Microfinance - As it Relates

Microfinance - as it Relates to Economic Inequality

Microfinance

Microfinance is generically understood as the offering of financial services, products and support for the poorer population -- including both individuals as well as entrepreneurs -- in order to present them with opportunities that would otherwise be inaccessible to them. Historically, microfinance would target women and its aim was that of supporting social development. In recent years nevertheless, it has become a noteworthy investment, able to generate profit and to as such attract investors.

"While the Grameen Bank promises to alleviate poverty and empower women through a non-profit model of financial services, new models of microfinance institute strict norms of financial sustainability and emphasize profits rather than human development. This […] is the microfinance revolution. It bears a new promise: that the bottom billion -- the world's poorest -- will serve as a frontier market, opening up new horizons of capital accumulation. Microfinance is no longer the sole domain of non-profit organizations such as the Grameen Bank, it is the domain equally of commercial banks, investment vehicles and money makers" (Roy, 2010).

2. Founders of microfinance

Microfinance has traditionally emerged through donations and sponsorships, but it gradually moved up a new level, in which institutions were formed and specialized in the field of financial aid to the poor. Emphasis was traditionally placed on domestic operations and lending, with less focus on international operations and resources. The chart below reveals the general scenery of microfinance institutions:

IFIs stands for international financial institutions

Source: Helms, 2006

"The landscape of funding options in microfinance is highly dynamic and complicated. Existing funders range from those with primarily a social mission to alleviate poverty (international donor agencies and foundations) to those with more commercial motivations (commercial investors and domestic capital markets) and many options in between" (Helms, 2006).

One notable founder within the microfinance community is represented by Grameen Bank in Bangladesh, which commenced to lend to the poor without requiring collateral, and which gradually inspired other players in the region to support the access of the poor to borrowed financial resources. The table below reveals the list of international financial institutions and private funds investing in microfinance:

Source: Helms, 2006.

3. Microfinance and poverty reduction

The scope of microfinance operations is that of reducing poverty and also decreasing the income gap between the rich and the poor. The underlying principle is represented by the need of the poor to gain more access to funds, as well as by the realization of the diverse needs of the poor. The major advantage microfinance reveals over other types of borrowing is symbolized by the flexibility involved, such as the lack of a need for collateral or the personalization of the loan and its conditions based on the particularities of each solicitant (Johnson and Rogaly, 1997).

4. Global approach

At a global level, microfinance is generically based on the centralization of funds to support the access to loans of the poor population. Generally, emphasis is placed on domestic sources of loans, but international microfinance institutions are also gaining momentum. An interesting note has to be made in the fact that the microfinance solutions differ from one region to the other, and one criterion which generates the differences is represented by the level of economic development.

Marguerite S. Robinson (2002): "My impression is that microfinance in former centrally planned economies is somewhat different from microfinance in most developing economies."

5. The United States

The United States possess one of the most developed credit markets, which strives to serve the needs of as many U.S. citizens as possible. In this context then, a question is being posed as to why should microfinance intervene in credit markets. The question is offered by the continued failures of the current system in attending to the needs of the poor. And the efforts have also included the support of the government, and in spite of this support, failure was still encountered and it as such reveals the need to intervene within the credit markets. Beatriz Armendariz de Aghion, Beatriz Armendariz and Jonathan Morduch (2007) explain:

"Good intentions often went awry as state owned-development banks mismanaged resources and interest rate restrictions prevented banks from operating viably in poor areas. Against this background, microfinance emerged as an especially promising way to rethink banking for the poor."

6. The Conservative perspective

Similar to any other economic concept, the field of microfinance is subjected to the influences of the four perspectives of political economy. The diagram below places these perspectives at the intersections of four different values: individualism, community, equality and hierarchy.

Source: Clark, 1998

At the level of the conservative perspective, it is attested that the central role for the development of the economy is represented by hierarchy and community. Community harmony is as such essential for development, but progress is sustained through a hierarchy which promotes those individuals with leading skills and abilities (Clark, 1998).

7. The Classical liberal perspective

The liberal dogma is focused on the individual, and the classical liberal perspective centers on both individualism as well as hierarchy. At its incipient stages, the economists militated for equality of the individuals, but they concluded that inequalities and hierarchies were necessary in order to stimulate economic growth and development (Clark, 1998).

8. The Modern Liberal perspective

The modern liberal perspective centers on the equivalent importance of both equality as well as individualism. The economists militating for this perspective are firm believers in the fact that equality and liberty protect human dignity and economic prosperity. The supporters of this belief recognize the existence of potential conflicts between the two values of equality and individualism, but argue that the disputes can be settled in a constructive manner and insist that this combination of principles is essential for economic development (Clark, 1998).

9. The Radical perspective

Finally, the radical perspective combines the commitments to the community and the equality of the individuals within the community. The underlying idea of this political view is that economic wealth and prosperity is to be attained at the level of the community, and only when the members of the community become united to support this development (Clark, 1998).

10. Microinsurance

As the field of microfinance developed, incremental emphasis came to be placed on microinsurances. These are generically understood as "insurance products that offer coverage to low-income households. A microinsurance plan provides protection to individuals who have little savings and is tailored specifically for lower valued assets and compensation for illness, injury or death" (Investopedia, 2011).

11. The role of gender

Microfinance institutions were traditionally opened to serve women. While they do not exclude men, an estimated 80 per cent of the customers of the microfinance institutions are female. The Grameen Bank for instance commenced by serving mostly men, but nowadays, as the social and cultural barriers have been weakened, 95 per cent of the bank's customers are women. De Aghion, Armendariz and Morduch (2007) argue that this situation has been created as a result of changing roles of women within the impoverished communities. Modern women are less prone to give birth to as many children and they focus more on education and profession. This makes them turn to financial aid from the microfinance institutions. Also, from a financial standpoint, the focus on women was due to technical information, such as higher repayment rates among the women and an improved household status when women are lent in the detriment of men -- the borrowings of which do not seem to impact the household living standards (de Aghion, Armendariz and Morduch, 2007).

12. Empirical evidence of effectiveness

At the level of actual empirical evidence to confirm the effectiveness of microfinance, it has to be noted that the number of studies detailing the topic is rather restricted. Additionally, most research projects focus exclusively on one country at the time. In a context in which the variables of the problem vary in each situation, the results of the individual studies are not relevant to confirm or infirm the theory according to which microfinance reduces the income gap.

Hisako Kai (2009) however has developed one of the most comprehensive approaches of the problem. The university professor has collected evidence from 61 countries and has found that, with few exceptions, the microfinance operations do indeed support the reduction of the income inequality.

"This paper provides a cross-country empirical study of 61 developing countries, concerning the impact of microfinance on inequality. We show that microfinance plays an important role in creating a financial system endowed with the equalizing effect. Until now, only a few single-country analyses of the impact of microfinance on inequality have been performed; a cross-country analysis has not been conducted thus far. To the best of our knowledge, our study is the first one to indicate the universality of the equalizing effect of microfinance by applying the cross-country methodology. Moreover, we contribute to the research accumulation of the impact assessment of microfinance at the macro level, which has seldom been analyzed" (Kai, 2009).

13. Management of MFIs

The management of MFIs is increasingly complex and this complexity is the result of the dual focus of the entities. On the one hand, they represent the needs of the poor population's access to loans and, in this sense, their operations seem selfless and focused on social well-being. On the other hand however, these entities are for-profit economic agents which need to register revenues, to generate funds and to be financially self-sustainable. This need is obvious at the level of all institutions, but even more so at the level of the entities which have share owners for whom they have to increase the value of the equity investments. In this order of ideas, emphasis is often placed on the recuperation of the costs incurred.

The efficiency of the managerial act at microfinance institutions is generally measured with the aid of the operational self-sufficiency ratio, which indicates that lenders are generally able to cover their costs. Some of them are however only able to cover 60 per cent of the incurred expenditure. The means in which companies manage this problem vary across firm, but the trend is that of reducing the costs associated per each borrower and those incurred with the management of the overdues (de Aghion, Armendariz and Morduch).

14. Group vs. individual lending

Group lending is characterized by the fact the members of the group -- generally between three to fifty women, depending on the case -- seldom possess any collateral, and share the risks of repayment problems. The success of the groups is based on regular meetings of the group members and the sense of responsibility embedded in the group members (de Aghion, Armendariz and Morduch, 2007).

Group lending can however be perceived in a different manner -- that in which the money is offered by a microfinance institution to a group of individuals, who then use the money and repay it. Individual lending occurs when the institution will grant the loan to a single person. Maria Lehner (2009) found that microfinance institutions generally prefer individual loans, but will offer group loans in specific circumstances, namely:

The size of the loan is increased

The competition between microfinance institutions is low and the refinancing costs are high.

In the future context in which the microfinance institutions gain increased access to capital markets, and if the competition in the field continues to intensify, Lehner expects individual loans to become more popular.

15. Sustainability

At the level of sustainability, it has to be noted that the scope of the microfinance institutions is not that of profit registration, but it is that of supporting the development of the poor population through an enhancement of their access to financial resources. The sustainability of such efforts has often been debated. De Aghion, Armendariz and Morduch (2007) find that the sustainability is increased among the most efficient microfinance lenders, but this sustainability does not overcome 64 per cent of the selected leading MFIs. At the overall level of the industry, the sustainability levels, generally difficult to assess, are expected to be lower.

16. Microfinance and the web

The advent of technology, with emphasis on the revolution of the internet, has reshaped the modern day society. And the field of microfinance has not been excluded from this evolution. In the era of the internet then, access to the funds in the microfinance system is eased through an enhanced availability of information. At Kiva for instance, "the Internet-based lending platform has allowed over 60,000 people around the world to channel nearly 6 million dollars in loans to small businesses in developing countries" (Flannery, 2007).

17. Criticism

In spite of the benefits it generates for the poor, for the communities as well as for the institutions which offer the resources, microfinancing is also confronted with a wide array of disadvantages. Thomas W. Ditcher and Malcolm Harper (2007) for instance argue that a main problem is that it generates too high and unrealistic expectations. The two authors also mention that important problems of microfinancing arise from improper design of the processes, the mismanagement of the resources or the improper policies set at the basis of the processes.

Ditcher and Harper also raise the questions regarding the actual benefit of microfinance. In essence, they imply that lending to the poor and helping them enter debt is not a sustainable solution to alleviate poverty. And this is also linked to the fact that the funds lent to the poor would only be helping them on the short-term, forcing them to make the future effort of repaying the loans. The most relevant example of useless microfinance is represented by the case of Africa, where, after billions of dollars were sent in the form of aid, the poverty levels in the region continue to increase (Mayo and Ferguson, 2010).

Tazul Islam (2007) argues that the final success of microfinance operations is also prone to failure as a result of corruption. On the one hand, this corruption can be present at the level of the policy makers, and it could result in legislations which do not promote the right causes of microfinance. On the other hand, corruption can be obvious at an internal level of the microfinance institutions and could materialize in fraud, inside trading and so on (Helms, 2006).

18. Challenges for the U.S. MFIs

At a general level, microfinance operations are subjected to the following challenges:

The need to increase the product and service palette in order to serve the needs of larger populations

The need to reach poorer people in more remote locations

The need to reduce the costs of the financial operations and loans for both the customers as well as the microfinance institutions.

At a more specific level nevertheless, the challenges include the following:

The need to use optimized technology in order to support the efficiency and superior results of microfinance operations

The need to leverage cross-border remittances and other transfers and use the large financial funds to improve the quality of life for the poor people