A type of financial services offered to individuals of lower socioeconomic backgrounds or those who lack access to traditional financial services
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What is Microfinance?
Microfinance is a term for financial services that are offered to individuals of lower socioeconomic backgrounds or those who lack access to traditional financial services. Microfinance includes a number of services, such as savings accounts, checking accounts, fund transfers, microinsurance, and microcredit.
Microfinance originally started with microcredit, which is the practice of providing extremely small loans to those who do not have a steady source of income, collateral, or any credit history. It also aims to support and kickstart entrepreneurs who do not have the financial backing to begin a small business or capitalize on an idea.
The objective of microfinance is similar to that of microcredit; its goal is to provide financial services to help encourage entrepreneurs in impoverished nations to act on their ideas and obtain the financial tools available to do so and to eventually become self-sustainable. A few more of its overarching goals include to promote economic development, decrease unemployment, and boost small businesses.
Additionally, some microfinance institutions provide financial and business education in order to best position their clients for starting up a small business or to act efficiently as an entrepreneur.
Microfinance Models
Two models outline how microfinance is operated:
- Banking for individual entrepreneurs and small businesses revolved around relationship-based banking.
- Services for a group, where multiple individuals come together to form a group to collectively apply for a loan.
When applying for microcredit, individuals may not get a large loan – loans range from $10 to $2,000 – thus, they may decide to come together and form a group to qualify for a larger loan.
History of Microfinance
Upon the creation of microcredit by Bangladeshi social entrepreneur Muhammad Yunus in 1983, microfinance was simultaneously created. In 1983, Yunus established Grameen Bank in Bangladesh. The goal of Grameen Bank was to initially provide small loans to entrepreneurs.
Yunus’ vision for microcredit was inspired when he witnessed women who made bamboo stools in Bangladesh making two cents a day. He decided that if the women were able to fall back on a loan, they would be able to improve their margins and gain a more substantial profit. After issuing them a loan of $27, following the group model, the women were able to repay the loan and keep their business running.
Microfinance’s aspect of a savings account can also tie into microcredit; creditors may choose to include a loan covenant. The loan covenant states that the borrower must set aside a portion of profits in a savings account with the financial institution to be held as collateral until the loan is paid. Thus, it provides some protection for creditors, and if the loan is repaid, the borrower would’ve earned savings interest on the money that was deposited in the savings account.
In 2006, Yunus received the Nobel Peace Prize for his efforts with Grameen Bank. The bank currently oversees i2,500 operational locations and employs about 22,000 individuals. Furthermore, there are currently 10,000 microfinance institutions.
Pros and Cons of Microfinance
Many argue that microfinance is very beneficial, as it provides financial opportunities for those in impoverished nations or those with lower socioeconomic backgrounds. Another benefit of microfinance is that it encourages people to be financially independent and provides them financial resiliency to be able to cover any large unforeseen expenses.
Additionally, microfinance helps to provide financial services to those in remote locations where traditional financial institutions do not have operations. It also provides education. Finally, microfinance can encourage entrepreneurial activity and business development in poverty-stricken areas.
Some downsides of microfinance include claims that it can take advantage of those in tough economic situations, a situation similar to loan sharks. Some microfinance loans may include interest that can be as high as 30% or even higher. Furthermore, according to several studies, recipients of microfinance loans did not realize an improvement in their annual net income.
Additional Resources
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:
