microfinance MBM notes

microfinance MBM notes

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  UNIT 1 OVERVIEW OFMICROFINANCE Concept: Microfinance is the provision of a broad range of financial services such as deposits, loans, payment services, money transfers and insurance products – to the poor and low-income households, for their microenterprises and small businesses, to enable them to raise their income levels and improve their living standards. Microfinance activities usually involve:  Small loans, typically for working capital  Informal appraisal of borrowers and investments  _Collateral substitutes, such as group guarantees or compulsory savings  Access to repeat and larger loans, based on repaymentperformance  Streamlined loan disbursement and monitoring  Secure savings products. Although some MFIs provide enterprise development services, such as skills training and marketing, and social services, such as literacy training and health care. these are not generally included in the definition of microfinance.MFIs can be nongovernmental organizations(NGOs), savings and loan cooperatives, credit unions government banks, commercial banks, or nonbank financial institutions. FEATURES OF MICROFINANCE 1) It is an essential part of rural finance. 2) It deals in small loans. 3) It basically caters to the poor households. 4) It is one of the most effective and warranted PovertyAlleviation Strategies. 5) It supports women participation. 6) It provides an incentive to grab the self employment opportunities. 7) It is more service-oriented and less profit oriented. 8) It is meant to assist small entrepreneur and producers. 9) Poor borrowers are rarely defaulters in repayment of loans as they are simple and God fearing. ROLE AND IMPORTANCE OF MICROFINANCE :- Microfinance institutions are those which provide credit and other financial services and products of very small amounts to poor in rural, semi-urban and urban areas for enabling them to raise their income and improve their standard of living.
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  1. Credit ToRural Poor : Usually rural sector depends on non-institutional agencies for their financial requirements. Micro financing has been successful in taking institutionalized credit to the doorstep of poor and have made them economically and socially sound. 2. Poverty Alleviation:- Due to micro finance poor people get employment. It also helps them to improve their entrepreneurial skills and encourage them to exploit business opportunities. Employment increases income level which in turn reduces poverty. 3. Women Empowerment :- Normally more than 50% of shelf help group(SHGs) are formed by women. Now they have greater access to financial and economical resources. It is a step towards greater security for women. Thus microfinance empowers poor women economically and socially. 4. Economic Growth :- Finance plays a key role in stimulating sustainable economic growth. Due to microfinance, production of goods and services increases which increases GDP and contributes to economic growth of the country. 5. Mobilisation Of Savings :- Microfinance develops saving habits among people. Now poor people with meagre income can also save and are bankable. The financial resources generated through savings and micro credit obtained from banks are utilised to provide loans and advances to its members. Thus microfinance helps in mobilisation of savings. 6. Development Of Skills:- Micro financing has been a boon to potential rural entrepreneurs. SHGs encourage its members to set up business units jointly or individually. They receive training from supporting institutions and learn leadership qualities. Thus micro finance is indirectly responsible for development of skills. 7. Mutual Help And Co.operation:- Microfinance promotes mutual help and co.operation among members. The collective efforts of group promotes economic interest and helps in achieving socio-economic transition. 8. Social Welfare:- With employment generation the level of income of people increases. They may go for better education, health, family welfare etc. Thus micro finance leads to social welfare or betterment of society. KEY PRINCIPLES OF MF 1.Poor people need a variety of financial services, not just loans. 2. Microfinance is a powerful tool to fight poverty. 3. Microfinance means building financial systems that serve the poor. 4. Microfinance must pay for itself toreach large numbers of poor people. 5. Microfinance is about building permanent local financial institutions.
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  6. Microcredit isnot the best tool for everyone or every situation. 7. Interest rate ceilings making it harder for poor people to get credit. 8. The role of government is to enable financial services, not to provide them. 9. Donor funds should complement private capital, not compete with it. 10. The key bottleneck is the shortage of strong institutions and managers. 11. Microfinance works best when it measures and discloses its performance KEY PRINCIPLES OF MICROFINANCE 1.The poor need a variety of financial services, not just loans: Just like everyone else, poor people need a wide range of financial services that are convenient, flexible, and reasonably priced. Depending on their circumstances, poor people need not only credit, but also savings, cash transfers, and insurance. 2.Microfinance is a powerful instrument against poverty: Access to sustainable financial services enables the poor to increase incomes, build assets, and reduce their vulnerability to external shocks. Microfinance allows poor households to move from everyday survival to planning for the future, investing in better nutrition, improved living conditions, and children’s health and education. 3.Microfinance means building financial systems that serve the poor: Poor people constitute the vast majority of the population in most developing countries. Yet, an overwhelming number of the poor continue to lack access to basic financial services. In many countries, microfinance continues to be seen as a marginal sector and primarily a development concern for donors, governments, and socially-responsible investors. In order to achieve its full potential of reaching a large number of the poor, microfinance should become an integral part of the financial sector. 4.Financial sustainability is necessary to reach significant numbers of poor people: Most poor people are not able to access financial services because of the lack of strong retail financial intermediaries. Building financially sustainable institutions is not an end in itself. It is the only way to reach significant scale and impact far beyond what donor agencies can fund. Sustainability is the ability of a microfinance provider to cover all of its costs. It allows the continued operation of the microfinance provider and the ongoing provision of financial services to the poor. Achieving financial sustainability means reducing transaction costs, offering better products and services that meet client needs, and finding new ways to reach the unbanked poor. 5.Microfinance is about building permanent local financial institutions: Building financial systems for the poor means building sound domestic financial intermediaries that can provide financial services to poor people on a permanent basis. Such institutions should
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  be able tomobilize and recycle domestic savings, extend credit, and provide a range of services. Dependence on funding from donors and governments—including government- financed development banks—will gradually diminish as local financial institutions and private capital markets mature. 6.Microcredit is not always the answer: Microcredit is not appropriate for everyone or every situation. The destitute and hungry who have no income or means of repayment need other forms of support before they can make use of loans. In many cases, small grants, infrastructure improvements, employment and training programs, and other non-financial services may be more appropriate tools for poverty alleviation. Wherever possible, such non-financial services should be coupled with building savings. 7.Interest rate ceilings can damage poor people’s access to financial services: It costs much more to make many small loans than a few large loans. Unless microlenders can charge interest rates that are well above average bank loan rates, they cannot cover their costs, and their growth and sustainability will be limited by the scarce and uncertain supply of subsidized funding. When governments regulate interest rates, they usually set them at levels too low to permit sustainable microcredit. At the same time, microlenders should not pass on operational inefficiencies to clients in the form of prices (interest rates and other fees) that are far higher than they need to be. 8.The government’s role is as an enabler, not as a direct provider of financial services: National governments play an important role in setting a supportive policy environment that stimulates the development of financial services while protecting poor people’s savings. The key things that a government can do for microfinance are to maintain macroeconomic stability, avoid interest-rate caps, and refrain from distorting the market with unsustainable subsidized, high- delinquency loan programs. Governments can also support financial services for the poor by improving the business environment for entrepreneurs, clamping down on corruption, and improving access to markets and infrastructure. In special situations, government funding for sound and independent microfinance institutions may be warranted when other funds are lacking. 9.Donor subsidies should complement, not compete with private sector capital: Donors should use appropriate grant, loan, and equity instruments on a temporary basis to build the institutional capacity of financial providers, develop supporting infrastructure (like rating agencies, credit bureaus, audit capacity, etc.), and support experimental services and products. In some cases, longer-term donor subsidies may be required to reach sparsely populated and otherwise difficult-to-reach populations. To be effective, donor funding must seek to integrate financial services for the poor into local financial markets; apply specialist expertise to the design and implementation of projects; require that financial institutions and other partners meet
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  minimum performance standardsas a condition for continued support; and plan for exit from the outset. 10.The lack of institutional and human capacity is the key constraint: Microfinance is a specialized field that combines banking with social goals, and capacity needs to be built at all levels, from financial institutions through the regulatory and supervisory bodies and information systems, to government development entities and donor agencies. Most investments in the sector, both public and private, should focus on this capacity building. 11.The importance of financial and outreach transparency: Accurate, standardized, and comparable information on the financial and social performance of financial institutions providing services to the poor is imperative. Bank supervisors and regulators, donors, investors, and more importantly, the poor who are clients of microfinance need this information to adequately assess risk and returns. MICRO-FINANCE REVOLUTION Microfinance arose in the 1980s as a response to doubts and research findings about state delivery of subsidized credit to poor farmers. In the 1970s government agencies were the predominant method of providing productive credit to those with no previous access to credit facilities—people who had been forced to pay usurious interest rates or were subject to rentseeking behavior. Governments and international donors assumed that the poor required cheap credit and saw this as a way of promoting agricultural production by small landholders. In addition to providing subsidized agricultural credit, donors set up credit unions inspired by the Raiffeisen model developed in Germany in 1864. The focus of these cooperative financial institutions was mostly on savings mobilization in rural areas in an attempt to ―teach poor farmers how to save.‖ Beginning in the mid-1980s, the subsidized, targeted credit model supported by many donors was the object of steady criticism, because most programs accumulated large loan losses and required frequent recapitalization to continue operating. It became more and more evident that market-based solutions were required. This led to a new approach that considered microfinance as an integral part of the overall financial system. Emphasis shifted from the rapid disbursement of subsidized loans to target populations toward the building up of local, sustainable institutions to serve the poor. At the same time, local NGOs began to look for a more long-term approach than the unsustainable income generation approaches to community development. In Asia Dr. Mohammed Yunus of Bangladesh led the way with a pilot group lending scheme for landless people. This later became the Grameen Bank, which now servesmore than 2.4 million clients (94 percent of them women) and is a model for many countries. In Latin America ACCION International supported the development of solidarity group lending to urban vendors, and Fundación Carvajal developed a successful credit and training system for individual microentrepreneurs. Changes were also occurring in the formal financial sector. Bank Rakyat
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  Indonesia, a state-owned,rural bank, moved away from providing subsidized credit and took an institutional approach that operated on market principles. In particular, Bank Rakyat Indonesia developed a transparent set of incentives for its borrowers (small farmers) and staff, rewarding on-time loan repayment and relying on voluntary savings mobilization as a source of funds. Since the 1980s the field of microfinance has grown substantially. Donors actively support and encourage microfinance activities, focusing on MFIs that are committed to achieving substantial outreach and financial sustainability. Today the focus is on providing financial services only, whereas the 1970s and much of the 1980s were characterized by an integrated package of credit and training—which required subsidies. Most recently, microfinance NGOs (including PRODEM/BancoSol in Bolivia, K-REP in Kenya, and ADEMI/BancoADEMI in the Dominican Republic) have begun transforming into formal financial institutions that recognize the need to provide savings services to their clients and to access market funding sources, rather than rely on donor funds. This recognition of the need to achieve financial sustainability has led to the current ―financial systems‖ approach to microfinance. This approach is characterized by the following beliefs:  Subsidized credit undermines development.  Poor people can pay interest rates high enough to cover transaction costs and the consequences of the imperfect information markets in which lenders operate.  The goal of sustainability (cost recovery and eventually profit) is the key not only to institutional permanence in lending, but also to making the lending institution more focused and efficient.  Because loan sizes to poor people are small, MFIs must achieve sufficient scale if they are to become sustainable.  Measurable enterprise growth, as well as impacts on poverty, cannot be demonstrated easily or accurately; outreach and repayment rates can be proxies for impact. One of the main assumptions in the above view is that many poor people actively want productive credit and that they can absorb and use it. But as the field of microfinance has evolved, research has increasingly found that in many situations poor people want secure savings facilities and consumption loans just as much as productive credit and in some cases instead of productive credit. MFIs are beginning to respond to these demands by providing voluntary savings services and other types of loans. RATIONALE OF GROWING MICROFINANCE 1. The promise of reaching the poor. Microfinance activities can support income generation for enterprises operated by low-income households. 2. The promise of financial sustainability. Microfinance activities can help to build financially self-sufficient, subsidy-free, often locally managed institutions. 3. The potential to build on traditional systems. Microfinance activities sometimes mimic traditional systems (such as rotating savings and credit associations). They provide the same services in similar ways, but with greater flexibility, at a
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  more affordable priceto microenterprises and on a more sustainable basis. This can make microfinance services very attractive to a large number of low-income clients. 4. The contribution of microfinance to strengthening and expanding existing formal financial systems. Microfinance activities can strengthen existing formal financial institutions, such as savings and loan cooperatives, credit union networks, commercial banks, and even state-run financial institutions, by expanding their markets for both savings and credit—and, potentially, their profitability. 5. The growing number of success stories. There is an increasing number of well-documented, innovative success stories in settings as diverse as rural Bangladesh, urban Bolivia, and rural Mali. This is in stark contrast to the records of state-run specialized financial institutions, which have received large amounts of funding over the past few decades but have failed in terms of both financial sustainability and outreach to the poor. 6. The availability of better financial products as a result of experimentation and innovation. The innovations that have shown the most promise are solving the problem of lack of collateral by using group-based and character-based approaches; solving problems of repayment discipline through high frequency of repayment collection, the use of social and peer pressure, and the promise of higher repeat loans; solving problems of transaction costs by moving some of these costs down to the group level and by increasing outreach; designing staff incentives to achieve greater outreach and high loan repayment;and providing savings services that meet the needs of small savers. Understanding the MF in Country(Nepalese) Context The overall political and economic environment of a country affects how microfinance is provided. Government economic and social polices, as well as the development level of the financial sector, influence microfinance organizations in the delivery of financial services to the poor. Understanding these factors and their effect on microfinance is called assessing the country context. This process asks the following questions:  Who are the suppliers of financial services?,What products and services do they supply?, What role do governments and donors play in providing financial services to the poor?  How do existing financial sector policies affect the provision of financial services, including interest rate policies, government mandates for sectoral credit allocation, and legal enforcement policies?  What forms of financial sector regulation exist, and are MFIs subject to these regulations?  What economic and social policies affect the provision of financial services and the ability of microentrepreneurs to operate?
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  As can beseen in figure above , contextual factors affect how suppliers of financial intermediation reach theirclients. This context uses a macroeconomic approach to place microfinance in the overall context of a country and so make clear how important macro-level policy and regulation are for developing microfinance providers and microenterprises. Practitioners and donors need to examine the financial system to locate needs and opportunities for providing microfinance services. Analyzing the country →context reveals whether changes in policy or in the legal framework are needed to allow more efficient markets to emerge. Suppliers of Financial Intermediation Services Formal financial institutions: They are chartered by the government and are subject to banking regulations and supervision. They include public and private banks, insurance firms, and finance companies. Within the formal sector, private institutions generally focus on urban areas, whereas many public institutions provide services in both urban and rural areas. Loans from private sector institutions are often large individual amounts and are usually allocated to large, established, private, and government-owned enterprises in modern industrial sectors. Private formal sector institutions typically mobilize the greatest amount of deposits from the general public. Public sector rural institutions often provide agricultural loans as a means of developing the rural sector. Funding sources include government-distributed and foreign capital, with savings and deposits as secondary sources. The formal financial institutions involves:  Central bank  Commercial banks  Developments banks  Finance companies  Term lending institutions  Pensions funds and mutual companies etc Semiformal institution: They are not regulated by banking authorities but are usually licensed and supervised by other government agencies. Examples are credit unions and cooperative banks, which are Contextual factors 1. Financial sector policies and legal environment  Interest rate restrictions  Government mandates  Financial contract enforcement 2. Financial sector regulation and supervision 3. Economic and social policy  Economic stability  Poverty levels  Government policies Suppliers of financial intermediation  Formal sector institutions  Semi-formal sector institutions  Informal sector institution Clients  Women  Micro entrepreneurs  Small farmers  Landless and smallholders  Resettled persons  Indigenous persons  Low-income persons in remote or subsistence areas Fig:Understanding the Country Context
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  often supervised bya bureau in charge of cooperatives. These financial institutions, which vary greatly in size, typically serve midrange clients associated by a profession or geographic location and emphasize deposit mobilization. Semiformal institutions provide products and services that fall somewhere between those offered by formal sector and informal sector institutions. The design of their loan and savings products often borrows characteristics from both sectors. In many countries semiformal institutions often receive donor or government support through technical assistance or subsidies for their operations. It involves:  Saving and credit cooperatives  Credit unions  Employees savings funds  Village banks  Registered self help group and saving clubs  NGO’s etc Informal financial intermediaries: They operate outside the structure of government regulation and supervision. They include local moneylenders, pawnbrokers, self-help groups, and NGOs, as well as the savings of family members who contribute to the microenterprise. Often they do not comply with common bookkeeping standards and are not reflected in official statistics on the depth and breadth of the national financial sector. Knowing where and how these financial sources operate helps determine what services are in demand. It involves:  Non registered self help groups  Individual moneylenders(friends,relative,neighbours)  Traders and shop keepers  NGO’s etc Contextual factors 1. Financial sector policies and legal environment Financial sector policy considerations include:  Interest rate policies Given the cost structure of microfinance, interest rate restrictions usually undermine an institution’s ability to operate efficiently and competitively. Typically, restrictions do not achieve their public policy purpose of protecting the most vulnerable sectors of the population. Instead, they drive informal lenders underground, so that poor borrowers fail to benefit from the intended low-cost financial services.  Government-mandated credit allocations In many countries, governments mandate that formal financial sector institutions provide a certain percentage of their portfolio or a certain volume of their assets to the informal or poorer segments of society or to certain economic sectors. For the most part, sectoral allocations do not work well because there are no incentives for commercial banks to participate. Many prefer to pay a penalty rather than meet their obligations. Those who participate must be aware of imposed conditions that may affect their operational sustainability-for example, below-market interest rates.  Legal enforcement of contractual obligations and the ability to seize pledged assets In some developing countries, the legal framework is unclear or does not allow for effective enforcement of financial contracts. Although the majority of microfinance providers does not require collateral equal to the value of the loans disbursed and hence is not concerned with its ability to legally repossess a client’s assets, there are many instances in which laws relating to financial transactions influence the behavior of borrowers. Welldefined property rights and good contract law help to minimize the costs of accomplishing both exchange transactions and production transactions. Minimizing transaction costs frees up resources that can be used to increase overall welfare. For eg. Some legal systems allow lenders to formally charge borrowers when they fail to repay a loan, which can lead to imprisonment or fines. Usually just the threat of jail or a visit from police can work as an effective deterrent for borrowers who are considering defaulting on a loan. It is useful for microfinance providers to determine the various legal sanctions
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  available when clientsdo not adhere to their agreements and the ability and effectiveness of the courts to enforce financial contracts. 2. Financial sector Regulation and supervision: Most informal and semiformal organizations providing financial services to microenterprises do not fall under the government regulations that are applied to banks and other formal financial institutions. Many nonbank MFIs, especially NGOs, operate on the fringes of existing regulations,especially with regard to deposit mobilization. In some instances they do so with the knowledge of the authorities, who, for political reasons or simply for lack of time and resources, do not interfere. In other instances these nonbank MFIs simply avoid dealing with the issues and proceed with deposit mobilization by calling it something else. All parties involved in microfinance in a particular country need to understand the dynamic of these legally ambiguous operations. One important danger is that as more bank and nonbank MFIs begin operating, authorities who have been disposed to liberal interpretations of the regulations will be forced to invoke a much stricter construction of the laws, thus tipping the balance unfavorably from the point of view of those engaged in microfinance. Financial regulation refers to the body of principles, rules, standards, and compliance procedures that apply to financial institutions. Financial supervision involves the examination and monitoring of organizations for compliance with financial regulation. Prudential regulation and supervision are designed to:  Avoid a banking crisis and maintain the integrity of the payments system  Protect depositors  Encourage financial sector competition and efficiency.  MFIs should be regulated if and when they mobilize deposits from the public. Individual depositors cannot be expected to monitor the financial health of an MFI and necessarily rely on the state to do this.  MFIs should also be regulated when standards of good practice are clearly needed, whether because there are no practicing organizations or institutions or because existing practitioners are not operating effectively When regulation is warranted, it requires coherent prudential guidelines that will further the growth of the microfinance sector while protecting the interest of small savers and supporting the integrity of the financial sector as a whole. Considerations When Regulating MFIs It is important for regulators to establish minimum standards for MFIs while at the same time remaining flexible and innovative. At a minimum, when regulating and supervising MFIs, five issues need to be considered (adapted from CGAP 1996b):  Minimum capital requirements (Minimum amount of equity capital to support their activities)  Capital adequacy (Capital in an organization that is available to cover its Risk)  Liquidity requirements (Amount of available cash or near-cash relative to the MFI’s demand for cash)  Asset quality (It measures the degree of risk that some of the loan portfolio will not be repaid)  Portfolio diversification (not concentrated their portfolio in one geographic sector or one market segment) 3.Economic and social policy Environment: Economic and social policies influence both the ability of an MFI to effectively provide financial services and the types of activities microenterprises undertake. For example, economic policies that affect the rate of inflation in a country, the growth of the economy, or the degree of openness to market forces all influence the required interest rate of loans as well as the ability of microentrepreneurs to successfully operate their businesses and thus utilize financial services. The government’s investment in infrastructure development, the scale and depth of poverty in a country, and access to social services also affect the way in which a microfinance organization operates. It includes:
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   Economic andPolitical Stability(the factors like inflation,GDP growth transition and political unrest affect the operation of MFI)  Poverty levels (An understanding of the degree of poverty in a country helps in estimating the size and needs of the potential market for microfinancial services and may also help to clarify or establish an MFI’s or donor’s objectives.  Government policies (Microenterprises and small businesses may be affected by government policies, including excessive regulation, prohibitive levels of taxation, inadequate government protection against cheap imported products, laxity about black markets (which results in unfair competition for the microbusiness sector), harassment by government officials for operating businesses on the streets, and inadequate services and high user fees in public market structures. Many of these regulations work effectively to encourage microenterprises to remain outside the legal or formal mainstream. Risks in the Microfinance Industry There are four main areas of risk that are specific to MFIs: portfolio risk, ownership and governance, management, and “new industry. Ownership and Governance risks:  Adequate oversight of management. Often, investors in MFIs are motivated by social objectives. As a result, they may not hold this investment to the same standards that they apply to commercial investments.  Organizational and ownership structures. If a social organization, which is funded with public resources and does not have owners, oversees the management and determines the policies of the regulated financial intermediary, social objectives may take priority over financial objectives.  Sufficient financial depth. MFIs may be capable of raising the initial capital requirements from their founding shareholders. However, these owners may lack the financial depth or the motivation to respond to additional calls for capital as required. Management Risks:  Decentralized operational systems: A decentralized organizational structure that permits the provision of financial services directly at the borrower’s or saver’s location is central to microfinance decentralized operating methods create an environment that can easily be subject to fraudulent practices. Regulators should require MFIs to maintain strong internal auditing capabilities, Consequently, senior management must train and supervise midlevel management, introduce appropriate reporting systems, and maintain adequate communication systems so that uniform policies and procedures are adopted.  Management efficiency. MFIs offer a high-volume, repetitive service that operates on very tight margins.If funds are not relent promptly, earnings will suffer. Regulators should ensure a high quality of management to ensure that brisk and timely services are provided.  Management information: In general, MFIs have not focused on providing adequate and appropriate financial information for making judgments about their financial viability. Government regulators, donors, potential depositors, and other types of potential creditors all need fairly standard information about financial viability in order to make informed judgments. Reporting requirements for regulated institutions make it necessary for MFIs to be able to produce accurate, useful, and timely management information.
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  New Industry A numberof the risks that face MFIs stem from the fact that microfinance is a relatively new field. Formal financial services may also be new to the micro market.  Growth management. MFIs that expand into new markets often face little competition. These institutions can experience dramatic growth in their initial years of operation. Regulators should closely monitor MFIs that dramatically surpass the growth projections presented in the license application.  New products and services. Although this industry has made considerable advances in the design of appropriate microfinance products and services, the field remains relatively young and untested. It is difficult to assess when a new product, or service is an illconceived deviation from an existing model or a breakthrough in new services for the market. New products and services must be well tested before being implemented on a broad scale. It may be appropriate to limit the number of new products or services that are introduced at any one time. The challenge facing MFIs is to conduct a large volume of very small transactions and to do so sustainably. Given this challenge, it is most appropriate to limit MFIs to relatively simple products and services that can be easily mastered.