CHAPTER 2

Microfinance is a phenomenon that reflects the provision of both credit and savings services to low income people. This provision of funds in form of credit and microloans empowers the poor and low income earners to engage in productive economic activities which can help boost their income level and thus alleviate poverty in the economy. According to Otero (1999, p.8), microfinance provides financial services to low-income poor and rural people. Conroy, (2003) defines it as the provision of financial services to poor and low income households who don’t have ready access to formal financial institutions. These financial services “generally include savings and credit but can also include other financial services such as insurance and payment services.” (Ledgerwood, 1999)

Schreiner and Colombet (2001, p.339) clearly describe microfinance as “the attempt to improve access to small deposits and small loans for poor households neglected by banks.” According to Olaitan (2005) and Akanji (2001), the tools of microfinance include increased provision of credit, increased provision of savings, repositories and other financial services to low income earners or poor households. Thus simply defined, microfinance is a development process through the provision of microcredit and savings service to small-scale entrepreneur. The Olaitan and Akanji perspective on microfinance go in line with Schreiner’s description of the concept. Schreineer (2001) also proposed a definition of microfinance as “uncollateralized loans to the poor and small-scale entrepreneurs”. This implies that microfinance provides financial strength to the low income earners so as to enable them carry on economic activities that can earn them improved living standard.

Furthermore, the last two decades about has witnessed an increasing number of formal sector organizations (non-government, government, and private), essentially created for the purpose of meeting these needs (Robinson, 2001). Microfinance is a term that has come to refer generally to such informal and formal arrangements offering financial services to the financially impaired productive individual and groups. The topic of microfinance has received extra attention within the last few decades. 2005 was declared the International Year of Micro Credit by UN. In recent times, there have been varying arguments for and against the implementation of microfinance.

A conceptual view of the phenomenon has shown a disparity in perception by scholars on this subject. While some relay microfinance as an instrument that empowers the poor, others negate this opinion; conceptualizing microfinance has a social liability. The conservatives view microfinance as social liability, consuming scarce resources, without significantly effecting long-term outcomes. Critics argue that the small enterprises supported by microcredit program have limited potential to grow and so have no sustained impact on the poor. They contend that these “microfinance programs rather make the poor economically dependent on the program itself” (Bouman and Hospes, 1994). Hence, even if the programs are able to reach the poor, they may not be cost effective and hence worth supporting as a resource transfer mechanism. Robinson (2001) posits that Credit is widely available from informal commercial moneylenders, but usually at a very high cost to the borrower. The Informal commercial lenders charge nominal interest rate ranging between 10% to over 100% a month.

However, the proponents of microfinance have instituted different ideas and relics of this phenomenon. According to Foster (1995), Rosenzweig and Wolpin (1993), if conventional banks and financial institutions fail to meet the needs of the poor, alternative mechanisms should be developed to contain this group’s demand for financial services. For instance, Anyanwu (2003) identified there is a need to exhilarate uncollateralized loans so as to benefit the poor for the purpose of the programme in improving their capacity utilization. The poor lack collateral to get loans from large banks, therefore there is the need to increase the number of microfinance institutions that provide such uncollateralized loans. Microfinance has three distinguishing features from other formal financial products. These include: (1) the smallness of loans advanced and/or savings collected, (2) the absence of asset-based collateral, and (3) simplicity of operations (Iganiga 2008, Mejeha and Nwachukwu 2008, Ramirez 2006).

According to Zeller and Meyer (2002), “the excitement about the use of microfinance to empower the low income people is not backed up with sound facts derived from rigorous research”. Many governments, institutions, and project managers are sometimes disinclined to carry out impact evaluations because they are regarded as invaluable, time taking, technically complex, and because the findings can be politically incisive, especially if negative. However, a rigorous evaluation can help to assess the suitability and effectiveness of such programs. Evaluation of impact is very important in a developing country where resources are relatively scarce and every dollar spent should aim at maximizing its impact on poverty reduction (Baker 2000). Impact analysis can guide in augmenting MFI management and customer service. There is therefore a strong notion for attempting to assess both the intensity of outreach of MFIs and its livability.

2.2 Contextual Views on Microfinance Institutions

The imperfections in the financial markets at micro level has held back formal financial intermediaries and put informal lenders in a better position for effective and efficient service delivery in the market. The 1990s marks a period of speedy growth in statistic of microfinance institutions established and also, emphasis on reaching scale increased (Robinson, 2001). Dichter (1999:12) refers to the period as “the microfinance decade”. Microfinance had now grown into an industry in most countries where it is practiced. In concordance with the growth in micro-credit institutions, emphasis has changed from just giving credit to the poor (micro-credit), to provision of other financial services like savings, insurance and pensions (microfinance) when it was glaring that the low income entrepreneurs had a rising demand for such additional services.

Maria (2006) identified Microfinance as “a part remedy to the problems posed by the conventional formal banking system”. It avails financial services to the poor people who cannot enter the formal financial sector and historically has been tamed towards poverty reduction. The divergence of demand for microfinance services requires a broad array of valiant financial Intermediation institutions which can expand outreach to households various stratum of poverty and in economically vibrant-poor urban and rural locality.

Varying in formality, historical microfinance systems have provided valuable financial services for group members, including savings programs, credit programs, and insurance programs. Although various functions of microfinance have existed for centuries, academic research in the area of microfinance institutions (MFIs) is relatively new. Qayyum & Ahmad (2006) explained MFIs in a more formal way as financial institutions with a primary objective of making credit available to that segment of the population which has been ignored by the commercial banking system for not having collateral requirements or in other words not bankable. African Development Bank considers MFI as institution that provides a broad range of financial services such as deposits, loans, payment services, money transfers, and insurance to poor and low-income households and, their microenterprises.

Leftwich (2006) classified MFIs into two categories, formal and informal, both of which constitute a society’s institutional framework. The former operates on formal rules and constraints, including political and economic rules. The constitutions, statutes, common laws and so on are part of the bedrock on which formal institutions function. On the other hand, Informal institutions supplement formal institutions and operate on the basis of customs, traditions, conventions, taboos, and unwritten rules/laws. Informal institutions help in easing transaction problems in any economy or society, including both developed and developing countries. Due to the poor and underdeveloped state of formal institutions in less developed countries, informal institutions seem to be more important and assume more prominence. Furthermore, the few formal institutions in existence are weak and often fail to meet the needs of a large percentage of members of the society, especially the less materially endowed (Jutting 2003; Junior and Smith 2004).

Churchill (2000), Schreiner (2000), and Norell (2001) all address attempts to incorporate existing banking practices into MFIs. Churchill discusses the impact of customer loyalty, similar to the relationship lending literature in mainline finance and concludes that customer loyalty is key to MFI success. Schreiner (2000) discusses the role of credit scoring in MFIs and argues that scoring can add value to the MFI process. Norell discusses techniques that MFIs can use to reduce arrears which include following-up quickly on late loans, forming strong solidarity groups, updating and enforcing credit policies, and concentrating on the scope of lending.

2.3 Paradigms of Microfinance

Another major study area on microfinance is the pattern in which the operations are better carried out, especially the funding of MFIs. There have been arguments about the sustainability of these MFIs. As most scholars perceive, microfinance is a panacea for effective provision of financial services to the financially retracted group of people. Issues regarding the sustainability of this practice have been brought to the lime light. Unlike formal sector financial institutions, majority of MFIs are not “sustainable” as termed in the microfinance literature. There is much semantic confusion surrounding the word “sustainable”. Ideally, sustainability implies institutional permanence; it captures the idea that an institution is and will continue to be a “going concern”.

Navajas et al. (1998, p. 5), defines sustainability as “to reach goals in the short-term without harming your ability to reach goals in the long-term”. Similarly, Edgcomb and Cawley (1994, p. 77) define sustainability as the ability of an organization to “sustain the flow of valued benefits and services to its members or clients over time”. Both sets of authors, however, later clarify their remarks to make clear that, in their view, the only way an MFI can become truly “sustainable” is to reach financial self-sufficiency. Edgcomb and Cawley (1994, p. 86), for example, argue that “sustainable institutions can and must [emphasis ours] meet 100 percent auto-financing for their credit operations”.

Most MFIs operate without covering their costs. This makes them not able to sustain in the long run even though some of them still receive subsidies from Government and foundations (Pollinger, et al., 2007; Qayyum & Ahmad, 2006). Essentially what we mean by sustainability, as also suggested by (Conning, 1999) is the ability to achieve full cost recovery or profit making and last into the future without continued reliance on government subsidies or donations. For example, the most careful and comprehensive recent survey shows that the programs that target the poorest borrowers generate revenues sufficient to cover just 70% of their full costs (Micro Banking Bulletin, 1998). Hence, the situation shows that most of them are performing badly because even when some of them still get subsidies, they could not survive. Out of the many MFIs that are established only a few are able to maintain sustainability in the long run, such as the Grameen Bank in Bangladesh, Bank Rakyat Indonesia, BancoSol in Bolivia, MiBanco in Lima Peru and ProCredit in Nicaragua. (Alexander, 2000; Barnett, 2006; Maurer & Seibel, 2001; Patten, et al., 2001; Pollinger, et al., 2007; Qayyum & Ahmad, 2006).

Considering the performance trend of the MFIs, there are two major views on the issue of sustainability of these institutions. The Institutionalist and the Welfarist view. How this argument is resolved has crucial implications for the future of microfinance- its guiding principles, its objectives and its clients. Jonathan Morduch (1998) refers to this division as the microfinance schism. The irony is that while the worldviews of each camp are not inherently incompatible, and in fact there are numerous microfinance institutions (MFIs) that appear in practice to embrace them both, there nonetheless exists a large rift between the two camps that makes communication between them difficult.

Those who hold the institutionalist view argue that an MFI should be able to cover its costs with its revenues. Institutionalists feel this self-sufficiency leads to long-term sustainability for MFIs, which will facilitate greater poverty alleviation in the long-term (Woller, Dunfield, and Woodworth, 1999). The institutionalist argument is coherent with Hollis and Sweetman (1998) who discussed six historical cases in an attempt to identify the institutional designs that facilitated success and sustainability for 19th century loan funds in the UK, Germany, and Italy. The emphasis here is placed on achieving financial self-sufficiency. The authors believe that subsidized loan funds were more fragile and lost focus more quickly than those that obtained funds from depositors. In his views, Morduch (2000) believes the poor households demand access to credit, not “cheap” credit. The primary concern of microfinance clients is access to microfinance services compatible with their requirements, rather than the cost of such services. The demand for savings facility by the low income group may be as strong as the demand for credit facilities. Thus, expanding the access to savings services can have a significant impact on an institution’s sustainability.

Institutionalists hold that, “Profits are necessary for sustainability, and sustainability is sufficient for worthwhileness” (Schreiner, 1997a, p. 5). Profitability increases access to credit and increasing access to credit in turn brings more profit to FL. This is known as meeting the “double bottom line”; that is, meeting a social bottom line as well as financial bottom line (Peachey, 2007). Thus, programs can charge high interest rates without compromising outreach. However, the welfarist opinion on sustainability differs. The welfarist idea is that which builds around social responsibility rather than self actualization. Welfarists are quite explicit in their focus on immediately improving the well-being of participants. They are less interested in banking per se than in using financial services as a means to alleviate directly the worst effects of deep poverty among participants and communities, even if some of these services require subsidies (Woller, 1999). In line with this perception, what is important is improving the well being of the economically active poor by promoting accessibility to financial services.

Whereas, the institutionalists advocate profit motive of MFIs and financial self sufficiency as a means for effectiveness in the industry, the Welfarists uphold subsidy as the mechanism for achieving this same goal; they share the Institutionalists’ vision of financial deepening. In as much as both approaches seem to proffer a remedy to sustainability issues of the microfinance mechanism, a one-sided practice could spell an expensive danger for the industry. Microfinance is not just about financial service accessibility, it is a program tailored to strengthen the poor. Services of this sort should therefore be provided at relatively low cost. This makes subsidy an important factor in micro financing but too much reliance on it could turn MFIs to ‘charity institutions’. Moreover, financially viable microfinance institutions limit their operational concentration to providing only financial services. It is important to differentiate and cleave financial intermediation (through microfinance) vis-à-vis social intermediation (through social safety nets) in contriving support programs.

2.4 Relevance of Regulation and Supervision

In recent years, the discussion on regulation broadens our understanding on the extent to which the realities of the political economy influence the regulatory policy choices on different financial institutions. Traditionally, the need for regulation of Microfinance institutions is justified in the finance literature as a policy instrument to minimize the effects of market failures due to informal banking pattern, and has gained substantial attention recently in developing countries (Armstrong, Cowan, & Vickers, 1994; Majone, 1996). For instance, Jenkins (2009) raised some fundamental questions that need to be answered if up-scaling is to be considered; “The transformation of Microfinance NGOs into regulated financial institution, how should they be regulated? Should they be subject to same prudential regulations as other banks or not? What happens when regulated like banks? If regulated, will they then start to act like banks and only make larger loans, and ask for collateral?” (Hatice, 2009: pp10-11)

Chaves & Gonzalez-Vega (1994) refers to regulation as a set of enforceable rules that restrict or direct the actions of participants and as a result alter the outcomes of this action. The financial crises in various countries have indeed brought the issue of regulation to the forefront of financial sector reforms, which is primarily about ensuring systemic stability and protecting depositors. Nevertheless, appropriate regulation of financial markets depends very much on the country-specific characteristics such as level of development and institutional capacities.

Since virtually every country in the world requires the licensing and regulation of institutions that mobilize deposits from the general public, the issue of regulating and supervising microfinance institutions has become an increasingly important item on the microfinance agenda, especially for the more successful and aggressive institutions. Gallardo (2002) asserts that, regulating and supervising traditional financial institutions is as important as microfinance itself. Many writers have therefore supported the argument for an umbrella body to ensure consumer protection for public depositors in financial institutions (Robert C. Vogel, Arelis Gomez and Thomas Fitzgerald, 2000; Gallardo, 2002).

Moreover, moral hazard issues usually arise because the interests of financial institutions vis-à-vis the interests of consumers per se are not necessarily compatible. Individual depositors and investors may not be in a position to judge the soundness of a financial institution (the issue of asymmetric information), much less to influence that institution’s management. Thus, an impartial third party such as the state or one of its agencies is required to regulate and control the soundness of a country’s financial institutions. Since bank failures and problems tend to be contagious and affect other banks regardless of their soundness, the protection of the whole banking and payment system becomes an additional objective of regulation and supervision. Stefan (1999) concurs to this perspective. In her views, the perceived advantage of functional regulation is that the different types of financial institutions are regulated by one single law and the same conditions apply for all. This principle rules out the possibility of gaining competitive advantages simply by shifting to another regulatory framework (so-called regulatory migration, e.g. converting a bank into a building society). Furthermore, she identified two major approaches to regulating the industry; the self-regulatory approach (regulated by members in the industry) and the hybrid regulatory approach (regulated by external agencies instituted by the state). The hybrid creates a legal framework for the sub-sector, but it is costly for most MFIs. In 1998, The Bank Supervision Department of the South African Reserve Bank recognise the fact that strict regulation would drive up costs, or force the participants into other informal financing arrangements. They believe that with member-driven institutions, the members or owners can exert control. Contrary to the hybrid approach which foresees an unavoidable conflict of interest between safeguarding the interests of the members and promoting the industry on the one hand and its regulation and supervision on the other. The hybrid approach identifies the need for Central Banks (or Reserve Banks) to institute regulatory and supervisory agencies that would focus on the custom and essence of best practices within the industry (Stefan, 1999).

Conclusively, conceding the idea of regulating and supervising MFIs is not without a flexibility run of policy that should be considerate to these institutions. A difficult environment will trigger a possible re-transformation of MFBs into commercial bank. For example, in El Salvador 1995, the regulatory authority raised the minimum capital requirement to $12million from a $1million mark. Financiera Calpia proposed raising the required capital for commercial banks instead. (Campion and White, 1999). A stiff regulatory environment runs the risk of hobbling the industry for microfinance. The commercial viability of micro lenders is relevant not just to the investors who put their money in the sector, but also to the growth and outreach of MFIs that will finally determine their effectiveness in bringing inclusion to the excluded. Even in their search for inclusive practices, regulators will have to ensure that competition and market forces don’t get crowded out.