offered.

Figure (2): Household life-cycle financial needs

Source: Hulme and Arun (2006)

What products does microfinance offer?

The types of products that microfinance offers are changing to match the shifts in the needs of the poor over time. The most commonly identified are the following products:

a) Agro Lending

b) Credit

c) Savings

d) Leasing

e) Housing finance

f) Money transfer

g) Micro-insurance

Many of the microfinance experts and MFIs managers are proponents for a shift in the products pattern in the microfinance industry, to show more flexibility and a better fit with the clients' diverse needs. Many are claiming the need for more attraction to savings and the need to carefully adopt policies for consumer loans (A/Rahman, 2009).

The Grameen Bank and the Beginnings of Microfinance:

The roots of microfinance can be found in many places, but the best known story is that of Muhammed Yunus and the founding of the Grameen Bank in Bangladesh.

During the 1970s, Bangladesh was facing many challenges while starting to create a new nation state (Yunus, 2007). The challenges included war, famine and poverty which had reached alarming figures- 80% of the population according to the Bangladesh Bureau of Statistics (1992) cited in Armendariz de Aghion and J. Morduch, (2005).

Muhammad Yunus, an economist trained at Vanderbilt University, was teaching at Chittagong University in Bangladesh, where he started to observe much of the implications and manifestations of poverty on rural people. In 1976, Yunus started a series of experiments, lending to poor households in the nearby village of Jobra. Yunus aimed to help the poor by supporting the spark of personal initiative and enterprise by which they could lift themselves out of poverty forever. It was an idea born in a day in 1976 when he loaned $27 from his own pocket to forty-two people living in Jobra. These micro-entrepreneurs only needed enough credit to purchase the raw materials for their trade activities in rice husking and bamboo weaving (ibid). Yunus's small loan helped them to break the cycle of poverty for good. His solution to world poverty, founded on the belief that credit is a fundamental human right, is brilliantly simple; lend poor people money on terms that are suitable to them, teach them a few sound financial principles, and they will help themselves (www. grameeninfo.org).

Yunus's theory worked. Yunus found that the borrowers were profiting from the loans and repaying reliably, even thouh they were not capable of offering any collateral (Armendariz de Aghion and J. Morduch, 2005). Realizing that he could only go so far with his own resources, Yunus convinced the Central Bank of Bangladesh to help him in establishing a branch to serve the poor people of Jobra. That was the key to a series of successes; Grameen went nation-wide, every time proving the positivity of his assumptions about the poor and defying the general perception that the poor are un-bankable. The most prominent factor of success was the innovation that allowed Grameen to grow exclusively. Group lending is the innovation which essentially allows poor borrowers to act as guarantors for each other, besides enlarging their resource availability (ibid).

The success of Grameen Bank has reached unprecedented records that went beyond expectations. Grameen has provided loans totalling six billion dollars to seven million families in rural Bangladesh. Today, more than 250 institutions in nearly 100 countries operate microcredit programs based on the Grameen methodology, placing Grameen at the forefront of a world movement towards eradicating poverty through micro-lending (Yunus, 2007). The amazing success story of Grameen Bank and the efforts of Prof. Yunus have won the Nobel Prize for Peace for their work in eradicating poverty.

Gender empowerment and microfinance:

One of the striking facts about microfinance is that it is perceived as a panacea for women empowerment. Much evidence on the role of microfinance in assisting the poor to come out of the poverty trap emphasises the striking fact that the overwhelming majority of borrowers are women; in aggregate seven out of each ten borrowers are women (Sundaresan, 2008). This can be attributed to the fact that the proportionate representation of women as the majority of the poor, i.e. "the feminization of poverty" and its implications. This predominant empowerment in lending has been examined in the literature, and many beneficial effects that arise from such an empowerment have been documented (ibid). However, other evidence, though anecdotal, points to some potential dysfunctional consequences of such an empowerment (ibid). This may indicate that the expansion in the microfinance practice is not supported by similar focus on impact studies and analysis of the extent to which the assumption about microfinance materialize. Accordingly, more research and scrutiny is needed at both the aggregate and the individual levels to help policy formulation and strategic planning for this industry.

Is microfinance the Panacea for poverty reduction and saving the poorest?

The popularity of MF as a tool to fight world poverty has been increasing rapidly over the past 10 years. Large pro-microfinance institutions such as the World Bank and the United Nations Development Program (UNDP) allocate public funds for microfinance which often carry a mandate to make life better for the poorest. However, the greater portion of aid budgets that go to microfinance may not always be the best way to help the poorest (Buckley 1997).In order for microfinance to really help the poor, some risks and challenges have to be proactively addressed and managed. The spring point is to reach a consensus on the definition, descriptive of the target clientele of microfinance. Descriptions for the very poorest are manifold. Lea Davis (2005) cited in A/Rahman (2009) has exhibited a variety of these descriptions; the poorest of the poor (Navajaset, 2000), the distressed or hardcore poor (Hashemi, 1997), the ultra poor (Hassan, 1998, in Davis, L. 2005), the entrepreneurial poor (Barlett, 1997), and the absolute poor (ibid).

Defining poverty and the poor is of an important strategic significance to measuring the impact of microfinance on the poor. This is greatly due to the fact that the poor are not an undifferentiated, homogeneous group with typically the same needs (Hulme and Mosley, 1996). A core question in defining the poor is whether it is mostly about material deprivation or about a far broader range of needs that permits a sense of well-being (ibid). Is the measure of poverty such as "households living on less than $1 a day, as stated by the MDG document" the best guide for governments and development agencies, who are planning anti-poverty strategies, and modeling microfinance as a tool? (Davis, L. cited in A/Rahman, 2009). This reflects the complexity of the issue of defining poverty and the poor, thus implying on the assessment of the role and the extent to which microfinance services help the poor.

Another important point is the fact that the approaches to microfinance are not homogenous either. There is a broad range of models and approaches to the practice of microfinance (ibid). Ledgerwood (1999) has simplified the classifications of these approaches by placing them on a continuum from the minimalist to the integrated approaches, and many others stand in between.

Microfinance has evolved in situations dominated by a conventional wisdom that considers the poor as un-bankable. The practice of major players in the field, such as the Grameen Bank in Bangladesh, BRAC in Indonesia and SEWA in India have defied that wisdom and proved that when microfinance programs are delivered in a financially sustainable way, they can operate as a meaningful strategy to change the lives of the poor. However, the same institutions have learned, through experience that the conventional financial strategies did not work as much for the extreme poor (Simanovitz, 2002; Morduch & Haley, 2002). Although microfinance is a very powerful poverty alleviating instrument, it is not however, suitable for all categories of the poor (Matin, 2002).

This finding exemplified the fact that a good match between the identifications of the poverty type/scope of the targeted clients and the way to approach them will determine the success of microfinance services in changing the poverty status of those clients. Research and experiences in many contexts have shown that it is very possible to help the poorest through microfinance. Microfinance can serve the poorest clients but rarely through conventional methods and approaches (Simanowitz 2002). Hulme and Mosely (1996) stated that, "extending financial services to the poorest will require innovations". Some suggested design measures that will make microfinance more useful to the poorest have been mentioned by Davis, L. cited in A/Rahman, 2009, include:

--Linking service to other development packages.

--Participation should not be linked to borrowing

--Targeting instead of a "community approach"

--Flexibility in loan management

--Protective strategies for the poorest (savings, safety nets, microinsurance, micro-grants, employment opportunities).

--Tailoring programs in accordance with the needs of the clients.

The Role of Governments and the Regulatory Systems in Supporting Microfinance

Governments are primarily responsible for creating a supportive policy environment for microfinance. The role of governments is to enable financial services, not to provide them directly. Depending on their approach, government run microfinance programs can either contribute to or be detrimental to microfinance services and activities. Governments that operate subsidized inefficient microfinance activities through health, social services or other non-financial state run bodies negatively influence the provision of sustainable microfinance services (Ledgerwood, 1999). This could be attributed to lack of experience in implementing microfinance services; in addition to the wrong perception that government supported microfinance is part of the social welfare commitment of the government. This can be exaggerated by the incidence of government subsidies and/or government forgiveness which is greatly harmful to private sector MFIs whose borrowers may wrongly think that their loans are not to be repaid as well as the others (ibid).

The role of governments in the provision of microfinance services involves long discussions that follow two tracks: (1) The proponents of the idea that governments should focus on creating a conducive environment for private MFIs and microenterprise development and not to directly offer loans; (2) others see that governments should provide services to micro-entrepreneurs but make it on a commercial basis to avoid distorting the financial markets (ibid).

Financial regulations refer to the body of principles, rules and compliance procedures that apply to financial institutions. Financial supervision on the other hand involves the monitoring and examination of the operations of the MFIs to make sure that they comply with the regulations (ibid). In general the aim of the regulatory bodies is to safeguard financial markets and secure all the stakeholders in the financial transactions. These bodies guarantee the appropriate mobilizations of the financial resources to the optimum benefit of the individuals, community and the macro-economic efficiency by controlling issues such as interest rates, reducing mistargetting and minimizing default rates.

Microfinance and the use of technological innovations:

Recently, microfinance has been operating in a context of high technological innovations that can offer a wide range of advantages. The rapid improvement in telecommunications and computer assisted programs such as the internet offer great opportunities for improved performance, control and outreach. Mobile phones and branchless banking, community internet portals that enable farmers to sell their products and so avoid intermediaries (Sundaresan, S. 2008) are just examples of an array of technological innovations that enhance the capacity of MFIs in many ways.

Conclusion;

This overview paper has exhibited basic theoretical dimensions around the microfinance concept. It gave the most important features of the evolution and definition of microfinance. It showed how the potential for innovative MFIs can improve the conditions of the low-income and the poor,

especially women who are the poorest least empowered group. A set of products offered by MFIs was shown and considered as yet adequate to satisfy the needs of the poor households over their life-cycle. The paper brought to focus the role that governments and regulatory systems can play in supporting MFIs, and how technological advancements can facilitate the enhancement of the microfinance industry. The paper gave a very brief description of the most recognized success story of the microfmance practice which is the Grameen Bank in Bangladesh.

References:

(1.) A/Rahman, W. (2009). A Reader in Microfmance: Microfinance concepts, definition and practical experiences. Compiled as part of the curriculum readings for the Master of Microfmance and Development, Ahfad University for Women, Omdurman.

(2.) Armendariz de Aghion, and Jonathan Morduch (2005). The economics of microfmance. The MIT Press, UK.

(3.) Bartlett, R. (1997). Microenterprise and the empowerment of the poor. State of the World Forum, Nov.6 [online]. Accessed from: http:// www.wfadsa.org/library/stworld.asp

(4.) Buckley, G. (1997). Microfinance in Africa: Is it either the problem or the solution? World Development. 25 (7).

(5.) Hashemi, S.M. (1997). Those left behind: A note on targeting the hardcore poor. In G. Wood & I.A. Sharif, eds. Who needs credit? Poverty and finance in Bangladesh. Zed Books, Dhaka.

(6.) Helms, B. (2006). Access for all: Building inclusive financial systems. The International Bank for Reconstruction and Development. The World Bank. Washington D.C.

(7.) Hulme, D. and Mosely, P. (1996). Finance against poverty. V01.1: London: Routledge. Los-137.

(8.) Ledgerwood, J. (1999). Microfinance Handbook: An Institutional and Financial Perspective. The World Bank, Washington D. C.

(9.) Matin, I. (2002). Targetted Development Programs for the Extreme Poor: Experiences from BRAC Experiments. CPRC Working Paper No.20 Available on Line: www.chronicpoverty.org/pdfs/ImranMatin.pdf

(10.) Morduch, J. and Haley, B. (2002).Analysis of the Effects of Microfinance on Poverty Reduction. NYU Wagner Working Paper No. 1014. Available at: http:/ www.nvu.edu/wanger/publichtml/cgibin/working Papers/wp 1014pdf.

(11.) Navajas, S., Shreiner, M., R.L., Gonzalez-Vega & Rodrinuez-Meza, J. (2000). Microcredit and the poorest of the poor: Theory and evidence from Bolivia. World Development. 28(2).

(12.) Simanovitz, A. (2002).Ensuring Impact: Reaching the poorest while building financially Self-sufficient Institutions and Showing Improvement in the lives of the poorest women and their families. http:/www.microeditsummit.org/papers/+5simanowitz.pdf

(13.) Sundaresan, S. (2008). Microfinance Emerging Trends and Challenges. Edward Elgar Publishing Ltd. UK.

(14.) Yunus, M. (1999). Banker to the poor and the battle against poverty. New York: Public Affairs. http//www. Grameen-info.org

Dr. Widad Ali A/Rahman

Assistant Professor; School of Management Studies; Ahfad University for Women.
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Author:Rahman, Widad Ali A.
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Date:Dec 1, 2010
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