MicroFinance

Microfinance is defined as the extension of financial services to low-income clients. Typically, microfinance involves lending to the poor in very small amounts known as microloans. Most often these loans are for the purpose of generating income that will empower poor entrepreneurs to improve their standard of living and create employment for others in their community. The primary intention of microfinance is to raise people out of poverty and provide access to the financial services once reserved for the middle and higher income levels of society.

A brick making business: Growth through MicroFinance.

Brick making is a common business in the township of Mamelodi, South Africa. A typical brick making business with a sole brick maker can produce about 40 blocks a day. Demand is much greater. The entrepreneurial brick maker borrows $400USD to buy more material, an additional mold and hire an employee. This microloan will allow the owner of the brick making enterprise to grow their business and produce additional income that can be used to improve their standard of living while creating new jobs for their community.

The poor are good borrowers. The worldwide repayment rate is far greater than that of traditional banks. One of the reasons is that Micro-finance institutions lend to groups rather than individuals. These groups are sometimes called solidarity groups. The group borrows collectively and members of the group hold each other accountable for repayment. Non-payment by one member adversely affects the lending ability of the entire group. Reputation becomes collateral.

One of the most intriguing concepts of micro-finance is the Double Bottom Line (DBL). DBL is the combination of financial return and positive social impact. Most traditional banks focus only on the financial gain or profit that their financial services bring. Microfinance Institutions (MFI's) obviously have a need to cover their costs but also measure their success on the social benefit gained toward poverty elimination.

Social Impact: Has the loan improved the living conditions of the borrower?

Economic: Is the profit from lending enough to sustain the MFI?

Some Microfinance Institutions are implementing a Triple Bottom Line measuring social, economic and environmental impact.

Environmental: Can an MFI play a role in supporting long-term activity of a business while controlling damage to the environment?

Microfinance institutions (MFIs) that make small loans to low-income borrowers have historically struggled to make their lending operations sustainable. MFIs need to charge a high enough interest rate to cover all of their operating costs. When MFIs cover their operating costs they can become sustainable and can continue to serve their clients without a constant need for more capital. The issue is that operating costs are substantially higher than those of a traditional bank. For example, lending $100,000 in 1,000 loans of $100 each requires additional staff and is far more labor intensive than a single loan of $100,000. In order for MFIs to cover these higher costs they need to charge a higher interest rate than traditional banks.

MFIs can attempt to lower interest rates and remain sustainable in one of four ways:
1. Decrease their cost of funds
2. Lower their default rate thus decreasing their loan loss expense
3. Increase efficiency thus decreasing operating costs
4. Decrease profit

The most effective method of lowering the interest rate that an MFI can offer its poor clients is to increase efficiency. Since Microfinance has such a steep learning curve MFIs should naturally become more efficient as they mature by improved understanding of the market and their loan delivery process.

Profit is the most controversial factor in determining the interest rate of a micro-loan but if an MFI made loans at a break-even point the interest rate may still be higher than traditional banks due to the much higher operational costs. So many MFIs tend to concentrate on efficiency as their method to control interest rates. MFIs should focus on providing a service to the poor at an interest rate that will promote sustainability while producing a modest profit to stimulate growth.

1 billion people in the world do not have a bank account but do have a mobile phone.

Mobile phones are becoming more popular every day, especially with the ease of buying pre-paid air time. An entrepreneur can borrow $500USD and purchase the rights to resell mobile air-time. The air-time is sold in small increments that are affordable to most and the entrepreneur gets a percentage of all sales plus a transaction fee for each sale. At the end of the day he or she has more than enough money to feed their family and save a little for education, housing or expanding their business. All made possible by micro-finance and small, flexible loans that meet the needs of the community.