Lack of access to credit is generally seen as one of the main reasons why many people in developing economies remain poor. Microfinance is banking for the poor. Mission, target group, and the applied credit technologies are features clearly distinguishing microfinance from the traditional banking sector. The poor in developing economies have increasingly gained access to small loans with the help of so-called microfinance during the past ten years. The essay’s objective is to introduce microfinance and its financial instruments and then discuss if it successfully solving the problems of financial service provision in EME’s.
The Definition of Microfinance and Its Development
Microfinance is defined as is the provision of financial services to low-income clients or solidarity lending groups including consumers and the self-employed, who traditionally lack access to banking and related services. The microfinance is nothing short of a revolution or a paradigm shift (Robinson 2001). The microfinance movement has helped to reduce poverty, improved schooling levels, and generated or expanded millions of small businesses (e.g. Khandker 1998). The idea of microfinance has now spread globally, with replications in Africa, Latin America, Asia, and Eastern Europe, as well as in richer economies like Norway, the United States, and England. The latest count includes over 2500 institutions worldwide, each serving on average over 25 000 low-income customers.
The Characteristics of Microfinance Financial Instruments
Microfinance makes use of different lending technologies than the traditional banking sector, namely the group lending and the unconventional individual lending technology (Armendáriz and Murdoch, 2005). A common characteristic of these technologies is that they are rather conservative.
The Group Lending Methodology
The group lending methodology will not require collateral and will serve the poorest only. It will make loans to individuals, but in a special way. The method is that individuals interested in borrowing will get loans for their own, independent projects, but they must approach the bank with four others who similarly seek loans. These five-person groups meet with a loan officer from the bank once each week, at which time loans are disbursed and payments are made. To reduce transactions costs, the loan officer meets simultaneously with eight five-person groups, formed as a 40-person“centre”; The meetings take place in the village rather than at the local bank branch.
The Contract is that should a borrower be unable to repay her loan (about 95 per cent of borrowers are women), she will have to quit her membership of the bank – as will her four fellow group members. While the others are not forced explicitly to repay for the potential defaulter, they have clear incentives to do so if they wish to continue obtaining future loans. The key is that microfinance banks loans (like loans from other microlenders) are more attractive than loans from other sources like moneylenders. While moneylenders may charge interest rates over 100 per cent per year, banks (e.g. Grameen Bank) usually keep its official rates at 20 per cent (and even with extra fees, effective rates are below 30 per cent per year).
The Unconventional Individual Lending Methodology
The unconventional individual lending technology assesses the client’s debt capacity on the basis of the current cash flow only, i.e. it neglects any potential revenues the client might have from the“project” being financed. Moreover, it includes a socio-economic analysis of the household exploiting the insight that “troubled homes often become troubled borrowers” (Churchill, 1999). Finally, the credit process is loan officer centric, making close ties to and knowledge of...