Term Paper (Advanced seminar), 2006
24 Pages, Grade: 1,0
2) Roots and History of Microfinance
a) Informal Financial Sector
b) Credit Cooperatives
c) National Development Banks
d) Modern Microfinance
3) Banking Theory and Microfinance’s response
a) Group Lending
b) Dynamic Incentives
c) Collateral Substitutes
d) Repayment Schedules and Saving
e) Other technologies
4) Microfinance in Latin America
a) Institutional Overview
c) Village Banking
d) Do commercial MFIs help the poor?
5) Concluding Remarks
Rewarding the Nobel Peace Prize to Muhammad Yunus, the committee acknowledged that microfinance is the latest fashion of both development policy and development economics, some call it even a “popular mass movement” (Woller et al. 1998). Indeed, the development over the last 30 years is impressive: Today, more than 100 million poor have access to small loans. While the formal financial sector perceived financial services to the poor “unimportant for the economy, unprofitable for financial institutions, and unnecessary for the poor”, modern microfinance institutions (MFIs) have proven that high recovery rates do not depend mainly on circumstances and the characteristics of the borrower, but on the design of the credit program: “repayment depends fundamentally on factors within the control of the lending institutions” (Robinson 2001).
This paper gives a short overview about the roots of modern microfinance and its global history. Some central theoretical aspects of financial markets are discussed and the main innovations of modern microfinance are presented. Focusing on Latin America, the paper shows that microfinance is booming on the continent. While Village Banks, focused on the poor, are still growing, a larger trend goes towards commercialization, including the entrance of established banks to the market. It seems quite clear that these banks reach even less of the poorest than not for profit NGOs do. More disturbing, there is little empirical evidence that microfinance can help many poor people in Latin America. The role of microfinance in the overall development progress is small at best.
What today is called „microfinance“ began in the 1970s, but is based on earlier experiences. The most important are (a) informal financial institutions, (b) credit cooperatives, and (c) development banks.
Of course, informal financial institutions are a lot older than any formal bank or insurance system and they are indeed the ancestors of today’s formalized institutions. Still today, informal institutions are the main providers of financial services for the world’s poor. The most important institutions are (a) the family, (b) ROSCAs, (c) money lenders, and (d) credit cooperatives.
Rotating Savings and Credit Associations (ROSCAs) are an institution to finance larger lump-sum investments or consumption expenditures. Several people form a group and everyone pays a little amount every time period and every time another single member gets all the contributions. Cleary, there are little incentives to keep paying after having received the disbursement. Further, this model is highly inflexible and it is purely redistributive: there is no possibility for saving or credit for the group as a whole.
Moneylenders are specialised money lenders or landlords, large farmers, or shopkeepers. In rural areas they have often de facto a monopoly, and they charge always very high interest rates. Marguerite Robinson (2001) gives estimates of 5% interest per day or 30% per month, which is 56.000.000 % and 2300% p.a., respectively. Beside of being very expensive moneylenders are a bad institution for saving since they are unregulated. Further, credit from moneylenders is normally not used for productive investments, but for emergency consumption needs (Nourse 2001).
Credit cooperatives or credit unions were developed in Germany in the 1850s and spread fast over the country and later over the world. They were based on many of the same assumptions today’s microfinance is based on. Most important: Poor need credit, but are excluded by the established banking system. Also, they used much of the same lending methodology, e.g. progressive lending, forced savings and primitive group lending (mutual guarantors). Most of the credits were very long-term and used for agricultural investments. In 1914 more than 19.000 Genossenschaftsbanken supplied 8% of the German credit. Today the Genossenschaftsbank founded by Frederick Raiffeisen in 1849 is one of the largest credit and saving banks of Germany. Interestingly, the connection to modern micro banking is closer than most people know: In the late 19th century there was a huge wave of credit unions in Ireland, and soon the British exported the concept to India. In 1946, credit cooperatives in India had already nine million members. So only few decades before Muhammad Yunus invented the Grameen Bank, a somewhat old fashioned form of “microfinance” was already established in Bangladesh (Ghatak & Guinnane 1999 and Murdoch 1999).
Many credit cooperatives and credit unions in Latin America were founded in the 1950s and 60s, often by catholic priests, US Peace Corps and USAID. The Confederación Latinoamericana de Cooperativas de Ahorro y Crédito (COLAC) was founded in 1970. Cooperatives do not use external sources of financing, but lend the savings of its members. They act manly locally and are managed by their own members. Although everyone agrees that credit cooperative play an important role in Latin American financial markets, actual figures vary enormously. Bicciato et al. (2002) report that in 1998 credit cooperatives in Latin America had a loan portfolio of $5bn and estimate that they provided 80% of all financial services on the continent. Ramírez (2004) reports 1.5m clients of credit unions in 2001 throughout Latin America and a total credit portfolio of $1.6bn, which are roughly the same numbers as for MFIs in the same year.
Large credit programs were the most popular development policy in the 1950s and 1960s. National Development Banks and international donors lend world-wide tens of billions of dollars in third world countries, mostly to farmers.
The underlying assumptions were: (a) There are technologies and opportunities available, the third world’s farmers are only too poor to adapt them and thus need capital. (b) Poor people are too poor to save and hence need credit. (c) Informal financial institutions play no or a negative role in the development process and established banks cannot fill the gap. (d) Poor are able and willing to pay credit back. Thus there must be demand for credit and satisfying the demand would have positive impact on development.
Many programs were designed after programs of the first world, e.g. the Farmer’s Home Administration of the US. Most programs were focused on rural areas and were implemented together with large programs of agricultural modernization, like the introduction of new machinery. Loan guarantees and subsidized interest rates were used as incentives for private banks to lend to the target group, and state development banks were founded to do the same. Credits were in general relatively large and long-dated. Evaluation was often based neither on costs-benefit analysis nor wealth effects on the target populations, but on measures like the number of tractors sold or acres of land irrigated. Often the programs were implemented by several ad-hoc institutions, often government agencies, and no sustainable financial institutions were established.
These programs faced major problems. Recovery rates were often less than 70% and dropped sometimes below 20%. So the credit programs were very costly. Further, many of the subsidies didn’t reach the poor but were captured by local elites, thus perpetuating patronage and political machines.
Little intent was made to mobilize savings, which made the programs even more expensive. Most important, credit restraints were often not the major problems of the rural poor and many preferred small short-term credits to the large long-term credits offered by the credit programs. Most programs disappeared after few years running out of resources.
Modern microfinance began in the 1970s in Bangladesh with the foundation of The Grameen Bank and in Latin America with the foundation of local banks affiliated with the Acción International network. After having world-wide only 10 million clients as recent as 1999, today more are 100 million people borrow from microfinance institutions MFIs. Credits are almost always only for productive investments start as low as $40 and often have to be paid back within weeks or month. Other MFIs lend several thousand dollars for more than one year. The target group are almost everywhere microenterprises such as merchants, small producers or petty traders, only few programs lend for agricultural activities. Although having relative to the loan size huge transaction costs, many MFIs want to be financially self-sustainable, several claim they are and few are actually highly profitable. The idea of “doing good by doing well” is not a new one, but contrasts sharply with all development policies implemented earlier. Working in a context of high transaction costs and all kinds of informational and other problems, MFIs have developed an impressive set of technologies, including progressive lending, group lending, all kind of incentives for clients and employees, strict repayment schedules, collateral substitutes and targeting of women. Interestingly, the pioneer of the work, Grameen Bank, has abandoned most of these innovations in 2001 (Yunus 2002), but many MFIs keep using them. Economists began writing about microfinance on a larger scale in the mid 1990s and have since then produced a large body of theoretical and empirical literature. Few years ago, governmental donors like USAID, multilateral institutions like World Bank and large private philanthropists like the Gates foundation jumped on the bandwagon. This culminated in the United Nation’s “year of microcredit” in 2005. As John Morduch argues, „the lack of public discord is striking“ and microfinance is the new trend in development politics, since microfinance gains support on the whole political spectrum: the left likes the “bottom-up” approach of NGOs and supports empowerment of women. Rightist are happy because microfinance gives incentives, makes free markets work and excludes subsidies and the state in general (Murdoch 1999).
The two major problems of financial markets are (a) to ascertain that the borrower is able to pay the loan back (adverse selection and (ex ante) moral hazard), and (b) to make sure that the borrower is willing to pay it back (auditing and enforcement or ex post moral hazard) (Ghatak & Guinnane 1999, Stiglitz & Weiss 1981). Another characteristic of the banking industry are high fixed costs both per institution and per transaction. That means that small banks that lend small credits have huge transaction costs. Since most of the solutions developed by the traditional banking industry do not work when poor of the third world demand credit, MFIs developed new innovative technologies to handle them.
Group lending is often seen as the major innovation of modern microfinance, dealing with all major problems of financial markets. Nevertheless, I won’t write anything about this lending technology, for three reasons. First, it is not a new innovation. Guarantors are very common in economic transactions and even early forms of group lending, for example mutual guarantors for a credit, were used in Europe by Genossenschaftsbanken in the 19th century (Ghatak & Guinnane 1999). Second, group lending has lost much of its attraction during the last years. Grameen introduced a new lending model that has lost much of its group characters, and in Latin America many MFIs have switched to individual lending. This is because both clients demand individual loans and group lending seems to work less well in tough economic times. Since most MFIs prosper more than ever, group lending does not to seem be the key to their success (Yunus 2002, Ramírez 2004). Finally, there is a well-developed theoretical, historical and empirical literature on the topic (Ghatak & Guinnane 1999, Murdoch 1999, Navajas et al. 2003, Murdoch & Armendáriz 2004).
 I use the term microfinance institutions in the broadest sense, including NGOs, village banks, financial companies and regulated banks – every formal institution that offers financial services to people with low-income.
 $5bn is about the amount of outstanding credit of all MFIs in Latin America in 2005 and ten times more as the largest global MFI in 1998 – The Grameen Bank – had at this point of time. But I doubt that they number of services provided is anything close to 80% and I can hardly believe that the aggregate portfolio was $5bn.
 Murdoch (1999) gives some background on these credit programs and Adams & von Pischke (1992) give an interesting – and highly pessimistic – comparison between credit programs and Microfinance.
 See, for quite an early example, Smith (1776). Actually, the entire classical and neoclassical theory is based on the assumption that selfish behaviour maximizes social welfare.
 For an overview about the literature see Brau & Woller (2004).
Essay, 7 Pages
Bachelor Thesis, 184 Pages
Term Paper (Advanced seminar), 12 Pages
Term Paper, 21 Pages
Research Paper (undergraduate), 18 Pages
Bachelor Thesis, 52 Pages
Essay, 19 Pages
Term Paper (Advanced seminar), 17 Pages
Research Paper (undergraduate), 77 Pages
Research Paper (postgraduate), 23 Pages
Research Paper (undergraduate), 39 Pages
GRIN Publishing, located in Munich, Germany, has specialized since its foundation in 1998 in the publication of academic ebooks and books. The publishing website GRIN.com offer students, graduates and university professors the ideal platform for the presentation of scientific papers, such as research projects, theses, dissertations, and academic essays to a wide audience.
Free Publication of your term paper, essay, interpretation, bachelor's thesis, master's thesis, dissertation or textbook - upload now!