Home > Finance essays > Microfinance and microcredit

Essay: Microfinance and microcredit

Essay details and download:

  • Subject area(s): Finance essays
  • Reading time: 6 minutes
  • Price: Free download
  • Published: 21 September 2015*
  • File format: Text
  • Words: 1,565 (approx)
  • Number of pages: 7 (approx)

Text preview of this essay:

This page of the essay has 1,565 words. Download the full version above.

Microfinance in the past few decades has been projected as one of the most pertinent channels for poverty alleviation. This is particularly reflected in the self-congratulatory information dissemination that has emanated from the microfinance institutions, of having tapped the most vulnerable sections of the Indian labour that exist in the informal sector. In a sense, it is said that the lack of access to microcredit is the sole factor that holds back the poor from consolidating better livelihoods i.e. hampers the development of their capabilities and consequently their functionings.
Thus, the impetus to provide credit at subsidized rates and regulatory protection for further growth lies with the government. Yet, with the passage of time, the government’s role in microcredit provision (via public bank-SHG linkage model) has been diminished by the aggressive consolidation of the microcredit market by the ‘social entrepreneurs’ (MFIs) who have sought to fuse the aims of poverty alleviation and profit making.
This paper has been divided into three parts; section I deals with the institution of microfinance, encompassing the models as they exist in India, the mode of functioning and the benefits that accrue. Section II consists of arguments against a particular model of microfinance i.e. private led MFIs which are assumed to have espoused neoliberal ‘globalisation agenda. The conclusive part of this paper (Section III) would focus on the regulation debate that derives from section I and II, particularly tracing the timeline of the existing and potential regulatory mechanisms concerning this niche sector.
Section I :The Concept Of Microcredit
‘Micro credit can be understood as providing small loans to groups of marginally poor without the existence of physical collateral, relying instead on social collateral. Micro finance is a broader term wherein microcredit, money transfers, savings, insurance etc come under the purview of micro finance.’-(en.wikipedia.org)
Every country follows different meanings and understanding of microcredit, but broadly the definition remains as stated above. The differences could be in the nature of the people the loan is given to and the limits of credit provision.
Small loans (microloans) to the poor have always existed in different countries in different forms. Going back to the 1700s, in Ireland, existed ‘Irish loan funds’ inspired by Jonathan Swift, one of the first forms of loan to the poor without collateral. Moreover, there were numerous savings and credit institutions across Europe, Asia and Africa in the 19th century and the earlier 20th century. But the work that really propelled microfinance into worldwide prominence as a measure of poverty alleviation was done by Muhammad Yunus, who set up the Grameen Bank model, in 1975. It emerged as the substitute for formal provision of credit by the public banks by enabling group lending and bringing about tied incentives. It has been extensively argued that the public banks neglect the credit need of the poor households as they have no collateral to surrender to the banks. There are three important reasons for the banks to not lend money.
Reasons For Lack Of Formal Credit Provision
Firstly, there is the problem of targeting which could be understood as errors of inclusion and exclusion, particularly due to the presence of adverse selection and moral hazard in the presence of information asymmetry. Related to this asymmetry is the second problem, that of screening which involves distinguishing the bad borrower from the good borrowers and their willingness for taking such a small loan. Third is the question of monitoring the usage of the loan (whether it has been used for consumption or investment purposes), in a sense to guarantee its timely repayment.
There are heavy transaction costs involved in all these cases which apply uniformly to every single credit transaction; hence there is a natural reluctance from the bankers to undertake these costs for advancing microloans/microcredit.
The Grameen Bank model claimed to have addressed all the three causes: the problem of targeting by enforcing certain eligibility criteria to be included in the group that shall receive the loan in terms of the amount of loan, frequency of repayments etc.
The problem of screening could be taken care of by enabling groups of like minded persons to create solidarity in such a way that borrowers who would default would naturally be excluded from the group.
The problem of monitoring was to be countered by short and small installments on a weekly or daily basis.
The Process Of Microcredit
In India, the process of microcredit could be explained with two different operating models-
1. Public Bank and the Self Help Group(SHG) model which consists of three variants :
‘ The bank has the sole authority of forming the groups and giving the loan.
‘ The bank approaches NGOs which form the borrower groups but the bank still holds the authority of distribution of the loan.
‘ The Bank approaches NGOs for both formation of groups and distribution of loan.
2. The private Microfinance (MFI) model: This model is understood as a legitimate profit generating business model giving rise to ‘social entrepreneurs’.
Key Features
Group lending: In this method, through tied incentives, the group members comply with timely repayments to facilitate future loans for the other group members. Thus, there are internal checks and balances.
Peer selection: The formations of groups are based on solidarity, reciprocity and common interests, to facilitate timely repayment.
Peer monitoring: The function of monitoring is carried out as soon as the loan is received by the group; they monitor each other to make sure they have invested in a safe project that will yield a guaranteed repayment. To secure future access, members are obligated to monitor each other. The social collateral constitutes a powerful device to reinforce repayment among group members.
Dynamic Incentives: loans given in groups reduce the transaction cost to a great extent compared to individual loans. Likewise progressive lending is a major incentive which helps to test the borrower’s credit worthiness by giving a small amount initially. A major incentive is reduction of interest rates to the borrowers if they pay loan on time, and therefore in the next term, the borrowers are given incentives like low interest rate and larger funds . The demand for a centralized credit rating agency also goes up as the competition increases. These dynamic incentives works better in areas with lower mobility, so that it would be easy from the side of banks to keep an account of transactions.
Regular Repayment Schedules: Regular repayment of loans is an important mechanism of microfinance to enforce discipline among the borrowers.
Collateral Substitutes: Grameen bank, for instance, has a system of partial collaterals. The borrowers are asked to contribute a very minute amount (0.5%) of the unit of loan which they borrow from the bank as insurance in case of emergency. In addition to this, 5% is taken as group tax that goes into a group fund.
MFIs And Financial Liberalisation
As financial liberalization spread in Asia in the late 1980’s there was a major retreat of public banks especially in the rural areas which created a major vacuum. The growing demand for rural credit posed a major question mark and was fully exploited by the money lenders. The Public Banks practiced the policy of differential interest rates, with loans extended at subsidized rates to the people with a poor financial background.
With the onset of liberalization, the private players started taking over the financial market of the rural areas, pushing the poor to greater vulnerability under the competitive pressures.
Advantages of Microfinance
‘ It increases financial accessibility of household. With group membership, it becomes easier for an individual to acquire loans which were hitherto difficult to attain because of a lack of collateral and creditability. It is beneficial for the group as a whole also, because if one member is suffering from any financial crisis, other members can repay that person’s dues which would make him eligible for the loan in the next term without any doubt on his creditability.
‘ It makes people self dependent and self employed in various activities which later become the sustainable source of income for the households.
‘ Imbibing a saving culture among rural poor. The rural poor started saving from the income that they received after the investment that they made with the micro credits.
‘ Micro credits are mostly focused on women entrepreneurship and empowerment. There are two reasons which make MFIs lend to the rural women: lower mobility and lack of alternative formal option. The amounts that they would borrow were intended to be invested in small/micro businesses wherein the women are self employed.
‘ Increase in incomes lead to an increase in consumption. There are ripple effects in terms of social repercussions like the increase in the demand of children’s education, a say in household’s reproductive decisions etc.
‘ Further it behaves as the tool of financial inclusion, with the increased access of finances in the formal credit market at interest rates lower than the rates charged by money lenders. It provides finances which can be used by the households for supporting their businesses and sustaining it, in a manner which increases the households’ income, preventing poverty exacerbation.
In sum, microfinance in the 20th century has been positioned as having all the ingredients for it to be a potent measure against poverty, substantiated by what Munammad Yunus declared in the International Microcredit Summit of 1997, ‘it is about creating a process that will send poverty to the museum.’

...(download the rest of the essay above)

About this essay:

If you use part of this page in your own work, you need to provide a citation, as follows:

Essay Sauce, Microfinance and microcredit. Available from:<https://www.essaysauce.com/finance-essays/essay-microfinance-and-microcredit/> [Accessed 19-04-24].

These Finance essays have been submitted to us by students in order to help you with your studies.

* This essay may have been previously published on Essay.uk.com at an earlier date.