What is Microfinance and how does it work? Microfinance is a form of financial services aimed at providing low-income individuals and small businesses with access to credit, savings accounts, insurance, and even food programs. Contemporary microfinance emerged in the late 20th century with the goal of promoting financial inclusion in developing regions that were traditionally excluded or physically isolated from commercial banking services. Today, these services are facilitated by microfinance institutions (MFIs), peer-to-peer (P2P) lending platforms, community development financial institutions (CDFIs), finance networks and development organizations, and select commercial banks.
One of the pioneering organizations in microfinance is Grameen Bank. Many link the origins of microfinance to its establishment by Professor Mohammed Yunus in 1983, who was awarded a Nobel Peace Prize in 2006 for his microcredit business model that is still in use today. Through his model, low-income individuals without a credit history or assets can access credit. Loans are divided among a group of borrowers who are each required to pay back their share of the loan in order for any one individual to take out additional loans (a practice dubbed “solidarity group lending”). Over the last few decades, the microfinance sector has grown more saturated with MFIs, P2P lending platforms, CDFIs, development organizations, and commercial banks. Let’s take a look at how each of these organizations operate within the microfinance sector.
Types of Microfinance Organizations
Microfinance Institutions
The most long-established organizations known for providing microfinance services are microfinance institutions (MFIs). MFIs are for-profit and non-profit organizations that provide small-scale financial services to groups traditionally unserved by commercial banks. MFIs operate locally to their clients and extend credit to them through loans. Usually, these institutions do not accept deposits like standard banks. However, some MFIs with more formal structures may even offer savings accounts and insurance plans. Social-impact oriented MFIs may also provide financial education programs to teach borrowers how to manage their money.
MFIs apply a variety of structures and models. For instance, IDH Microfinanciera is a non-profit MFI that provides credit services in Honduras to individual and group clients with backgrounds ranging from the rural agricultural sector to the artisan industry. Compartamos Banco, the largest microfinance bank in Latin America, operates as a for-profit bank and offers both credit and insurance.
Oftentimes, 'MFI' is used as an umbrella term to classify an organization that engages in the microfinance sector in any capacity, even when it may not be the most accurate term. A good way to gauge whether or not an organization is an MFI is to determine whether it directly facilitates credit-lending services or channels funds though partner microfinance institutions. (Although it might not be as clear-cut for organizations that take on multiple functions.)
Peer-to-Peer Lending Platforms
Peer-to-peer (P2P) lending platforms enable individual lenders to make loans to individual borrowers online. Many of these organizations emerged in the mid 2000s as a way to cut out the transaction costs associated with financial intermediaries that traditionally worked to transfer credit between lenders and borrowers. This implies lower interest rates for borrowers, but also that individual lenders, rather than the company, must bear default risks. While not all P2P lending companies aim their services at poor people, the minimal transaction costs and online accessibility of the P2P model offers a viable alternative to traditional microfinance institutions.
Community Development Financial Institutions
Community development financial institutions (CDFIs) are private financial institutions with community development goals. They primarily operate in the United States, with some based in the United Kingdom. The CFDI industry expanded in the 90s with the creation of the CDFI Fund in 1994, a U.S. government agency that funds CDFIs through a competitive application process. Like MFIs, CDFIs adhere to a variety of different structures, including (but not limited to) community development banks, community development loan funds, community development credit unions, and community development venture capital (VC) funds. While the way each type of CDFI goes about financing social enterprise, entrepreneurs, and low-income individuals is different, all CFDIs possess a social-impact oriented mission.
Finance Networks & Development Organizations
Finance networks and development organizations play a pivotal supporting role in the microfinance sector through funding and grants, education and advocacy, and expertise provision. Often, these organizations operate nationally or globally and work to scale microfinance efforts within their domain. For example, Opportunity Finance Network is an association of CDFIs that supports member organizations through advocacy, funds, grants, awards, and other member-oriented programming. Building Resources Across Communities (BRAC), a global development organization, tackles a host of development challenges, with expanding financial inclusion through microfinance serving as a key pillar of its work since the 70s.
Because development organizations cover a broad range of issues, it may make it difficult for them to hone in on a niche service like microfinance. At the same time, these organizations are often able to address infrastructure and scaling issues within the microfinance sector that other organizations with a narrower scope may not have the resources, expertise, or desire to address.
Commercial Banks
Select commercial banks have also opted to partake in the microfinance sector. For example, in 1997, Deutsche Bank established the first microfinance fund managed by a global bank. Over the span of two decades, it operated the Essential Capital Consortium, a $50 million fund that backed social enterprises and low-income entrepreneurs until the fund's closure in 2020. Citigroup also has a history of engaging in microfinance activities. Over the last fifteen years or so, Citigroup has set up credit facilities in partnership with MFIs to fund their clients.
One possible reason commercial banks have taken interest in the microfinance sector over the last two decades is that microfinance has been shown to be lucrative. A second reason is that with the increased pressure for corporations to make socially responsible investments and decisions, banks may see microfinance as a way to demonstrate their commitment to social responsibility to the public in a way that aligns with their area of business.
While microfinance organizations compete with one other for their services, they also often work with one another to serve the financial needs of poor people. For example, P2P lending platform Kiva works with partners on the ground, many of which are MFIs and CDFIs like Fundenuse in Nicaragua and LiftFund in the United States. Once an individual lender makes a loan to a borrower through the online platform, MFIs and other partner organizations operating on the ground can administer credit as well as collect repayments.
The microfinance sector is a complex and intertwined ecosystem that has evolved many times over since the founding of Grameen Bank in the 80s. Understanding the role microfinance can play in promoting financial inclusion, and its limitations, is important for microfinance organizations and socially responsible investors alike as they navigate emerging changes in this sector.
Present-day Perspectives on Microfinance
In its early years, microfinance was lauded by the public because it fundamentally rejected the notion that poor people with no credit history or assets were unworthy of credit. Through microfinance, poor people could start a business, support their families, and kickstart economic development in their communities. But over the past few decades, microfinance has evolved in the limelight from the solution to eliminate poverty to one of many resources to drive financial inclusion.
This shift largely stems from criticism of microfinance for not serving the poorest of borrowers, often due to the credit risk of lending to these individuals or the high costs of operating where they reside. The State of the Microcredit Summit Campaign Report 2015 reports that the number of microfinance borrowers since the late 90s has skyrocketed, yet the number of borrowers considered to be among the poorest declined from 62 to 54 percent of borrowers in 2013. Concerns about the credit worthiness of borrowers and high costs of operating in developing regions have elevated as the microfinance sector grows more competitive, making MFIs and other microfinance organizations more risk and cost-averse.
Source: The World Bank Development Research Group, Adapted from Figure 1, State of the Summit Report 2015
Along the same lines, the microfinance sector has faced additional criticism for earning high profits while failing to provide borrowers with appropriate education on financial management as they grapple with crippling interest rates and accumulating debt. These shortfalls led to reputational losses across the microfinance sector in the late 2000s and early 2010s.
Nonetheless, The World Bank considers financial inclusion to be a key driver in 7 out of 17 of the UN Sustainable Development Goals. For the past few decades, the microfinance sector has played an important role in driving financial inclusion and more recently, reducing the digital divide, by providing banking services to previously unreached individuals through online lending and mobile banking. With greater public awareness of the historic pitfalls of microfinance and the propagation of industry self-regulation through the Universal Standards of Social Performance Management, established in 2012 by The Social Performance Task Force (SPTF), we could be entering a new era of microfinance.
Source: The Social Performance Task Force
Moving forward, financial service organizations operating in the microfinance sector need to be attentive to whether their business models are bringing value to the customers that need it the most. From a regulatory standpoint, these organizations must also keep watch of emerging regulation within the microfinance sector to ensure they are complying with (or ideally, exceeding) the standards upheld by industry peers. This is especially true for MFIs and CDFIs that assert themselves as social-impact players and thus have a greater stake in meeting the financial needs of the poor. For large commercial banks, microfinance usually constitutes a small portion of the total portfolio. But it is also a highly visible area to the public and socially responsible investors, so ensuring they are delivering meaningful solutions to low-income clients is nonetheless pertinent.
Given the large existing network of companies providing microfinance services, financial institutions entering this market should assess how they can bolster existing institutions and identify gaps in their services. These companies should think about how they can align their work with non-financial institutions that operate in low-income regions and have greater expertise about the needs of local microfinance clients. Larger global companies in particular should also think beyond driving financial inclusion through funds, grants, and other financial tools, but consider how they can build out supporting infrastructures (financial technology, telecommunications, transportation, etc.) in this sector to enhance the accessibility of financial services.
For example, financial service companies can invest in artificial intelligence (AI) tools to streamline their operations and mediate credit risk for low-income borrowers. Applications like AI chatbots provide microfinance clients who may have never accessed credit before with instant feedback to questions on a product or their account. Predictive modeling platforms can use AI to ingest and convert financial news into meaningful data on the credit health of a prospective borrower. By leveraging AI tools, financial service companies operate with greater efficiency because their clients and employees no longer experience a lag time in accessing the information that they need to make financial decisions. Through expertise exchange with other organizations in this sector and implementing AI tools in their value chain, financial service companies are well positioned to scale microfinance to new customers.
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