Microfinance—small investments for big change.

What is Microfinance?

Microfinance provides loans, savings accounts, insurance and other financial products and services to low-income clients. They are called "microloans" because they are very small amounts—as low as 25 USD—and are usually paid back within six months to one year. Microfinance clients tend to be excluded from the mainstream banking system because they lack formal employment, regular income or assets that can be pledged. It is estimated that approximately 500 million people globally do not have access to basic financial services.

Microfinance institutions (MFIs) play an essential role in providing micro entrepreneurs (MEs) with a range of suitable financial products and services. These small-business people typically run enterprises such as retail shops, street vending, artisanal manufacture, trade and farming. Access to financial services enables them to build up a basic livelihood or expand their businesses, ultimately contributing to the development of the local economy.

Benefits of microfinance: How does it help alleviate poverty?

Microfinance has helped alleviate poverty for more than 30 years by providing access to loans and other financial services. It helps microentrepreneurs become more financially stable, stabilize their cash flows and manage disruptions such as the sickness of a wage earner, theft or natural disaster. The system also gives them credit to acquire assets such as land and equipment.

The majority of microloans are given to women, as research on microfinance has demonstrated that women use the profits from their businesses to serve their families and the greater community. Typically, they pay for their children's education, improve their families' living conditions and nutrition, or re-invest in their businesses. Women microentrepreneurs often experience significant self-empowerment.

Challenges and risks in microfinance

Over the past three decades, microfinance has evolved from small nongovernmental organizations lending very small amounts to, in some cases, larger, formal banks that cover costs and grow through profits. Microfinance institutions are now comprised of a mix of non-profits, nongovernmental organizations and licensed banks.

Microfinance is still developing as an industry, and while it can be an effective tool for poverty reduction, it must be managed responsibly to avoid some of the associated challenges and risks, including:

• High interest rates and the cost of doing business

  The interest rates on microloans are substantially higher than for traditional bank loans, ranging from 25% to 60% interest or even higher, as the administrative cost of making micro loans is much higher than the cost of making large loans. It takes less staff time to make a single loan of $100,000 than 1,000 loans of $100 each. Other factors also can make microloans more expensive than traditional loans. Credit decisions for borrowers who have neither collateral nor a salary cannot be based on automated scoring, and require a loan officer to judge the risk of each loan on an ad hoc basis. MFIs may operate in remote or low-population areas, making lending more expensive. If an MFI wants to operate sustainably, it has to price its loans high enough to cover all its costs.

• Over-indebtedness

  When MEs take out too high or multiple loans from several different institutions at once, they may become over-indebted and unable to meet their obligations. This can result in defaults and increases the risk of the overaggressive collection practices by some MFIs. The media have reported stories of MFIs intimidating loan recipients or confiscating their property in order to recover their losses.

• Inappropriate targeting of poor households

  The high demand for microfinance and the lack of regulation has led some MFIs to extend loans to poor villagers at too-high interest rates and without enough regard for their ability to repay.

• Lack of financial literacy

  Research shows that when MEs are not properly informed about the risks and obligations of their loan, the risk of default and over-indebtedness increases. Training and education around loan terms, interest rates, and other policies increases MEs' chances of repaying their loan.

The Smart Campaign

Many of the larger, more established MFIs are responding to these issues and other challenges facing the industry by:

• Focusing on consumer protection issues, including disclosure requirements about interest rates and payments, rules and prohibitions related to lending practices to prevent over-indebtedness
• Creating mechanisms for handling complaints from MEs
• Offering consumer education

Accion, a Credit Suisse microfinance partner organization, illustrates how MFIs are addressing these issues. Accion and CGAP, an independent policy and research center that helps increase financial access for the world's poor, have initiated the Smart Campaign. The campaign created a minimum standard for the treatment of microfinance clients to ensure that:

• MEs are treated respectfully
• Microfinance programs are transparent about their interest rates and pricing
• Clients avoid over-indebtedness or purchasing financial products that they don't need
• The microfinance industry remains focused on meeting the needs of its clients

The campaign is designed to strengthen the microfinance industry and elevate it as a model of responsible banking around the world.