October 08, 2010
An Explanation of Microfinance
As FridgeWaves gets more and more exposure, and as I tell more people about what we do, the question inevitably comes up:
What is Microfinance? What are microloans? What is microlending?
And because sometimes it is difficult to explain the concept concisely and completely, I am writing this post to explain the concept in fullness.
Microfinance became known as a lucrative field in the 1970s when Dr. Muhammad Yunus loaned an amount equivalent of $27 to 42 women believing that they (1) needed it and (2) would work hard to pay it back. Since then, Dr. Yunus’ Grameen Bank has loaned out $6.5 billion in small loans to over 7 million borrowers, and has a repayment rate of over 98%. The success of this bank was recognized in 2006, when Yunus was awarded a Nobel Peace Prize. Microloans are now recognized as viable business transactions that not only yield profit for investors, but also allow impoverished borrowers the initial funds to create a better life for themselves.
Microfinance is founded on 3 principles:
Access to funds is a basic human right and should not be limited only to a portion of the population.
Credit is not usually thought of as a universal human right. Creditworthiness is based on what are known as the 5 Cs of credit analysis:
- Character: borrower’s history/reputation,
- Capacity: borrower’s income and expenses,
- Capital: borrower’s contribution to investment,
- Collateral: borrower’s assets and liabilities,
- and Condition: terms of credit being considered.
In poorer countries, a borrower might not qualify for a loan under ANY of these characteristics, much less all of them, as is usually preferred. Profit-maximizing company thus deduce that such borrowers are not lucrative investments.
Microfinance eliminates the 5 Cs, and recognizes that poor people are just as capable of repayment as anyone else. In smaller communities, they are sometimes more capable and motivated to repay loans, as they have the support of the entire community.
Investment banking has only one objective: to multiply money. And this misrepresents human nature, which has multiple objectives.
Yunus describes profit-maximizing economics as one-dimensional and misrepresentative of human nature. Current economic systems measure success or failure in terms of dollars and cents. Although currency was invented as a common denomination to measure value, its highly flexible and tradable nature has made it grossly overvalued. So much so that one dollar worth of goods is worth less than one dollar bill. (Interesting psycho-study, by the way)
In reality, human beings care about more things than dollar wealth; e.g. health, satisfaction, spiritual growth, connection to society, etc.
For our economic system to reflect these values, it is important that we include measure of success in these values as well. The returns on microfinance are measured in the number of lives that are changed per loan. A $10 loan that allows a farmer in China to buy a new plow that will increase productivity and profitability is valuable because of the story it tells, not the interest that is levied on the loan.
Social responsibility can be part of a profitable business model, and is not just limited to the non-profit, volunteer, and philanthropic fields.
The effectiveness of philanthropy is generally susceptible to skepticism. Charity may feel good, but it does not create self-sufficient economies that can exist independently. The cash only flows in one direction. When it stops, economic activity stops, and generally societies are dragged back into poverty again.
Microfinance, on the other hand, allows individuals and communities to create self-supporting economic systems, supports innovation and entrepreneurship, and at the same time turns a profit for investors.
MFIs focus on building relationships with their borrowers and lend to those whose intentions are supported by the community. These characteristics reduce default rates and encourage borrowers to use loans for constructive and profitable activities.