Microfinance is the practice of sustainably providing financial services to low income or poor clients.
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The models of service delivery used by traditional financial services are not amenable to servicing these clients, and hence traditional financial services firms do not cater to them.
One such constraint is the inability of poor clients to provide collateral in exchange for loans which is typically demanded from conventional clients. It has been observed that access to credit could help set up income generating micro enterprises or maintain steady consumption despite erratic income patterns. Microfinance institutions (MFI) also act as an alternative to the local money lenders who usually charge extremely high interest rates.
What potential does Microfinance hold?
It is estimated that there is currently a demand for a capital of $250 billion but only an estimated $25 billion in microfinancing has been deployed.
The challenge thus lies in acquiring this capital and also using it effectively to engage low income clients in the formal sector. The World Bank estimates there are about 7000 MFIs operating worldwide with an estimated cash turnover of $2.5 billion and reaching over 16 million clients.
Microfinance can bring about radical changes with an extremely small capital outlay. Sometimes loans as low as $10 have been disbursed to local entrepreneurs to help them start a livelihood.
Apart from micro credit (small loans) other services like banking and micro insurance can also be offered through these channels. Given the estimated population of over 1 billion that currently lives in dire poverty; there is immense scope for microfinance.
Service Delivery Models
Innovative, low cost delivery models are very important to tackle the low value and high volume nature of the transactions.
Microfinance is often saddled with high transaction costs as these costs are usually independent of value but depend only on volume. For instance, the staff time and paper work required for a $5000 loan and a $100 loan is pretty much the same. However, the former provides much higher returns and is thus more lucrative.
There are some microfinance service models that entrepreneurs may be interested in adopting or customizing.
For example, MicroPlace has set up an online platform for retail investors to contribute capital exclusively for micro lending purposes. Through a series of financial intermediaries these contributions are then provided as micro loans to low income clients who start micro enterprises and repay the principal along with the interest.
Similarly, Kiva is an online platform for individuals to make specific micro loans (as low as $25) to specific poor entrepreneurs whose profiles and backgrounds are also available. Kiva's microfinance partners then disburse these loans to the specific entrepreneurs who later repay after setting up the micro enterprise.
SKS Microfinance, a microfinance institution based out of India, functions almost like a bank for the poor clients. It employs its own capital and has set up grass root level hierarchies with a joint liability system. Basically, there is a small group of 5 members and another larger group comprising about 4 to 12 such small groups. The joint liability (if a member in any group defaults the group becomes ineligible for further credit similarly if a group of the larger group defaults the larger group becomes ineligible for further credit) exists at the smaller and the larger level as well.
Some MFIs have been able to register return on assets of 4% to 5.5% (which compares favorably with that of banks) and quite a few of them have become sustainable as well. Given the small capital outlay required and the existence of effective and innovative models it is possible for small and medium entrepreneurs with a social bent of mind to venture into this exciting space.