General Information on Microfinance:
E conomic processes are that subset of social processes wherein value is created by human agency. This value is manifest in the form of products valued by human beings as manifest by some social process (such as the use of these products in providing for a better life or in the production of other goods necessary to the establishment or maintenance of a certain level of consumption). The evolution of exchange processes provided a means of verifying and quantifying the value embodied in products and services. If someone was willing to exchange (transfer ownership rights to) property for ownership or control over a a product or service held by others then this exchange of ownership rights served to confirm that the item exchanged for was valued at least as much as the item(s) given up. The evolution of a monetary economy further developed the means of verifying or realizing and quantifying value. As money became a universal equivalent in exchange, the use of money to acquire products or services in exchange provided a means of directly quantifying value in terms of this common denominator. Any product or service could be valued in exchange as a particular quantity of money, where this measured quantity represented the socially determined value of the product or service. If someone was willing to pay 12 cowrie shells for X then X was valued at 12 cowrie shells. Of course, it is more complicated than this because value is not based on what one person will pay but is ultimately a function of social processes, which is precisely why we describe value as socially determined. Thus, the value of X is the value one might normally expect to get from it within the society, given existing tastes, incomes (where incomes are reflected in the ability to pay for something, either with money and/or barter), and political rules governing exchange. The rights to use money may, if rules allow, be exchanged just as easily as one exchanges apples and oranges. However, in monetary exchanges we expect to exchange money for the apples and oranges or other physical commodities or that set of ephemeral labor practices we call services. But what do we expect to get when we engage in a monetary exchange where one side of the exchange is the use rights to money? Well, we'll see in a moment that this type of exchange has a special place in financial relationships (and in microfinance, as a subset of such relationships).
As money could be stored and used across time to realize value, the relationship between money, exchange, and value took on an intertemporal dimension. If money at time 0 could be stored for future periods, such that it had value in exchange in time 7, then it was possible to develop intertemporal relationships based on this characteristic of money. For example, one might let someone use your money in time 0 and not lose value if the money lent might reasonably be expected to be returned at time 7 and still command (in exchange) the same products or services. Of course, if you give up the use of the money in time period 0 and do not receive it back until time 7 then it might be said that you have given something up. Humans have limited lifespans and products or services accessed today (in time 0) might be used to generate wealth over the period from time 0 to time 7. This point will become important as we continue to make sense of finance, but for now we will suffice it to say that, under most loan arrangements, the money returned in time 7 needs to be greater than the money lent in time 0 under most circustances or the lender will be uninterested in entering into this relationship. As we will see later, when institutional structures are set up to provide loans, there is also an institutional cost generated by operating a lending process and this cost must be covered in some way for the institution to remain a viable economic enterprise. Whether it is microfinance or macrofinance, institutions engaging in lending (or other financial services/products) must generate cash flow incomes to pay for the administrative costs of carrying out this activity. But we will return to this point later.
Therefore, finance, as another economic process, presupposed the existence of money because it was a social process by which the exchange and store of value functions of money could become the basis of a derivative service -- a service that had value derived from the products that might be created as a result of the service, a financial service. The loan described above is, perhaps, the earliest of these financial services. A loan is simply the transfer of money (with its exchange and store of value functions) from one human being (or institution) to another human being (or institution) in exchange for both the repayment of the amount of the loan (principal) and some additional amount of money (interest). Because these early loans would have been relatively small sums it is tempting to call them micro loans. However, as you will see, we will reserve the term microlending (and the larger category of microfinance ) to financial services that are not only relatively small sums of money but also are targeted to serve clientele who are without any significant material collateral. It is possible that the concept of collateral was innovated later than loans and if such was the case then the early loans would have fit our definition of microloans. However, in contemporary societies individuals who are most likely to have little or no collateral are those who are also relatively marginalized in terms of political and economic power. Thus, microfinance may also be seen as financial relationships involving loans or other financial products directed to marginalized individuals, typically the poor, women, and/or ethnic minorities.
Microfinance does not only involve the provision of loans to marginalized populations. Insurance was another financial innovation that has become important to microfinance. All human beings face uncertainty. It is a fact of life. However, human beings can take actions to mitigate the risks that arise out of uncertainty, at least to some extent. For example, storing food can provide a means of mitigating the risk of future food shortages. Kinship relationships have, for much of human history, served as another means of mitigating future risks. If person A suffers a catastrophe, such as a debilitating accident, then her family might provide for her well being during recovery (or even over the remainder of her life, if necessary). Insurance provided another means for mitigating risk whereby person A might enter into an exchange agreement with person B that is based on B providing money to person A in the event of some prespecified disaster and person A would make payments to person B for this insurance. As with loans, the earliest forms of insurance were likely relatively small. Today, insurance is relatively widespread in most societies. Nevertheless, many of those households with no collateral are also likely to be without insurance and there is a potentially sizeable market for insurance that serves this population. Microfinance may, therefore, not only serve as a way to open up lending to such underserved populations but to also provide a means for such individuals to obtain insurance.
Whether in the form of loans or insurance, financial services require the existence of an institution capable of and willing to provide such services. Financial institutions, by allocating money (and the economic power that comes from weilding money) exercise significant influence over social
life and the development of economic relationships. Given that poverty is defined, in part, by the absence of some level and/or type of economic power (such as the power to command sufficient food or other necessities to maintain household well-being), then it is not difficult to understand why the structure and behavior of financial institutions would be implicated in the existence and reproduction of poverty and, potentially, in the alleviation of poverty. Thus, the development of institutions directed to providing financial services to marginalized populations, defined as microfinance institutions (MFIs), may be understood, at least in part, as part of a strategy to reduce levels of poverty by directly granting to the poor (whether in whole or via some subset of the poor population, such as poor women) access to money that enhances their economic power and mitigates some of the risks that arise from an uncertain future.
Therefore, financial institutions, including MFIs, when present, are key players in shaping the economic environment. Any economic process that involves the allocation of money, whether in the present or the future, may be created, reproduced, or fundamentally altered by financial processes and related financial instruments. In order to understand the role of MFIs in shaping economic activities it is helpful to list some of these allocative functions. All forms of budgeting involves the allocation of money to meet objectives (by financing material technics or social activities that are required to meet such objectives). Risk mitigation takes a variety for forms, including the forementioned insurance function. Insurance takes the form of obligations to provide money in future under certain specified conditions. For example, one might insure against the failure of a party to a contract meeting the conditions of that contract. Insurance may protect a party from future claims against them because of their inability to meet obligations in future or because of legal claims generated by a political process (such as court imposed obligations resulting from a law suit). Future risks could also involve the unexpected termination of a contract that generates negative cash flows to a party. Insurance could provide mitigating positive cash payments. One example of this would be a farmer having entered an agreement to sell a specific quantity of rice or some other product to an intermediary who subsequently goes out of business and cannot honor the contract. The farmer has incurred expenses related to producing the crop, as well as future obligations related to her agricultural activities, and may not be able to meet these obligations (or even generate sufficient income to meet household obligations) and there may not be an alternative outlet for their crop to make up for the lost contract. Insurance could provide the farmer with the income necessary to meet these obligations and avoid complete failure/bankruptcy, which might include losing their farmland and their ability to practice farming. Thus, as one can see, the existence of micro-insurance could be critical to a poor farmer (or other poor entrepreneur) continuing to do business or even maintain an existing level of livelihood. This is no less true of those at higher income levels but the poor often face a situation where no such insurance is available.
All social institutions necessarily alter the economic environment in the society in some way. Financial institutions that exclude the poor or other marginalized members of the society create roadblocks in the path of economic development from the grassroots level because entrepreneurs from the excluded groups will be severely handicapped in their efforts to finance business projects in the present and future, even if such business projects would generate greater value for the society. The same can be said of the roadblocks placed in the way of poor consumers acquiring labor saving durable goods because of the lack of credit. And, given the pervasive presence of uncertainty about future events and outcomes, both entrepreneurship and consumption behavior can be dramatically impacted by the presence or absence of insurance.
MFIs are innovative institutions that have moved into the wasteland of inadequate finance for the poor and marginalized. However, these institutions face a number of difficult obstacles. Firstly, if microloans are to be issued to borrowers with little or no collateral, then it becomes imperative to address the potential problem of default (where default refers to a failure to make contractually obligated payments of interest and principal on the loan). When banks make loans, not only is there usually a requirement of some form of collateral (property that will be forfeited in the event of default) but the bank will typically have some means of evaluating the probability of default based on data gathered on the potential borrower and a dataset on past borrowers that can be used for comparative purposes. This process of evaluating the credit-worthiness of potential borrowers is a form of due diligence. For MFIs, this dataset is less likely to exist for a class of borrowers who have been traditionally excluded from the availability of loans (and without loans, rates of default are non-existent) and information on specific potential borrowers are also likely to be rather minimal. In other words, managers within the MFI must make decisions on lending to people they are likely to know very little about. The solution to this problem has mostly taken the form of shifting the responsibility for due diligence from managers within the MFI to peer groups for which the borrower would be a member. The peer group would not only evaluate the worthiness of its members to receive loans but sometimes act as guarantor of the repayment, thus further mitigating the absence of material collateral. Thus, this innovative approach to lending, creating peer groups to mitigate the lack of transparency regarding the credit-worthiness of individual borrowers within targeted poor or marginalized communities while simultaneously forging stronger social relationships among these borrowers to raise the social cost to those borrowers for defaulting on loans, as well as potentially providing another layer of repayment insurance for the lending MFI (if the peer group guarantees the repayment), has had a dynamic impact on the growth of microfinance.
Another innovation that has had a dynamic impact is the transformation of MFIs into depository institutions where the targeted population for microfinance services and products (the poor and marginalized communities) is provided with incentives to make small deposits into savings accounts at the MFI. It may seem a bit contradictory to try to get poor people to save money when, by the very nature of being poor, they are suffering from a scarcity of money. However, it turns out that poor people who begin to put aside small sums of money into savings account can develop financial management skills that can help them to escape poverty or, at the least, to improve their livelihood and that of their children. And it also helps the MFI to solve a key problem, finding seed funds for microlending.
And a lot of seed money is needed by MFIs with an estimated over $1 billion in microloans. Most microlending projects are revolving loan funds where the repayments of principle provide continuous replenishment of the funds such that new loans can be made. However, the need for expansion in microlending is great and the development of innovative ways of attracting more funds to MFIs for use in lending is important if microfinance is to realize more of its potential. This is all the more true if microfinance continues to expand beyond microlending into providing other financial services/products, such as microinsurance.
Copyright © 2013, Satya Gabriel, Mount Holyoke College.
Copyright © 2011, Satya Gabriel, Economics Department, Mount Holyoke College.
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