The details of micro
Microfinance has brought relief to many in the developing world. It challenges established understanding of market and its dynamics

Whenever we here the term ‘finance’, we usually think of the stock market, FDI, venture capital, flashy jobs, and of course the great financial crisis it has all brought upon us! Amidst the whole brouhaha regarding ‘finance’, we often miss another of its distant cousin, which has silently created social revolutions in different parts of the world. ‘Microfinance’, as a term has been doing rounds for decades. Various models of microfinance have run successfully in many developing countries and have challenged conventional wisdom time and again.

What is microfinance? There are numerous technical definitions of microfinance. Ideally, it is loans of very small amount (at times as low as US$ 50), given to the poorest of the poor in rural areas of developing countries, with little or no collaterals. But what really triggered the emergence of microfinance given that almost all the countries where it has worked have an established conventional banking system?

It is common knowledge that to borrow money, you need to have assets, which you either mortgage or put up as collaterals in event of a default, ie in case you cannot repay the loan. Thus under conventional financial structure, the poorest of the poor are always cut off from bank loans or other such kind of financing. It is almost taken for granted that the poorest of the poor cannot repay their loans. Most often than not, the loans they take are not for investment purposes but to fund their consumption needs (which does not have ‘returns’ and are hence ‘unprofitable activities’). Not having collaterals essentially means that there are no means of recovering the loans in case of repayment default. All this makes lending to the poorest of the poor a futile exercise. No bank is interested in doing that. Nationalised banks with social obligations are often forced to engage in low interest rate priority lendings, and it is argued as common knowledge that they create non performing assets (NPAs) which burden the entire financial system.

If you believe in this conventional wisdom, just pause to consider this: the Bangladesh Grameen Bank, the brainchild of Nobel Prize winner Mohammad Yunus, gives loans to over two million borrowers, most of whom are women, without any collateral, and has a repayment rate of over 90 per cent (official estimates are as high as 97-98 per cent, but even by conservative estimates, it is as high as approximately 92 per cent)! Banco Solidario (Bancosol) of Bolivia defines overdue by very conservative standards. If a loan repayment is overdue by even one day, it considers the entire unpaid balance at risk. Even then, in 1997 it reported only 2.03 per cent of its portfolio at risk, the rest was being paid back in time!! Unit Desa programme of Bank Rakyat of Indonesia, another shining example, reported repayment rates of 97 per cent in 1998 in the wake of a financial crisis in the country!

So what is the secret behind the success of these banks? To start with, all three have differing modus operandi (which makes the whole thing all the more interesting). Grameen and Bancosol engage in group lending. In case of Grameen, a group of five borrowers are formed in a village. Grameen would lend to two borrowers at first, then to the other two, and then to the fifth. The basic rule is that if one of the borrower defaults in repayment, no member of the group will get any loans in the future! The groups are formed voluntarily by the borrowers amongst themselves, the decision of choosing who to lend first is taken in group meetings with bank officials. Meetings of groups take place weekly (seven groups meet together at a time, giving the bank officials greater coverage over time) and the entire process is as transparent as it can be. The bank does not need to worry about repayment from the borrowers because they face such social pressure that news of social isolation or even physical retributions by group members have been reported in case of any member failing to prepay in time!

This model of forming groups also has numerous positive sociological effects in the rural hinterlands. New kind of social bonding, camaraderie and co-operative activities have been triggered by this simple but effective formula. Bancosol lends to urban poors in Bolivia; focuses sharply on banking and not so much on social service like Grameen (it charges a much higher interest rate, so much so that its operations are profitable and it does not depend on subsidies unlike Grameen) and lends to all members of the group (it can vary in number from three to seven members) simultaneously.

Bank Rakyat’s Unit Desa differs from both the previous example by miles. It does not engage in group lending, asks for collaterals (which essentially results in Bank Rakyat lending to the ‘richer of the poor’) and like the Bancosol is less bothered about social benefits and is more like a successful business venture (and successful it is, with reported profit of US$ 175 million in 1995!). The secret of its success lies in its extensive branch network, where its officials in every village know the borrowers almost personally. The loan structure offered is progressive in nature, ie a small amount will be lent at first. Successive lending amounts can be increased (and interest rates adjusted) depending on repayment record of the borrower. Thus it depends on good behaviour practice, where the borrower works not under social pressure but an incentive structure of bigger loans if he/she repays in time. Needless to say, failure to repay closes all options of any future loans. The issue of collaterals is a bit contentious in the case of Unit Desa, with bank officials insisting that they rarely collect it (most of the time they do not need to given repayment records) but nonetheless, the threat of loosing asset (and the poor have very few of such assets) surely is a big factor for repayment. However, it has been observed that the good behaviour incentive is often the more convincing factor than the threat of collaterals.

There are numerous other examples of such kind of rural financing, with village banks being set up successfully in many other places. The village banks differ from the above cited examples as they are not big chains spread over large areas, but are rather localised structures limited to specific villages. However, all these examples do show that lending to the poors need not necessarily be a futile exercise, they often have better repayment records than the mainstream richer financial lendings and can also be profitable.

The last point is of prime importance here. Grameen Bank for example sees itself as a social service. It charges very low interest rates, organizes trainings and schooling to socially empower the poor, and gives loans not only for investments but also social needs. It thus depends heavily on subsidies and donors for its activities. Unit Desa of Bank Rakyat on the other hand is essentially a business exercise. It might be limited in its scope, but as it has proved to all skeptics, rural sector lending by commercial or even nationalised banks needs not necessarily be cross subsidised or a burden on the banks.
India too has some wonderful experiences of successful microfinancing activities, though much of it concentrated in South India, and Andhra Pradesh in particular.