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Microfinance: Types, Advantages and Challenges

  • Yashoda Gandhi
  • Dec 31, 2021
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Microfinance has expanded from a few charity organizations' inconspicuous efforts to a global sector with branches in tens of thousands of institutions, reaching 150–200 million clients. 


Microfinance has progressed from only giving loans to now including offering savings, insurance, healthcare, and education. Despite this, many people still refer to it as microcredit.



What is Microfinance?


Microfinance, often known as microcredit, is a type of banking service that offers financial services to unemployed or low-income people and businesses that would otherwise be unable to get them.


The majority of microfinance organizations focus on providing small working capital loans, sometimes referred to as microloans or microcredit. However, many of them also provide insurance and money transfers, and licensed microfinance banks provide savings accounts.


Microcredit stood out because it avoided the flaws of prior generations of targeted development financing by requiring repayment, charging interest rates that could cover the expenses of credit distribution, and focusing on clients whose only other option for the loan was the informal sector.


There are microfinance institutions known as MFIs. Microfinance institutions' responsibilities include providing modest loans to low-income borrowers, creating job possibilities, and increasing borrowers' capacity by teaching them skills such as how to use loans, entrepreneurship, and management.



Types of microfinance Institutions in India


  1. Joint liability Group


This is generally a small, informal group of 4-10 people who seek loans on the basis of mutual assurance. The loans are typically used for agriculture or related operations. This group of debtors includes farmers, rural laborers, and renters. 


Each member of a JLG is equally liable for the timely repayment of the loan. Because it is basic in nature, this entity does not require any financial administration. However, one of the structure's major flaws is personal preferences in credit lending, which has resulted in the system's partial failure. 


The legitimacy of the Joint Liability Group model has recently gotten a boost thanks to several promotional measures conducted by institutions like Indian Bank, Karur Vysya Bank, and Indian Overseas Bank (The Hindu, 2016). It is still remembered as a watershed moment in the fight to defend farmers' land ownership rights.


  1. Self-help Group


A Self-Help Collection is a group of people from similar socioeconomic circumstances who get together to help one other. These small company owners band together for a limited time to form a shared fund for their mutual business requirements.


These organizations are classed as non-profits. The debt collection is handled by the organization. This type of cooperative financing does not necessitate the use of collateral. In addition, borrowing rates are often cheap. Several banks have formed partnerships with SHGs in order to increase financial inclusion in the country's rural areas.


One of the most important is the NABARD SHG linkage program, which allows numerous self-help groups to borrow money from banks if they can show that their borrowers have made regular payments.


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  1. Grameen bank model


Nobel Laureate Prof. Muhammad Yunus developed the Grameen Model in Bangladesh in the 1970s. Regional Rural Banks (RRBs) have been established in India as a result. The main purpose of this strategy is to boost the rural economy from start to finish. In India, however, SHGs have done better as MFIs than Grameen Banks.


However, in India, this approach has not been completely implemented since rural credit and recovery systems are a major issue. These regional banks also failed due to a large volume of non-performing assets (Shastri, 2009). 


Self Help Groups have fared better than this approach since they are more suited to India's population density and significantly more sustainable (Dash, 2013).


  1. Rural cooperatives


At the time of India's independence, rural cooperatives were founded. Poor people's resources were pooled, and financial services were offered through this fund. This approach, however, had complicated monitoring systems and was only useful to creditworthy borrowers in rural India. As a result, this strategy did not meet with the expected success.


Furthermore, this system exclusively served credit-worthy persons in rural regions, excluding a substantial portion of the country's financially disadvantaged population.



Advantages of microfinance


Microfinance is important because it provides resources and money to those who are financially disadvantaged, such as those who are unable to access checking accounts, credit lines, or loans from traditional banks.


Without microfinance, these people may be compelled to rely on risky loans or high-interest payday advances, or even borrow money from family and friends. Microfinance enables people to invest in their enterprises, and hence in themselves;


  • Credit access


"By expanding microfinance possibilities, people can have access to small sums of credit, which can help them get out of poverty quickly. Microfinance is founded on the idea that even little sums of loans may help people break free from poverty."


Plan International, a global organization committed to the advancement of children's rights and women's equality, concurs, stating: Banks simply will not lend to those who have little or no assets, and they seldom provide the tiny loans that are associated with microfinance.


  • Assistance with education


Children who live in poverty are more likely to miss school or not be enrolled at all. This is due to the fact that the agriculture industry employs the bulk of low-income families. 


Families require their children to work and be productive in order to meet their financial necessities. Receiving microfinance products reduces the risk of running out of money, which implies more options for children to continue in school.


  • Encourages saving


Microloans, like saving money, are an essential part of microfinance. When people's fundamental requirements are addressed, it's normal for them to preserve the money they don't need for a future emergency. This opens the door to additional investments and, eventually, greater income for individuals living in developing countries.


Microfinance provides for modest changes rather than large ones. When enough of these reforms take place, people will have a safe place to put their money. (source)


  • Creates chances for employment


Microfinance can also assist entrepreneurs in poor nations in creating new job possibilities for others. Because there are more revenues available to circulate through local companies and service providers as a result of more individuals being able to work and make an income, the rest of the local economy benefits as well.


Job development through microfinance benefits people at all levels, not just entrepreneurs. Grameen Bank employs around 21,000 people in Bangladesh, and it's core financial products are microfinance. That translates to tens of thousands of employment produced by the business solely for the aim of lifting people out of poverty. 


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Challenges of microfinance institutions 


  • Higher interest rate compared to mainstream banks


Microfinance institutions have a limited transaction volume, yet the cost of those transactions is constant and substantial, posing a considerable problem for all of them.


Mainstream banks have long roots in the market, which has evolved to meet the demands of the times. People may find a wide range of things at one location at a reduced cost when compared to MFIs. 


The majority of conventional banks charge a modest interest rate on their loans, ranging from 8 to 12 percent, whereas MFIs charge a high-interest rate on loans ranging from 12 to 30 percent of the principal amount.


  • Default on a loan


People's failure to manage their debts leads to loan default, which stymies the expansion of Microfinance Institutions.


Borrowing has increased significantly, while risk management has remained ineffective. The industries provide loans without requiring collateral, increasing the risk of default and bad debts. Effective planning is required for good growth, which is still lacking in most MFIs.


  • The expertise of financial services is limited


Another important stumbling block in the road of microfinance institutions is citizens' lack of understanding of basic principles.


The absence of financial services in the microfinance business is a problem for both customers and institutions. This not only prevents individuals from joining MFIs, but it also puts them in a financial bind.


  • Insufficient investment validation 


Investment valuation may be a critical competency for an MFI's smooth operation. MFIs operate in developing and developed areas with minimal activity. As a result, MFI finds it difficult to gain access to information for appraisal purposes.


MFI management teams cannot understand the quantity of quality information they have to develop investment decisions due to a lack of consistent and trustworthy valuation methodologies.


  • Incapacity to withstand


The subject of long-term action is a recurring theme in the microfinance debate. Despite MFIs' economic models and "best practices" understanding, virtually all programs are heavily supported. Only 10% of micro-lending institutions are self-sufficient, according to UN research.

 The vast majority rely on contributions and subsidies to stay afloat, putting their long-term survival in jeopardy. This is particularly true for programs with overtly social goals. 


According to a recent assessment, the programs that target the poorest borrowers only produce enough money to pay 70% of their total expenditures. Because viable initiatives can attain a larger size than subsidized programs, a lack of financially sustainable programs is an issue.


To conclude, borrowers who are above the poverty level benefit more from microloans than those who are below the poverty line. As an important element of poverty reduction initiatives, microfinance can help to solve the problem of insufficient housing and urban services. It would be wonderful to improve the poor's creditworthiness and make them more "bankable."


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    Dec 31, 2021

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