INTRODUCTION

According to International Labor Organization (ILO), Microfinance is an economic development approach that involves providing financial services through institutions to low income clients.

Microfinance
To most, microfinance means providing very poor families with very small loans (microcredit) to help them engage in productive activities or grows their tiny businesses. Over time, microfinance has come to include a broader range of services (credit, savings, insurance, etc.) as we have come to realize that the poor and the very poor that lack access to traditional formal financial institutions require a variety of financial products.

Microcredit came to prominence in the 1980s, although early experiments date back 30 years in Bangladesh, Brazil and a few other countries. The important difference of microcredit was that it avoided the pitfalls of an earlier generation of targeted development lending, by insisting on repayment, by charging interest rates that could cover the costs of credit delivery, and by focusing on client groups whose alternative source of credit was the informal sector. Emphasis shifted from rapid disbursement of subsidized loans to prop up targeted sectors towards the building up of local, sustainable institutions to serve the poor. Microcredit has largely been a private (non-profit) sector initiative that avoided becoming overtly political, and as a consequence, has outperformed virtually all other forms of development lending.

Traditionally, microfinance was focused on providing a very standardized credit product. The poor, just like anyone else, need a diverse range of financial instruments to be able to build assets, stabilize consumption and protect themselves against risks. Thus, we see a broadening of the concept of microfinance--our current challenge is to find efficient and reliable ways of providing a richer menu of microfinance products.

Role of Governments in Supporting Microfinance

Governments have a complicated role when it comes to microfinance. Until recently, governments generally felt that it was their responsibility to generate development finance', including credit programs for the disadvantaged. Twenty years of insightful critique of rural credit programs revealed that governments do a very bad job of lending to the poor. Short term political gain is just too tempting for politically controlled lending organizations; they disburse too quickly (and thoughtlessly) and they collect too sporadically (unwillingness to be tough on defaulters). In urban areas, governments never really got into the act, and subsidized microenterprise credit is still relatively rare when compared to its rural counterpart.

Now that microfinance has become quite popular, governments are tempted to use savings banks, development banks, postal savings banks, and agricultural banks to move microcredit. This is not generally a good idea, unless the government has a clear acceptance of the need to avoid the pitfalls of the past and a clear means to do so. Many governments have set up apex facilities that channel funds from multilateral agencies to MFIs. Apex facilities can be quite complicated and there are few successful examples in microfinance. Successful apex organizations in microfinance tend to be built on the backs of successful MFIs, not the other way around. Finally, governments can also get involved in microfinance by concerning themselves with the regulatory framework that impinges on the ability of a wide range of financial actors to offer financial services to the very poor. This topic is treated below.

The Role of the Financial Regulator in Supporting The Development Of Microfinance

Many feel that the most important role of a financial regulator in supporting the development of microfinance is to create an alternative institutional type that allows sound financial NGOs, credit unions, and other community-based intermediaries to obtain a license to offer deposit services to the general public and obtain funds through apex organizations. In a few countries, this may be an appropriate strategy. In most countries, however, the general level of development of the microfinance industry does not yet warrant the licensing of a separate class of financial institutions to serve the poor. And, in most countries, budgetary restrictions faced by bank regulators make it very unlikely that they will be able to supervise a whole host of small

institutions; these institutions' total assets may make up a tiny percent of the total financial system, but the cost of adequate supervision could eat up between 25 and 50 % of the total budget of the agency.

Rather, regulators can work with the nascent microfinance industries of most countries on issues such as modifying usury limits as stated in the commercial code to allow appropriate levels of interest, generating credit information clearinghouses to share information on defaulting borrowers to limit their ability to go from one MFI to another, working with civil authorities to ensure that private loan contracts can be recognized by courts in those transition economies that lack even basic legislative infrastructure, and reporting requirements that will prepare MFIs to eventually become regulated.

Regulators can also examine the laws, executive decrees, and internal regulations that limit the ability of traditional banking institutions to do microfinance. These regulations include limits on the percent of a loan portfolio that can be lent on an unsecured basis, limits on group guarantee mechanisms, reporting requirements, limits on branch office operations (scheduling and security), and requirements for the contents of loan files. Not least, banking regulators may need to look at the way in which they would evaluate microloan portfolios within large banks.

Difference Between Microfinance and Microcredit

Microfinance refers to loans, savings, insurance, transfer services and other financial products targeted at low-income clients. Microcredit refers to a small loan to a client made by a bank or other institution. Microcredit can be offered, often without collateral, to an individual or through group lending.

Clients of Microfinance

The typical microfinance clients are low-income persons that do not have access to formal financial institutions. Microfinance clients are typically self-employed, often household-based entrepreneurs. In rural areas, they are usually small farmers and others who are engaged in small income-generating activities such as food processing and petty trade. In urban areas, microfinance activities are more diverse and include shopkeepers, service providers, artisans, street vendors, etc. Microfinance clients are poor and vulnerable non-poor who have a relatively stable source of income.

Access to conventional formal financial institutions, for many reasons, is directly related to income: the poorer you are, the less likely that you have access. On the other hand, the chances are that, the poorer you are, the more expensive or onerous informal financial arrangements. Moreover, informal arrangements may not suitably meet certain financial service needs or may exclude you anyway. Individuals in this excluded and under-served market segment are the clients of microfinance.

As we broaden the notion of the types of services microfinance encompasses, the potential market of microfinance clients also expands. For instance, microcredit might have a far more limited market scope than, say, a more diversified range of financial services which includes various types of savings products, payment and remittance services, and various insurance products. For example, many very poor farmers may not really wish to borrow, but rather, would like a safer place to save the proceeds from their harvest as these are consumed over several month by the requirements of daily living.

Microfinance the new Mantra in Rural Finance

The rural finance policy pursued in most developing countries beginning from 1950s was based on providing subsidized credit through state controlled or directed institutions to rural segments of population. Expansion of credit coverage through state interventions was based on various theoretical assumptions. Seibel & Parhusip (1990) mention that this approach was based on the premise that rural micro-entrepreneurs are unable to organize themselves, they need subsidized

credit for increasing their income and are too poor to save. Yaron, Benjamin & Piprek (1997) have traced this traditional approach in rural finance leaning heavily towards direct interventions to Keynesian influence. Under this approach, in addition to the assumptions listed above, the key problem areas visualized in rural financial markets included a lack of credit in rural areas, absence of modern technology in agriculture, low savings capacity in rural areas and prevalence of moneylenders. These distortions and imperfections in rural credit markets were sought to be addressed through Government interventions. With difference of range and degree, most developing countries from 1950s to the 1980s were home to interventions ranging from establishing state owned financial institutions, interest rate ceiling on deposits and credit, credit subsidy, directing credit to particular sectors and nationalization of private banks. This supply led approach in rural finance caused various qualitative issues such as concerns about financial viability of institutions on account of high rate of loan delinquency, cornering of subsidy by well off people in what has been described as rent seeking behaviour, continued presence of moneylenders, inability to reach the core poor and led to a reorientation in thinking around 1980s. United States Agency for International Developments (USAID) spring review of Small Farmer Credit in 1972/73, covering 60 reports on specific farm credit programmes in developing countries followed by a World Conference on Credit for Farmers in Developing Countries in 1975 organised by FAO were the first landmark events pointing the deficiencies of directed and subsidized credit approach. These thoughts got crystallized during the Colloquium on Rural Finance in Low Income Countries by USAID and World Bank in 1981 and shaped the emergence of new thinking in rural finance. Hulme & Mosley (1996) credit the counter revolution against Development Financial Institutions (DFIs) which were a prime symbol of Government intervention in rural credit markets to Ohio school as the economists at Ohio State University provided the theoretical underpinnings to the critique of past approach and contributed to transfer of these ideas into operational policies of World Bank.

Features

Old Paradigm

New Paradigm

Problem Definition

Overcome imperfections

market Lower risks and transaction costs Intermediate efficiently Clients Create institutions independent resources

Role of Financial Markets

Implement State plans Help the poor

View of users Subsidies

Beneficiary Create subsidy dependence

Sustainability Evaluations

Largely Ignored Credit beneficiaries impact

A major concern on Performance Institutions of financial

On account of the above developments, the resultant shift in rural finance discourse

How Does Microfinance Help the Poor..

Experience shows that microfinance can help the poor to increase income, build viable businesses, and reduce their vulnerability to external shocks. It can also be a powerful instrument for self-empowerment by enabling the poor, especially women, to become economic agents of change.

Poverty is multi-dimensional. By providing access to financial services, microfinance plays an important role in the fight against the many aspects of poverty. For instance, income generation from a business helps not only the business activity expand but also contributes to household income and its attendant benefits on food security, children's education, etc. Moreover, for women, who, in many contexts, are secluded from public space, transacting with formal institutions can also build confidence and empowerment.

Recent research has revealed the extent to which individuals around the poverty line are vulnerable to shocks such as illness of a wage earner, weather, theft, or other such events. These shocks produce a huge claim on the limited financial resources of the family unit, and, absent effective financial services, can drive a family so much deeper into poverty that it can take years

to recover.

When Is Microfinance NOT An Appropriate Tool?? ? ?

Microfinance increasingly refers to a host of financial servicessavings, loans, insurance, remittances from abroad, and other products. It is hard to imagine that there would be any family in the world today for which some type of formal financial service couldn't be designed and made useful. But the fact of the matter is, that in most people's mind, "microfinance" still refers to microcredit. Microcredit is only useful in certain situations, and with certain types of clients. As we are finding out, a great number of poor, and especially extremely poor, clients exclude themselves from microcredit as it is currently designed. Extremely poor people who do not have any stable incomesuch as the very destitute and the homelessshould not be microfinance clients, as they will only be pushed further into debt and poverty by loans that they cannot repay. As currently designed, microcredit requires sustained, regular, and often significant payments from poor families. At some level, the very cause of poverty is the lack of a sustained, regular, and significant income. Even though a family may have a significant income for extended periods, it may also face months of no income, thereby reducing its ability to enter into the type of commitment demanded today by most MFIs. Some people are just too poor, or have incomes that are too undependable to enter into today's loan products. These extremely poor people at the bottom percentiles of those living below the poverty line need safety net programs that can help them with basic needs; some of these are working to incorporate plans to help graduate recipients to microfinance programs.

Often times governments and aid agencies wish to use microfinance as a tool to compensate for some other social problem such as flooding, relocation of refugees from civil strife, recent graduates from vocational training, and redundant workers who have been laid off. Since microcredit has been sold as a poverty reduction tool, it is often expected to respond to these situations where whole classes of individuals have been made poor. Microcredit programs directed at these types of situations rarely work. Credit requires a 98% hit rate to be successful.

This means that 98% of recent vocational school graduates or returning refugees would need to be successful in establishing a microenterprise for repayment rates to be high enough to allow for a program's overall sustainability. This is simply unrealistic. Running a program with substantial default rates undermines the very notion of credit and destroys credit discipline among those who could repay promptly but who look foolish given that many do not.

Microcredit serves best those who have identified an economic opportunity and who are in a position to capitalize on that opportunity if they are provided with a small amount of ready cash. Thus, those poor who work in stable or growing economies, who have demonstrated an ability to undertake the proposed activities in an entrepreneurial manner, and who have demonstrated a commitment to repay their debts (instead of feeling that the credit represents some form of social re-vindication), are the best candidates for microcredit. The universe of potential clients expands exponentially however, once we take into account the broader concept of microfinance.

How Is Microfinance Doing In India????

Its been growing fast in the last six years. Recovery rates are at about 98 per cent. Interest rates are higher than the formal sector (18 to 24 per cent) but lower than moneylenders (40 to 50 per cent). However, its reach is reported to be around 2 million, far less than the reach of Grameen in Bangladesh. The scope of expansion is limited by the lack of a proper regulatory framework.

Can Microfinance Be Profitable?? ? ?

Yes it can. Data from the MicroBanking Bulletin reports that 63 of the world's top MFIs had an average rate of return, after adjusting for inflation and after taking out subsidies programs might have received, of about 2.5% of total assets. This compares favorably with returns in the commercial banking sector and gives credence to the hope of many that microfinance can be sufficiently attractive to mainstream into the retail banking sector. Many feel that once microfinance becomes mainstreamed, massive growth in the numbers of clients can be achieved.

Others worry that an excessive concern about profit in microfinance will lead MFIs up-market, to serve better off clients who can absorb larger loan amounts. This is the crowding out effect. This may happen; after all, there are a great number of very poor, poor, and vulnerable non-poor who are not reached by the banking sector.

It is interesting to note that while the programs that reach out to the poorest clients perform less well as a group than those who reach out to a somewhat better-off client segment, their performance is improving rapidly and at the same pace as the programs serving a broad-based client group did some years ago. More and more MFI managers have come to understand that sustainability is a precursor to reaching exponentially greater numbers of clients. Given this, managers of leading MFIs are seeking ways to dramatically increase operational efficiency. In short, we have every reason to expect that programs that reach out to the very poorest micro clients can be sustainable once they have matured, and if they commit to that path. The evidence supports this position.

Why Should Commercial Banks Be Interested In Lending To The Poor????

Consider a commercial bank like ICICI. It would typically charge an MFI 12 per cent. The MFI would then incur a service charge and lend to the SHG at about 16-18 per cent. The borrower would get the loan, for example, at 20 per cent. This is cheap for her compared to the moneylender and that is why she would like to continue the credit relationship with ICICI and not default on the loan. If she defaults, the whole group gets cut off, so the group either puts pressure on her to repay, or helps her repay the loan. If ICICI had lent to industry it might have received 8 or 10 per cent. Therefore, once the bank has dealt with the questions of transaction costs and information asymmetries and risk by lending to the poor through MFIs, the poor are a commercially attractive proposition.