Twice a month, Rose Anite, a 26-year-old Sudanese woman, buys fish from a place near the Nile River in Uganda. Rose then sells the fish at the open market in the Sudanese town of Yea. However, due to poor roads and a dilapidated infrastructure, Rose’s trips to Uganda take seven long and grueling days. To improve her business and her quality of life, Rose joined SUMI, the Sudan Microfinance Institution. From SUMI, Rose obtained a loan equivalent to $100, a large sum considering that Rose started her business with the mother equivalent to $75. With the money from her loan, Rose is able to buy fish in large quantities, earning more on each trip. Even this small increase in earnings has made a significant difference in her quality of life.
Providing small loans or microcredits to the poor, like Rose, who lack access to traditional financial services due to lack of collateral, employment and credit history, is known as microloans or microcredit. Microlending is a division of microfinance, the provision of financial services to those living in extreme poverty, and is a booming phenomenon that shows great promise in alleviating the condition of the poor in developing countries and being a viable channel of earnings for financial institutions.
The history of microcredits
Although microcredits are a recent phenomenon, their origin goes back centuries. One of the first microlending organizations was the Irish Loan Fund system founded in the early 18th century by the Irish author and essayist Jonathan Swift. In order to help alleviate poverty, the Irish Loan Fund system provided unsecured credit to the poor.
The modern microcredit revolution did not occur until the 1970s. One of the first pioneers was Acción Internacional. Acción Internacional began as a student-run volunteer organization seeking to alleviate poverty in Latin America through construction and infrastructure projects, but turned its efforts toward microfinance. In 1973, Accion offered some of the first modern microcredit to the poor in Recife, Brazil, who were looking to establish small businesses. The Action experiment turned out to be a success; in four years, they had made 885 loans with a repayment rate greater than 90%. Additionally, the loans helped create and stabilize 1,386 new jobs.
Perhaps the most important and successful pioneer in microcredit is Muhammad Yunus, a Bangladeshi economist and professor of economics. In 1974, famine struck Yunus’ home country and Yunus became involved in poverty reduction. Yunus determined that small loans could greatly alleviate the condition of the poor. In 1976, he founded the Grameen Bank in Bangladesh, the world’s largest and most successful microfinance institution, or MFI. Since its inception, Grameen has provided over $5 billion in loans to several million borrowers and boasts a repayment rate of up to 98%. Last year, the institution obtained a profit of $20 million. Most importantly, Grameen Bank has set the business model for most other modern microfinance institutions.
How to make microcredits work
The central principle of microcredit is to lend to the poor without collateral. Microcredit is based on the belief that the desire of the poor to improve their conditions will make them successful entrepreneurs capable of repaying their loans. These loans should not be treated as charity; interest is expected to be paid and accrued. While this is the core principle, the following are several other strategies typical of the microcredit model:
1. Lend to small groups of people.
Joint liability alleviates the need for collateral because several members of a group are more likely to manage a debt than one individual. Group lending reduces the need for an institution to control borrowers because each member of the group has a vested interest in repaying the loan and will control the other members. Also, groups are more likely to fund successful projects because group members can advise each other to solve business problems.
2. Lend to women.
Most microcredit institutions lend almost exclusively to women. Global microlending experience has shown that women are more likely to repay their loans than men, and while men are more likely to spend their loans on themselves, women are more likely to finance upgrading their businesses.
3. Use a graduated loan policy.
Because borrowers lack a credit history from which an institution can assess default risk, a tiered loan policy is required. Borrowers start with small loans. At the time of payment, borrowers qualify for larger loans that can be obtained for longer periods of time.
4. Charge high interest rates.
Typical annual interest rates range from 20% to 50%. High interest rates are necessary due to smaller loan sizes, higher risk of borrower default, and intensive collection work due to borrowers residing in rural areas.
5. Focus on productivity and quality management.
The key to a profitable microcredit channel is efficient banking operations. Loan origination, processing, and collections must be streamlined and tightly managed with efficient planning, forecasting, and scheduling capabilities. With such small loan amounts and high volume, institutions cannot afford any waste that erodes the bottom line.
Humanitarian Implications
In addition to ensuring economic viability, several aspects of the microcredit business model have humanitarian implications. The central principle of microcredit for the poor is to offer borrowers a way out of poverty. However, loans, unlike charitable giving, ensure that borrowers also learn the financial skills necessary for success by providing a foundation for building a credit history.
Today
The international community has recently recognized the promise and impact of microcredit. The United Nations declared 2005 the International Year of Microcredit. In 2006, the Norwegian Nobel Committee awarded the Nobel Peace Prize to both Muhammad Yunus and the Grameen Bank “for their efforts to create economic and social development from below” through the use of microcredit.
According to World Bank estimates, there are more than 7,000 microfinance institutions serving 20 million people in developing countries. CGAP, the Consultative Group to Care for the Poor, estimates that 500 million households have benefited from microcredits. While most of these programs exist in developing nations in Asia and Latin America, microcredit is now present in more advanced economies such as the United States, England, and Norway. A 2005 study by the Aspen Institute, an international nonprofit organization committed to studying global issues, found that there are 246 lenders in the United States that have made 13,231 loans worth $114 million.
In the net
In October 2005, microcredits reached the Internet. Kiva.org was the first website that allowed users to provide microloans to entrepreneurs in developing countries. Lenders choose a business to patronize listed on the website and make loans using their credit cards. The funds are transferred to Kiva’s local partner microfinance institutions, which then deliver the money to the borrowers and collect the repayments that are returned to the lender.
In October 2007, eBay launched MicroPlace.com. Unlike Kiva.org, loans at MicroPlace.com are securitized and lenders will earn interest.
The future of microcredits
Grameen Bank and Accion International have been very successful. However, not all MFIs have been successful and some experts have expressed doubts about the economic viability of microlending and the sustainability of MFIs. In fact, Grameen Bank was tied to subsidies in its early development before becoming self-sustaining, and the Wall Street Journal has questioned its repayment rates. Yet Grameen Bank’s profits continue to grow each year and half of its borrowers have been lifted out of extreme poverty, as measured by standards such as their ability to pay for their children’s education, provide 3 meals a day to their home, purchase a rainproof shelter, etc. Microfinance, in some circumstances, has shown great promise in alleviating poverty while remaining a profitable enterprise.