What is Microcredit?

Microcredit is the supply of loans to the poor.

As the financial services of microcredit usually involve small amounts of money, the term “microcredit” helps to differentiate these services from those which formal banks provide.

Why are they small?

Someone who doesn't have a lot of money isn't likely to want to take out a $5,000 loan, or be able to open a savings account with an opening balance of $1,000. Hence – “micro”.

It’s easy to imagine poor people don’t need financial services, but when you think about it they are using these services already, although they might look a little different.

Poor people save all the time, although mostly in informal ways. They invest in assets such as gold, jewelry, domestic animals, and things that can be easily exchanged for cash. They may set aside corn from their harvest to sell at a later date. They bury cash in the garden or stash it under the mattress.

They participate in informal savings groups where everyone contributes a small amount of cash each day, week, or month, and is successively awarded the pot on a rotating basis. Some of these groups allow members to borrow from the pot as well. The poor also give their money to neighbors to hold or pay local cash collectors to keep it safe.

However widely used, informal savings mechanisms have serious limitations. It is not possible, for example, to cut a leg off a goat when the family suddenly needs a small amount of cash. In-kind savings are subject to fluctuations in commodity prices, destruction by insects, fire, thieves, or illness (in the case of livestock).

Informal rotating savings groups tend to be small and rotate limited amounts of money. Moreover, these groups often require rigid amounts of money at set intervals and do not react to changes in their members’ ability to save.

Perhaps most importantly, the poor are more likely to lose their money through fraud or mismanagement in informal savings arrangements than are depositors in formal financial institutions.

The poor rarely access services through the formal financial sector. They address their need for financial services through a variety of financial relationships, mostly informal.

Why is this? For a moment pretend that you are a poor goat-herder walking into a bank:

• You don’t have any money to open a savings account with
• You don’t have any collateral to secure a loan with
• You don’t have a credit record as you have never been formally employed and you’ve never taken out a loan before
• You might even be unable to complete the necessary paperwork as you are illiterate.

Formal financial institutions were not designed to help those who don’t already have financial assets – they were designed to help those who do. Imagine trying to get a loan in the United States without any savings, an employer or a credit report.

Credit is available from informal commercial and non-commercial money-lenders but usually at a very high cost to borrowers. Savings services are available through a variety of informal relationships like savings clubs, rotating savings and credit associations, and mutual insurance societies that have a tendency to be erratic and insecure.

Why don’t banks accommodate poor people?

The majority of formal banks do not provide microcredit products as microcredit is an expensive enterprise – you can make a lot more money on a large loan than a small loan, and you won’t make much money holding savings accounts with very little funds in them. Banks can make more money if they only provide financial services to those who already have money.

Comprehensive impact studies have demonstrated that:

• Microcredit helps very poor households meet basic needs and protect against risks;
• The use of financial services by low-income households is associated with improvements in household economic welfare and enterprise stability or growth;
• By supporting women’s economic participation, microcredit helps to empower women, thus promoting gender-equity and improving household well-being;
• For almost all significant impacts, the magnitude of impact is positively related to the length of time that clients have been in the program.

Poor people, with access to savings, credit, insurance, and other financial services, are more resilient and better able to cope with the everyday crises they face. Even the most rigorous econometric studies have proven that microcredit can smooth consumption levels and significantly reduce the need to sell assets to meet basic needs. With access to micro-insurance, poor people can cope with sudden increased expenses associated with death, serious illness, and loss of assets.

Access to credit allows poor people to take advantage of economic opportunities. While increased earnings are by no means automatic, clients have overwhelmingly demonstrated that reliable sources of credit provide a fundamental basis for planning and expanding business activities. Many studies show that clients who join and stay in programs have better economic conditions than non-clients, suggesting that programs contribute to these improvements. A few studies have also shown that over a long period of time many clients do actually graduate out of poverty.

By reducing vulnerability and increasing earnings and savings, financial services allow poor households to make the transformation from “every-day survival” to “planning for the future.” Households are able to send more children to school for longer periods and to make greater investments in their children’s education. Increased earnings from financial services lead to better nutrition and better living conditions, which translates into a lower incidence of illness. Increased earnings also mean that clients may seek out and pay for health care services when needed, rather than go without or wait until their health seriously deteriorates.

Empirical evidence shows that, among the poor, those participating in microcredit programs who had access to financial services were able to improve their well-being—both at the individual and household level—much more than those who did not have access to financial services.

• In Bangladesh, Bangladesh Rural Advancement Committee (BRAC) clients increased household expenditures by 28% and assets by 112%. The incomes of Grameen members were 43% higher than incomes in non-program villages.
• In El Salvador, the weekly income of FINCA clients increased on average by 145%.
• In India, half of SHARE clients graduated out of poverty.
• In Ghana, 80% of clients of Freedom from Hunger had secondary income sources, compared to 50% for non-clients.
• In Lombok, Indonesia, the average income of Bank Rakyat Indonesia (BRI) borrowers increased by 112%, and 90% of households graduated out of poverty.
• In Vietnam, Save the Children clients reduced food deficits from three months to one month.

Microcredit is but one strategy battling an immense problem.

In the last two decades, substantial progress has been made in developing techniques to deliver financial services to the poor on a sustainable basis. Most donor interventions have concentrated on one of these services, microcredit. For microcredit to be appropriate however, the clients must have the capacity to repay the loan under the terms by which it is provided. Otherwise, clients may not be able to benefit from credit and risk being pushed into debt problems. This sounds obvious, but microcredit is viewed by some as “one size fits all.” Instead, microcredit should be carefully evaluated against the alternatives when choosing the most appropriate intervention tool for a specific situation.

Microcredit may be inappropriate where conditions pose severe challenges to standard microcredit methodologies. Populations that are geographically dispersed or nomadic may not be suitable microcredit candidates. Microcredit may not be appropriate for populations with a high incidence of debilitating illnesses (e.g., HIV/AIDS). Dependence on a single economic activity or single agricultural crop, or reliance on barter rather than cash transactions may pose problems. The presence of hyperinflation, or absence of law and order may stress the ability of microcredit to operate.

Microcredit may be inappropriate where conditions pose severe challenges to loan repayment. For example, populations that are geographically dispersed or have a high incidence of disease may not be suitable microcredit clients. In these cases, grants, infrastructure improvements or education and training programs are more effective. For microcredit to be appropriate, the clients must have the capacity to repay the loan under the terms by which it is provided.

Microcredit programs have generally targeted poor women. By providing access to financial services only through women—making women responsible for loans, ensuring repayment through women, maintaining savings accounts for women, providing insurance coverage through women—microcredit programs send a strong message to households as well as to communities.

Many qualitative and quantitative studies have documented how access to financial services has improved the status of women within the family and the community. Women have become more assertive and confident. In regions where women’s mobility is strictly regulated, women have become more visible and are better able to negotiate the public sphere. Women own assets, including land and housing, and play a stronger role in decision making.

In some programs that have been active over many years, there are even reports of declining levels of violence against women.

• Grants can be used to help overcome the social isolation, lack of productive skills, and low self-confidence of the extreme poor, and to prepare them for microcredit.
• Investments in infrastructure, such as roads, communications, and education, provide a foundation for economic activities. Community-level investments in commercial or productive infrastructure (such as market centers or small-scale irrigation schemes) also facilitate business activity.
• Employment programs prepare the poor for self-employment. Food-for-work programs and public works projects fit this model. In many cases, these programs may be out of reach for cash-strapped local governments but within the purview of donors.
• Non-financial services range from literacy classes and community development to market-based business-development services.
• Legal and institutional reforms can create incentives for microcredit by improving the operating environment for both microcredit providers and their clients. For example, streamlining microenterprise registration, loosening regulations governing non-mortgage collateral, strengthening the judicial system, and reducing the cost and time of property and asset registration can foster a supportive climate for microcredit.