What is Micro finance ?

Microfinance is the supply of loans, savings and other financial services to the poor. The term micro is
in reference to the small amounts typically involved in the practice. These services are small micro
because a person who does not have a lot of money most likely will not need a loan of several thousand
dollars. However, a loan of a few hundred dollars may make a huge difference in their lives, giving them
the ability to purchase livestock for a small farm, a sewing machine to help make accessories and
clothes, or supplies for a small store

Microfinance is a source of financial services for entrepreneurs and small businesses lacking access to
banking and related services. The two main mechanisms for the delivery of financial services to such
clients are: (1) relationship-based banking for individual entrepreneurs and small businesses; and (2)
group-based models, where several entrepreneurs come together to apply for loans and other services
as a group.

For some, microfinance is a movement whose object is "a world in which as many poor and near-poor
households as possible have permanent access to an appropriate range of high quality financial services,
including not just credit but also savings, insurance, and fund transfers. Many of those who promote
microfinance generally believe that such access will help poor people out of poverty

The goal of microfinance was the alleviation of poverty. For many years, microfinance had this primary
social objective and so traditional MFIs consisted only of non-governmental organizations (NGO),
specialized microfinance banks and public sector banks. More recently, the marketplace has been
evolving.

History of micro finance

The concept of microfinance is not new. Savings and credit groups that have operated for centuries
include the "susus" of Ghana, "chit funds" in India, "tandas" in Mexico, "arisan" in Indonesia, "cheetu" in
Sri Lanka, "tontines" in West Africa, and "pasanaku" in Bolivia, as well as numerous savings clubs and
burial societies found all over the world.
Formal credit and savings institutions for the poor have also been around for decades, providing
customers who were traditionally neglected by commercial banks a way to obtain financial services
through cooperatives and development finance institutions. One of the earlier and longer-lived micro
credit organizations providing small loans to rural poor with no collateral was the Irish Loan Fund system,
initiated in the early 1700s by the author and nationalist Jonathan Swift. Swift's idea began slowly but by
the 1840s had become a widespread institution of about 300 funds all over Ireland. Their principal
purpose was making small loans with interest for short periods. At their peak they were making loans to
20% of all Irish households annually.

In the 1800s, various types of larger and more formal savings and credit institutions began to emerge in
Europe, organized primarily among the rural and urban poor. These institutions were known as People's
Banks, Credit Unions, and Savings and Credit Co-operatives.

n Indonesia, the Indonesian People's Credit Banks (BPR) or The Bank Perkreditan Rakyat opened in 1895.
The BPR became the largest microfinance system in Indonesia with close to 9,000 units.

In the early 1900s, various adaptations of these models began to appear in parts of rural Latin America.
While the goal of such rural finance interventions was usually defined in terms of modernizing the
agricultural sector, they usually had two specific objectives: increased commercialization of the rural
sector, by mobilizing "idle" savings and increasing investment through credit, and reducing oppressive
feudal relations that were enforced through indebtedness. In most cases, these new banks for the poor
were not owned by the poor themselves, as they had been in Europe, but by government agencies or
private banks. Over the years, these institutions became inefficient and at times, abusive.

Between the 1950s and 1970s, governments and donors focused on providing agricultural credit to small
and marginal farmers, in hopes of raising productivity and incomes. These efforts to expand access to
agricultural credit emphasized supply-led government interventions in the form of targeted credit
through state-owned development finance institutions, or farmers' cooperatives in some cases, that
received concessional loans and on-lent to customers at below-market interest rates. These subsidized
schemes were rarely successful. Rural development banks suffered massive erosion of their capital base
due to subsidized lending rates and poor repayment discipline and the funds did not always reach the
poor, often ending up concentrated in the hands of better-off farmers.

Meanwhile, starting in the 1970s, experimental programs in Bangladesh, Brazil, and a few other
countries extended tiny loans to groups of poor women to invest in micro-businesses. This type of
microenterprise credit was based on solidarity group lending in which every member of a group
guaranteed the repayment of all members. These "microenterprise lending" programs had an almost
exclusive focus on credit for income generating activities (in some cases accompanied by forced savings
schemes) targeting very poor (often women) borrowers

How was micro finance system started

The history of microfinancing can be traced back as long to the middle of the 1800s when the theorist
Lysander Spooner was writing over the benefits from small credits to entrepreneurs and farmers as a
way getting the people out of poverty. But it was at the end of World War II with the Marshall plan the
concept had an big impact.

The today use of the expression microfinancing has it roots in the 1970s when organizations, such as
Grameen Bank of Bangladesh with the microfinance pioneer Mohammad Yunus, where starting and
shaping the modern industry of microfinancing. Another pioneer in this sector is Akhtar Hameed Khan.
At that time a new wave of microfinance initiatives introduced many new innovations into the sector.
Many pioneering enterprises began experimenting with loaning to the underserved people. The main
reason why microfinance is dated to the 1970s is that the programs could show that people can be relied
on to repay their loans and that its possible to provide financial services to poor people through
marketbased enterprises without subsidy. Shorebank was the first microfinance and community
development bank founded 1974 in Chicago .

An economical historian at Yale named Timothy Guinnane has been doing some research on Friedrich
Wilhelm Raiffeisens village bank movement in Germany which started in 1864 an by the year 1901 the
bank had reached 2million rural farmers. Timothy Guinnane means that already then it was proved that
microcredit could pass the two tests concerning peoples paybackmoral and the possibility to provide the
financial service to poor people.

Another organization, The caisse populaire movement grounded by Alphone and Dorimne Desjardins in
Quebec , was also concerned about the poverty, and passed those two tests. Between 1900 to 1906
when they founded the first caisse, they passed a law governing them in the Quebec assembly , they
risked their private assets and must have been very sure about the idea about microcredit.

Today the World Bank estimates that more than 16 million people are served by some 7000 microfinance
institutions all over the world. CGAP experts means that about 500 million families benefits from these
small loans making new business possible. In a gathering at a Microcredit Summit in Washington DC the
goal was reaching 100 million of the worlds poorest people by credits from the world leaders and major
financial institutions.

What is a microfinance institution?

A microfinance institution (MFI) is an organization that provides microfinance services loans, savings,
maybe even insurance to the worlds poor. An MFI can operate as a nonprofit such as a non
government organization (NGO), credit cooperative, non bank financial institution (NBFI), or even a
formal, regulated for profit bank.

MFIs differ in size and reach; some serve a few thousand clients in their immediate geographical area,
while others serve hundreds of thousands, even millions, in a large geographical region, through
numerous branches. Many MFIs offer services beyond loans and savings, including education on
business and financial issues and social services focused on health and children.

A microfinance institution (MFI) is an organization that provides microfinance services. MFIs range from
small non-profit organizations to large commercial banks.

Historical context can help explain how specialized MFIs developed over the last few decades. Between
the 1950s and 1970s, governments and donors focused on providing subsidized agricultural credit to
small and marginal farmers, in hopes of raising productivity and incomes. During the 1980s, micro-
enterprise credit concentrated on providing loans to poor women to invest in tiny businesses, enabling
them to accumulate assets and raise household income and welfare. These experiments resulted in the
emergence of nongovernmental organizations (NGOs) that provided financial services for the poor. In the
1990s, many of these institutions transformed themselves into formal financial institutions in order to
access and on-lend client savings, thus enhancing their outreach."

Principles of Grameen Bank followed by World wide Micro Financial Institutions

Grameen Bank is founded on the principle that get a loans are better than charity to interrupt poverty:
they offer people the opportunity to take initiatives in business or agriculture, which provide earnings
and enable them to pay off the debt.

The Grameen Bank is founded on the belief that people have endless potential, and unleashing their
initiative and creativity which helps them end poverty. Grameen Bank has offered credit to hierarch of
people formerly underserved: women , the poor, unemployed and illiterate people . Access to credit is
based on reasonable terms , example as the group lending system and weekly-installment payments,
with reasonably long terms of personal loans, enable the poor to build on their skills to earn higher
income in each cycle of personal loans .

Grameens objective has been to promote financial independence among the poor.Muhammad Yunus
encourages all borrowers to become savers, so that their capital will be converted into new loans to
others. Since 1995, Grameen Bank has funded 90%of its loans with interest income and deposits
collected, aligning the interests of its depositor-shareholders and new borrowers . Grameen Bank
converts deposits made in villages into loans for the more needy in the villages (Yunus and Jolis 1998).

Grameen Bank targets the poorest of the poor, with a particular emphasis on women . They receive 95%
of the Grameen banks loans. They had less access to financial alternatives of incomes and ordinary
credit lines . Women traditionally were seen to have an inequitable share of power in household decision
making. Muhammad Yunus and others have found that lending to women generates good effects,
including empowerment of a marginalized segment of society . They share betterment of income with
their children , unlike many men. Muhammad Yunus claims that in 2004, women still are difficult to get
new loans; they comprise less than 1% of borrowers from commercial banks . The interest rates charged
by microfinance institutes including Grameen Bank is high compared to that of traditional banks;
Grameens interest on its main credit product is about 20%.

Grameen has diversified the types of loans it makes. It supports hand-powered wells and loans to
support the enterprises of Grameen members immediate relatives. It has found that seasonal
agricultural loans and lease-to-own agreements for equipment and livestock help the poor establish
better agriculture. The bank has set a new goal: to make each of its branch locations free of poverty, as
defined by benchmarks such as access to clean water and latrines having adequate food .

Grameen is best known for its system of solidarity lending.This bank also incorporates a set of values
embodied in Bangladesh by the Sixteen Decisions. At every branch of Grameen , the borrowers repeat
these decisions and vow to follow all of them. As a result of the Sixteen Decisions, borrowers of
Grameen Bank have been encouraged to adopt positive social habits. One such habit includes educating
kids by sending them to school. Almost all Grameen borrowers have their school-age children enrolled
in regular classes since the Grameen Bank embraced the Sixteen Decisions,. This in turn helps educate
and bring about social change in the next generation.

Solidarity lending is a cornerstone of micro loans, and the system is now used in more than 43 countries.
Though each borrower must belong to a 5-member group, the group is not required to give any
guarantee for a loan to its members. Repayment responsibility rests solely on the individual borrower.
The group and the centre oversee that everyone behaves responsibly and none gets into a repayment
problem. No formal joint liability exists, it means group members are not obliged to pay on behalf of a
defaulting member. But, in practice the group members often contribute the defaulted amount with an
intention to collect the money from the defaulted member at a later time. Such behavior is encouraged
because Grameen does not extend further credit to a group in which a member defaults.

No legal instrument (no written contract) is made between Grameen Bank and its borrowers; the system
works based on trust ( it means unsecured loans ).To supplement the lending, Grameen Bank requires
the borrowing members to save very small amounts regularly in a number of funds, designated for
emergency, the group, etc. These savings help serve as an insurance against contingencies.

In a country in which few women may take out loans from large commercial banks, Grameen Bank has
focused on women borrowers; 97% of its members are women.While a World Bank study has concluded
that womens access to micro loans empowers them through greater access to resources and control
over making decision , some another economists argue that the relationship between micro loans and
women-empowerment is less straightforward.

In other areas, Grameen Bank has had very high payback ratesover 98%. However, according to the
Wall Street Journal, in 2001 20% of the banks loans were more than a year overdue. Grameen Bank says
that more than half of its borrowers in Bangladesh (close to 50 million) have risen out of acute poverty
thanks to their loans, as measured by such standards as all household members eating three meals a day
, having all children of school age in school , rainproof house , clean drinking water , a sanitary toilet, and
the ability to repay a 300 taka-a-week (around $4) loan

CORE VALUES IN MICROFINANCE

INTEGRITY

Our mission is to service low-income clientswomen and menand theirfamilies, providing them short
term and/or long-term access to financial services, that are client focused, designed to enhance their
well-being, and delivered in a manner that is ethical, dignified, transparent, equitable and cost effective.

QUALITY OF SERVICE
We believe that our clients deserve fair and efficient microfinance services. We will provide these
services to them in as convenient, participatory and timelymanner as possible.

TRANSPARENCY

We shall give our clients complete and accurate information and educate them about the terms of
financial services offered by us in a manner that is understandable by them.

FAIR PRACTICES

We are committed to ensure that our services to our clients are not unethical and deceptive. In providing
microfinance services including lending and collection of

dues, we are committed to fair practices, which balance respect for clients dignity and an understanding
of a clients vulnerable situation, with reasonable pursuit of recovery of loans.

PRIVACY OF CLIENT INFORMATION

We will safeguard personal information of clients, only allowing disclosures and exchange of such
information to others who are authorized to see it, with the knowledge and consent of clients.

INTEGRATING SOCIAL VALUES INTO OPERATIONS

We believe that high standards of governance, participation, management and reporting are critical to
our mission to serve our clients and to uphold core socialvalues.

FEEDBACK MECHANISM

We shall provide our clients formal and informal channels for their feedback and suggestions for building
our competencies to serve our clients better.

Code of Conduct for Micro finance Institution

INTEGRITY We agree to
Act honestly, fairly and reasonably in conducting microfinance activities. Conduct our microfinance
activities by means of fair competition, notseeking competitive advantages through illegal or unethical
microfinance practices.

No officer, employee, agent or other person acting on our behalf shall take unfair advantage of anyone
by manipulation, concealment, abuse of privileged information, misrepresentation of material facts or
any other unfair practice.

Prominently display the core values and code of conduct on the notice board of head office and all
branches, and put systems in place to ensure compliance.

Ensure that our staff and any person acting for us or on our behalf, are trained or oriented to put these
values into practice.

TRANSPARENCY We agree to -

Disclose to clients all the terms and conditions of our financial services offered in the language
understood by the client.

Disclose the source of funds, costs of funds and use of surpluses to provide truthful information to
clients.

Core Values and Voluntary Mutual Code of Conduct For Microfinance Institution

Provide information to clients on the rate of interest levied on the loan, calculation of interest
(monthly/quarterly/half-yearly), terms of repayment, and any other information related to interest rates
and other charges

Provide information to clients on the rate of interest offered on the thrift services provided by us.

Provide information to clients related to the premium and other fees being charged on insurance and
pension services offered by us as intermediaries.

Provide periodical statements of our accounts to the clients.

FAIR PRACTICES

We are committed to follow fair practices built on dignity, respect, fair treatment, persuasion and
courtesy to clients. We agree to.

Provide micro finance services to low income clients irrespective of gender, race, caste, religion or
language.
Ensure that the services are provided using the most efficient methods possible to enable access to
financial services by low income households at reasonable cost. Recognize our responsibility to provide
financial services to clients based upon their needs and repayment capacity.

Promise that, in case of loans to individual clients below Rs 25,000, the clients shall not be asked to hand
over original land titles, house pattas, ration cards, etc as collateral security for loans except when
obtaining copies of these for fulfilling know your customers norms of the RBI. Only in case of loan to
individual clients of Rs 25,000/- and above can land titles, house pattas, vehicle RC books, etc. be taken
as collateral security

Interact with the clients in an acceptable language and dignified manner and spare no efforts in fostering
clients confidence and long-term relationship.

Maintain decency and decorum during the visit to the clients place for collection of dues.

Avoid inappropriate occasions such as bereavement in the family or such other calamitous occasions for
making calls/visits to collect dues.

Scrupulously avoid any demeanour that would suggest any kind of threat or violence.

Emphasize using social collateral which includes various forms of peer assurance such as lending through
groups and group guarantees at the village, hamlet or neighbourhood level, or guarantees by relatives,
friends, neighbours or business associates; and explain clearly to clients what are the obligations of

social collateral.

GOVERNANCE

We agree to

Observe high standards of governance, ensuring fairness, integrity and transparency by inducting
persons with good and sound reputation, as members of Board of Directors. We shall ensure that the
majority of the directors are independent directors and/or duly elected representatives of the
community we serve, and that we will involve the Board in all policy formulation and other important
decisions.

Ensure transparency in the maintenance of books of accounts and reporting/ presentation and
disclosure of financial statements by qualified auditor/s.

Put in our best efforts to follow the Audit and Assurance Standards issued by the Institute of Chartered
Accountants of India (ICAI).
Place before the Board of Directors, a compliance report indicating the extent of compliance with this
Voluntary Mutual Code of Conduct, specifically indicating any deviations and reasons therefore, at the
end of every half financial year.

FEEDBACK/ GRIEVANCE MECHANISMS

We agree to

Establish effective and efficient feedback mechanism Take steps to correct any errors and handle
complaints speedily and efficiently.

Provide; where a complainant is not satisfied with the outcome of the investigation into her complaint,
she shall be notified of her right to refer the matter .

Microfinance Products and Services

The following products and services are currently being offered by MFIs:

Microloans: Microloans (also known as microcredit) are loans that have a small value; most loans are less
than $100 in size. These loans are generally issued to finance entrepreneurs who run micro-enterprises
in developing countries. Examples of micro-enterprises include basket-making, sewing, street vending
and raising poultry. The average global interest rate charged on micro-loans is about 35%. Although this
may sound high, it is much lower than other available alternatives (such as informal local money
lenders). Moreover, MFIs must charge interest rates that cover the higher costs associated with
processing the labor-intensive micro-loan transactions. (Learn more about microfinance in Microfinance:
Philanthropy Through Industry.)

Microsavings: Microsavings accounts allow individuals to store small amounts of money for future use
without minimum balance requirements. Like traditional savings accounts in developed nations, micro-
savings accounts are tapped by the saver for life needs such as weddings, funerals and old-age
supplementary income.

Micro-Insurance: Individuals living in developing nations have more risks and uncertainties in their lives.
For example, there is more direct exposure to natural disasters, such as mudslides, and more health-
related risks, such as communicable diseases. Micro-insurance, like its non-micro counterpart, pools risks
and helps provide risk management. But unlike its traditional counterpart, micro-insurance allows for
insurance policies that have very small premiums and policy amounts. Examples of micro-insurance
policies include crop insurance and policies that cover outstanding balances of micro-loans in the event a
borrower dies. Due to the high administrative expense ratios, micro-insurance is most efficient for MFIs
when premiums are collected together with microloan repayments
The Income Generating Loan is used for a variety of activities that generate income for their families.
Clients submit a loan application and based on approval receive the loan after one week. Loans are paid
in 50 equal, weekly installments. After completion of a loan cycle, the client can submit a loan
application for a future loan. The approach with smaller short-term loan is to avoid long-term economic
problems with bigger loans.

The Mid Term Loan is available to clients after 25 weeks of repaying their IGL loan. A client is eligible for
a MTL if the client has not taken the maximum amount of the IGL. The residual amount can be taken as a
MTL. The terms and conditions of the MTL are otherwise exactly the same as IGL.

The Emergency Loan is available to all clients over the course of a fiscal year. The loan is interest free and
the amount and repayment terms are agreed upon by the MFI and the client on a case by case basis. The
amount is small compared to the income generating products and is only given in times of dire need to
meet expenses such as funerals, hospital admissions, prenatal care and other crisis situations.

The Individual Loan is designed for clients and non clients that have specific needs beyond the group
lending model. Loans are given to an individual outside of the group lending process. Amounts are
typically higher than that of the income generating loan and repayments are less frequent. Applicants
must complete a strict business appraisal process and have both collateral and a guarantor.

Products common used in the microfinance sector today is:

Micro savings A possibility to save money without no minimum balance. Allows people to retain money
for future use or for unexepected costs. In SHGs the members save small amounts of money, as little as a
few rupees a month in a group fund. Members may borrow from the group fund for a variety of
purposes ranging from household emergencies to school fees. As SHGs prove capable of managing their
funds well, they may borrow from a local bank to invest in small business or farm activities. Banks
typically lend up to four rupees for every rupee in the group fund;

Micro insurance Gives the entrepreneurs the chance to focus more on their corebusiness which
drastically reduces the risk affecting their property, health or workingpossibilities. The is different types
of insurance services like life insurance, property insurance, healt insurance and disability insurance. The
spectrum of services in this sphere is constantly expanded, as schemes and terms of providing insurance
services are determined by each company individually;
Micro leasing For entrepreneurs or small businesses who cant afford buy at full cost they can instead
lease equipment, agricultural machinery or vehicles. Often no limitations of minimum cost of the leased
object;

Money transfer A service for transferring money, mainly overseas to family or friends. Money transfers
without opening current accounts are performed by a number of commercial banks through
international money transfer systems such as Western Union , Money Gram, and Anelik. On the surface
they may seem like small money transfers, but when one considers that such transactions take place
millions of times around the world each week, the numbers start to become impressive. According to
the World Bank, the annual global market for remittances money transferred home from migrant
workers is around 167 billion US dollars. The estimated total is closer to 230 billion dollars if one counts
unregulated transactions. Remittances are also an important source of income for many developing
countries including India, China and Mexico, all of which receive over 20 billion dollars each year in
remittances from abroad.

Advantage of micro finance.

Microfinance involves extending small loans, savings and other basic financial services to people that
dont currently have access to capital. Its a key strategy in helping people living in poverty to become
financially independent, which helps them become more resilient and better able to provide for their
families in times of economic difficulty. Considering nearly half the world survives on less than $2 a day,
microfinance is a vital solution. Here are six benefits of microfinance:

1. Access Banks simply wont extend loans to those with little or no assets, and generally dont engage in
the small size of loans typically associated with microfinancing. Microfinancing is based on the
philosophy that even small amounts of credit can help end the cycle of poverty.

2. Better loan repayment rates Microfinance tends to target women borrowers, who are statistically less
likely to default on their loans than men. So these loans help empower women, and they are often safer
investments for those loaning the funds.

3. Extending education Families receiving microfinancing are less likely to pull their children out of school
for economic reasons.
Assa serves tea in her grocery and snack shop in Nepal. Assa received skills training and a business loan
from Plan.

4. Improved health and welfare Microfinancing can lead to improved access to clean water and better
sanitation while also providing better access to health care.

5. Sustainability Even a small working capital loan of $100 can be enough to launch a small business in a
developing country that could help the benefactor pull themselves and their family out of poverty.
Watch Salamatus story of starting a rice-selling business in Sierra Leone.

6. Job creation Microfinancing can help create new employment opportunities, which has a beneficial
impact on the local economy.

Disadvantage of Micro Finance

Financial illiteracy

One of the major hindrances in the growth of the microfinance sector is the financial illiteracy of the
people. This makes it difficult in creating awareness of microfinance and even more difficult to serve
them as microfinance clients. Though most of the microfinance institutions claim to have educational
trainings and programmes for the benefit of the people, according to some of the experts the first thing
these SHG and JLG members are taught is to do their own signature. The worst part is that many MFIs
think that this is what financial literacy means. We all know how dangerous it can be when one doesnt
know how to read but he/she knows how to accept or approve it (by signing it).

Inability to generate sufficient funds

Inability of MFIs to raise sufficient fund remains one of the important concern in the microfinance sector.
Though NBFCs are able to raise funds through private equity investments because of the for-profit
motive, such MFIs are restricted from taking public deposits. Not-for-profit companies which constitute a
major chunk of the MFI sector have to primarily rely on donations and grants from Government and
apex institutions like NABARD and SIDBI. In absence of adequate funding from the equity market, the
major source of funds for MFIs are the bank loans, which is the reason for high Debt to Equity ratio of
most MFIs.

MFIs receive debt from banks against their equity and in order to increase their portfolio size they need
to increase their debts for which they further need to increase their equity. After the Andhra crisis, it is
reported that banks have stopped issuing fresh loans and even though currently few banks have
resumed, they want MFIs to increase their equity to get fresh loans. So the only mode for the MFIs to
increase their portfolio size is to increase their equity. The problem of inadequate funds is even bigger
for small and nascent MFIs as they find it very difficult to get bank loans because of their small portfolio
size and so they have to look for other costlier sources of fund.

Dropouts and Migration of group members

Majority of the microfinance loans are disbursed on group lending concept and a past record of the
group plays an important role in getting new loans either through SHG-Bank linkage or through MFIs.
The two major problems with the group concept are dropouts (when one or more members leave the
group) and migration (when one or more members move to another group). Most MFIs lend on the basis
of the past record of the group i.e. SHG or JLG and also on the individuals repayment performance. In
absence of a decent past record, members are deprived of getting bigger loan amounts and additional
services.

Transparent Pricing

Though the concern about the transparent pricing in the microfinance sector has been an older one, it is
gaining significance with the growing size and the increasing competition in the sector. Non-transparent
pricing by MFIs confines the bargaining power of the borrowers and their ability to compare different
loan products, because they dont know the actual price. In absence of the proper understanding of the
pricing, clients end up borrowing more than their ability to payback which results in over-indebtedness
of the borrower.

MFIs, in order to make their products look less expensive and more attractive, are disguising their
actual/effective interest rates (better known as the Annualized Percentage Rates APR) by including
other charges like service charge, processing fee etc. Some MFIs even take interest free deposits for
lending microloans. There have been cases where the interest rates are linked with the loan amount,
which means a higher interest rate for smaller loans (because of higher transaction cost). This is resulting
in highest interest rate being charged to the poorest clients, which contradicts with the social aspect of
microfinance.

Ambiguity in the pricing by MFIs is inviting regulatory bodies to implement strict measures

Why dont poor people just use traditional banks?

Poor people in developing countries usually do not qualify for any type of services from the formal
banking sector: they typically have no credit history, and most are not employed in the formal sector, so
there is no record of employment. Moreover, they are unable to provide collateral. And in many parts of
the world, opening a savings account at a traditional bank requires a certain amount of money be
deposited, and poor people, although statistically excellent savers, do not have the large sum of money
required to open a savings account.

Yet, people living in poverty, like everyone else, need access to a diverse range of financial services to
help run a small business, manage risks, and plan for a more stable future.

Why are microcredit interest rates so high?

The answer lays in expenditures.

Administrative expenditures for approving small scale loans are higher in percent than the costs of
approving large scale loans. An employee consumes lesser time for processing the loan in the amount of
EUR 100,000 in comparison to processing hundred loans amounting to EUR 1,000.

In addition to the loan amount, there are also other factors contributing to more expensive approval of
micro - loans. Loan decisions for clients lacking guarantees or salaries may not be grounded on
automated system for the assessment of loan request. Therefore, it requires significant interventions of
credit assistants in assessing the risk of each loan individually.

MFI also operate in remote and less populated areas for the purpose of making the loans more available
for this population, overburdening the loan processing costs. That is also the reasons why the traditional
banks do not have tendency of operating in these areas. For the purpose of achieving successful
operation, the MFI has to calculate all factors related to the loan approval for the purpose of covering all
expenses and continuing sustainable operation.

Like other financial institutions, MFIs charge an interest rate for the loans they give their clients. This is a
way for the MFI to be self-sustaining so that it can be a stable, long term provider of finances in its area
of operations. A self-sustaining MFI is critical to the health of the sector and for it to continue to provide
microfinance services to its clients. However, because managing many small loans costs more money for
any institution than managing one large loan, an MFI typically needs to charge higher interest rates to
cover their costs.

Credit decisions for borrowers who have neither collateral nor a salary cannot be based on automated
scoring. These decisions require substantial intervention of a loan officer in judging the risk of each loan.
MFIs may operate in areas that are remote or have low population density, making lending more
expensive. This is often why traditional banks tend to stay away from such areas. If an MFI wants to
operate sustainably, it has to price its loans high enough to cover all its costs.
Although microcredit interest rates can be legitimately high, inefficient operations can make them higher
than necessary. As the microcredit market matures in a given country, administrative costs usually drop
as managers learn from experience and in some cases because competition forces lower pricing and
greater efficiency.

Microfinance institutions struggle for funds as banks raise lending rates

Microfinance companies, especially the small and mid-sized micro-lenders, are expected to struggle to
access money for lending even if the regulatory environment clears up, industry participants and
observers say.

The main impediment will be banks' reluctance to fund microfinance companies even after a proposed
microfinance law comes into effect. Catering mainly to those at the bottom of the pyramid, microfinance
providers rely heavily on banks for money which they lend at interest rates ranging between 24% and
36%.

Banks have steadily raised their lending rates to microfinance firms from 9%-12% earlier to 15%-18%
now, making loans to small borrowers costlier. The ones likely to be most affected by higher bank lending
rates will be small and mid-sized microfinance companies with loan portfolios between Rs 50-crore and
Rs 250-crore.

"We have to wait and watch what is happening to the small and mid-tier players. The Bill will also force
some amount of consolidation because banks are not comfortable in lending to small players," Padmaja
Reddy, managing director of Hyderabad-based MFI Spandana Spoorthy.

Banks have adopted an increasingly cautious approach towards the microfinance sector, and have
preferred to lend money only to the marquee names that already have large equity base, such as Ujjivan
and Equitas.

The Micro Finance Institutions (Development and Regulation) Bill, 2012, proposes an interest rate cap of
26% for microfinance institutions, with a margin cap of 10% above the cost of funds for players with loan
portfolios exceeding Rs 100-crore, and 12% for smaller ones.

The Bill gives the Reserve Bank of India-the regulator for the sector--sweeping powers to control lending
rates and margins, apart from fixing prudential norms. A microfinance development council, one of two
advisory bodies proposed to be set up under the Bill, will set the policy agenda.

"It will turn out to be a loss-making business. If greater liquidity does not flow in over the next 12-18
months, we could see a number of the smaller microfinance companies disappear," observed Venky
Natarajan, managing partner of Delhi-based impact investment firm Lok Capital.
Turning to the risk capital industry is also not a viable option, he said.

"Equity cannot replace debt, and should not as well, simply because the risk-return characteristics are
very different," he said. Lok Capital has invested around $25 million (Rs 140-crore) in microfinance
providers such as Ujjivan Financial Services, Janalakshmi, Satin Creditcare and Basix.

The Indian microfinance sector has been in a crisis since late 2010, when Andhra Pradesh, the hub for
microfinance in India, imposed tight regulations on microfinance firms citing usurious interest rates and
the use of coercion to recover loans.

SKS Microfinance, one the country's largest, and the only listed microfinance company, bore the brunt of
the fallout.

The microfinance company has been forced to write off nearly Rs 1,500 crore in loans over the past six
quarters, and its stock, which traded at Rs 1,021 in October 2010, is now hovering at around Rs 65,
having lost more than 90% of its value since the Andhra Pradesh crisis

The sector has seen some recovery in 2012, but it has been a skewed one. Larger companies have
continued to successfully raise funds, with Bangalore-based Ujjivan having raised a $35 million so far this
year.

"Larger players can survive and perhaps return to profitability in three to six months, but, frankly, I don't
see how the other smaller ones can survive," said Dilli Raj, chief financial officer of SKS Microfinance.

Difference Between Microfinance and Microcredit

Microfinance vs Microcredit

Businesses and even individuals would sometimes need assistance in the financing of their enterprises.
These are commonly offered by banks and financial institutions through loans and credit.

Not all people can avail themselves of these loans, though, as there are many requirements that they
have to accomplish and satisfy. One of these is to provide collateral for the loan which can be assets such
as real estate property.

Poor people do not have properties, and when they need financial assistance, they cannot get it from
banks but from loan sharks who charge very high interest rates. This led to the development of the
concepts of microfinance and microcredit.

Microfinance is the process of extending financial aid and services to people who have low incomes such
as consumers and the self-employed who find it hard to avail themselves of these services from banks
and other financial institutions. These financial institutions only offer loans or credit to those who have
properties that they can use as collateral and those who have a steady income which the poor do not
have.

In the 1970s, the Grameen Bank of Bangladesh pioneered modern microfinance which soon spread
across the worlds less developed and developing countries. It was meant to prevent the poor from
borrowing money from loan sharks who make their lives even harder. It offers not just loans but savings
and insurance to the underprivileged of society as well. It is designed to pay for itself and the integration
of the financial needs of the poor into a countrys established financial system. It is seen as a tool for
economic as well as social development. The loans are usually used to finance small businesses that help
them earn an income. This is referred to as microcredit.

Microcredit is one aspect of microfinance, and it is designed to provide credit to poor clients, the
proceeds of which are meant to be used as capital for a small business so that they may become self-
sufficient and finally get out of their poverty. Through microcredit, poor people can have a chance at
acquiring a loan without collateral or a steady income provided that they use it to start a business
enterprise that will earn them an income.

Through the years, microcredit has become generally accepted by the financial systems of most
countries. It is now being used as a gauge by banks to determine the credibility of borrowers who may
have availed themselves of it before going to them.

Microcredit and microfinance are both seen as important factors in a countrys development since a
huge percentage of the population is usually poor and needs all the help it can get to make its life better
and, in effect, improve the economic status of the country.

What does microfinance mean for you?

The development and growth of the microfinance market affects more than just those who are engaging
in or contemplating microfinance services. Here's how it may affect you:

As an investor: Return-focused institutional investors are now making microfinance-related investments.

In addition, major ratings agencies are rating microfinance transactions. For example, Morgan Stanley
issued a microfinance backed bond, which contained tranches and was rated "AA" by S&P. (To learn
more about debt rating, please see: What Is A Corporate Credit Rating?)

This shows that microfinance is beginning to provide investment opportunities for all investors. The
Micro Banking Bulletin reports that 63 of the world's top MFIs have an average return (after adjusting for
inflation and after taking out subsidies programs received) of about 2.5% of total assets. Local and
regional banks are generally the first to integrate microfinance investments into their portfolios, while
large international banks currently prefer to provide financing to other banks, MFIs or NGOs. As
mentioned earlier, even consumer finance companies may have exposure to microfinance activities. As
an investor, you may wish to look to see whether the companies you are investing in have exposure to
microfinance and if so, whether the risk-return characteristics of those activities appeal to you. Visit the
MIX market for current information on the supply, demand and facilitation of capital within the
microfinance market.

As a finance professional: Microfinance requires highly specialized financial knowledge as well as a

unique combination of skills, such as knowledge of social science, local languages and customs. New
careers are emerging to fit these unique demands. For finance professionals, this means that new
careers are opening up for those who have this unique combinations of skills and experiences. Moreover,
traditional career roles are blurring as microfinance brings together professionals with varied
backgrounds to work in collaborative teams. For example, development professionals (such as people
who have worked for the Asian Development Bank or other development agencies) can now be found
working side by side with venture capitalists. A wide range of microfinance career opportunities can be
found at Microfinance Gateway.

As an individual: Some believe that we are living in a time when poverty may be eradicated. Studies
support that belief. According to the Virtual Library on Microcredit, during an eight-year period, among
the poorest in Bangladesh with no credit service of any type, only 4% pulled themselves above the
poverty line. But with individuals and families with microcredit from an MFI, more than 48% rose above
the poverty line. What poverty eradication means to you as an individual depends largely upon your
personal philosophy. You might welcome it as a key achievement in the history of humanity. You also
might celebrate the possibility that we each can all buy and sell to one another. Individuals who seek to
be a part of this poverty eradication phenomenon may now loan money to a micro-entrepreneur in
another part of the world through the non-profit online service Kiva.

Recommendations for Micro Finance

1. Proper Regulation: The regulation was not a major concern when the microfinance was in its nascent
stage and individual institutions were free to bring in innovative operational models. However, as the
sector completes almost two decades of age with a high growth trajectory, an enabling regulatory
environment that protects interest of stakeholders as well as promotes growth, is needed.

2. Field Supervision: In addition to proper regulation of the microfinance sector, field visits can be
adopted as a medium for monitoring the conditions on ground and initiating corrective action if needed.
This will keep a check on the performance of ground staff of various MFIs and their recovery practices.
This will also encourage MFIs to abide by proper code of conduct and work more efficiently. However,
the problem of feasibility and cost involved in physical monitoring of this vast sector remains an issue in
this regard.

3. Encourage rural penetration: It has been seen that in lieu of reducing the initial cost, MFIs are opening
their branches in places which already have a few MFIs operating. Encouraging MFIs for opening new
branches in areas of low microfinance penetration by providing financial assistance will increase the
outreach of the microfinance in the state and check multiple lending. This will also increase rural
penetration of microfinance in the state.

4. Complete range of Products: MFIs should provide complete range of products including credit,
savings, remittance, financial advice and also non-financial services like training and support. As MFIs are
acting as a substitute to banks in areas where people dont have access to banks, providing a complete
range of products will enable the poor to avail all services.

5. Transparency of Interest rates: As it has been observed that, MFIs are employing different patterns of
charging interest rates and a few are also charging additional charges and interest free deposits (a part of
the loan amount is kept as deposit on which no interest is paid). All this make the pricing very confusing
and hence the borrower feels incompetent in terms of bargaining power. So a common practice for
charging interest should be followed by all MFIs so that it makes the sector more competitive and the
beneficiary gets the freedom to compare different financial products before buying.

6. Technology to reduce Operating Cost: MFIs should use new technologies and IT tools & applications to
reduce their operating costs. Though most NBFCs are adopting such cost cutting measures, which is
clearly evident from the low cost per unit money lent (9%-10%) of such institutions. NGOs and Section
25 companies are having a very high value of cost per unit money lent i.e. 15-35 percent and hence such
institutions should be encouraged to adopt cost-cutting measures to reduce their operating costs. Also
initiatives like development of common MIS and other software for all MFIs can be taken to make the
operation more transparent and efficient.

7. Alternative sources of Fund: In absence of adequate funds the growth and the reach of MFIs become
restricted and to overcome this problem MFIs should look for other sources for funding their loan
portfolio. Some of the ways through which MFIs can raise their fund are:

By getting converted to for-profit company i.e. NBFC: Without investment by outside investors, MFIs are
limited to what they can borrow to a multiple of total profits and equity investment. To increase their
borrowings further, MFIs need to raise their Equity through outside investors. The first and the most
crucial step to receive equity investment are getting converted to for-profit NBFC. Along with the change
in status the MFI should also develop strong board, a quality management information system (MIS) and
obtain a credit rating to attract potential investors.

Portfolio Buyout: It is when banks or other institutions purchase the rights to future payment stream
from a set of outstanding loans granted by MFIs.
Conclusion

Capital and expertise are increasingly flowing into microfinance. Increased competition can be seen
among MFIs. As they continue to develop their internal operating capacities, more of the potential 80%
of the market will be served. Key players such as ratings agencies and institutional investors are also
moving into the marketplace, signaling the fact that a true market is developing. Although microfinance
has been happening since the 1970s, it is now much more relevant to investors, finance professionals
and individuals. Specifically, you might wish to look at your portfolio, your career opportunities, or your
personal philosophy to determine how the microfinance phenomenon is impacting you.

Grameen Bank firmly believe that an integrated approach to servicing clients can enhancemicrofinances
effectiveness as a poverty alleviation tool. The benefits of this approach are two fold.

First, by acting as a platform to deliver important social services along with credit andfinancial services,
MFIs can contribute to greater sustainability at the client level. Integratingmicrofinance with social
services such as health, education and natural disaster relief orprevention addresses the other
contributing factors to poverty beyond the economic factor.

In doing so, we are providing clients with a comprehensive solution to minimize the risks they face. By
addressing the very issues that inhibit a clients chances of succeeding with microfinance,microfinance
can increase its overall efficacy. Focusing on client sustainability instead ofinstitutional sustainability is
how the field can ensure that we are not just reaching more individuals, but that we are providing them
with the services they really need once we do reachthem, and that we accompany them throughout
their journey to economic freedom.

Second, using microfinance as a platform to offer integrated services increases economies of scope for all
the organizations involved in trying to service the same base of clienteles. With leveraged resources
assets, infrastructure, knowledge, distribution channels, etc. we can increase the capacity of the
service offerings to reach more clients and to reach them more effectively. By partnering with other
critical social providers and businesses and serving as a platform, microfinance can offer other
organizations with a distribution channel to reach individuals in need, share experiences in working in a
particular region and community, and offer countless other tangible and intangible products and
services. This only makes sense because microfinance is not in the business of maximizing profits but
rather of maximizing lives touched and transformed.

With that said, we encourage microfinance institutions to follow in the steps of pioneers, such as the
Grameen Bank, BRAC, Pro Mujer, Fonkoze and Sareeram, in offering integrated services to their clients
and to partner wherever it makes sense. The fight to alleviate poverty is too great a task for anyone or
any one discipline to combat it alone. As an entrenched and recognized leader in this mission,
microfinance can serve as a bridge beyond banking and development. It can be the link that brings
together the services and products available today to the people who need them most. Only through a
collective effort will we have the best chance of succeeding.