The poor are a population living in high risk environments with limited access to formal sectors of government and business. Their unstable surroundings and low incomes previously kept conventional thinking from considering them a segment of the population that needed or could manage financial services, but recently this has changed. A closer look at the impoverished of the world shows that the presence of a formal financial institution that provides access to affordable loans, insurance and savings accounts can help poor clients cope with the effects of poverty and empower them to climb out of it. As a result, microfinance institutions have emerged to provide services, such as loans and savings accounts, to poor people that primarily make a living through small businesses referred to as micro-enterprises.
The main reason that poor people can utilize MFI services is found in the way they make a living. Instead of holding a steady job with a secure income, most of the poor are owners of self-run, small and humble businesses - in other words they are micro-entrepreneurs. But unlike other entrepreneurs, the poor usually do not have access to the capital necessary to invest in technology, resources and labor that can make businesses run efficiently. Usually their businesses employ less than ten people (as defined by USAID) and are run out of the household. Often they provide just enough money to feed the family and in some instances they compliment another source of income. These clients work in a varied number of areas including farming, craftwork, sewing, owning workshops and many more (Year of Microcredit 2005).
The environment of the poor dictates much of their behavior. In most cases this environment can be adequately described using one word: uncertain. The poor live day-to-day, unsure if whether they will make enough money make ends meet. They are the population of a country that is most vulnerable to external shocks from their environment. Economic crisis, natural disasters and environmental conditions often lead to low crop output, malnutrition, and business failure. Poor health conditions and disease are also problematic. At unexpected times families may suffer from lower production because of sick family members, high expenses from medical treatments and untimely deaths. The poor are also victims to theft, breaches of contracts from employers and insecure conditions in the work place. Another characteristic of their environment is that "they operate in a mini-economy" where most of their transactions are on a small scale (Hulme et al., 2002, p 275). This discourages any participation in the traditional formal financial sector as the transaction costs are too large compared to their income, saving and exchanges.
The informal financial options to the poor are difficult to track, as informal lenders do not keep records and are not bound by the financial laws of the countries they are in. Many of the informal options to the poor come from within. There is much lending from neighbors and family. In these instances the size of the loans is very small and the interest is arbitrary. There are people in the business of lending but can only do so when they have excess income. Others specialize in lending as their primary mode of earning income. Many of these lenders are very informal and only make loans for small amounts. They take advantage of being one of the few sources for money by charging high interest rates, especially in times of emergencies when demand is high. One unconventional way poor people find to save and to make loans is through each other. This is referred to as "reciprocal lending" and they commonly represent most of poor people's financial transactions. They also show that poor people have the capacity to save by lending money to each other and also have they capacity to pay back (Matin and Sinha, 1998).
There is a saying that is it better to teach a man to fish than to give him a fish. Many MFIs do this and more: they give people the means to buy the boat and the fishing rod. The loans that are made are specifically aimed at micro-entrepreneurs so that they may be used toward their businesses. While there may be equally important areas where loans can be applied, investments in small businesses have high potential to show return. Therefore, people are not merely given a gift for temporary relief; instead they are given a mechanism in which to make more money. Through training and advice to their users, MFIs teach and encourage the poor to run small businesses. Through their credit, they allow them to make investments that allow them to create or improve small businesses. MFIs encompass the notion of using finance as a business tool rather than using donations as a charity (Johnson and Rogaly, 1997). The following sections will describe the financial services offered by many MFIs and how they are used as business tools to fight poverty.
Of the service provided by MFIs, microcredit is probably the most important. Most MFIs dedicate most of their funds to their branch of microcredit and much of their sustainability relies on the strength of this service. microcredit is defined as a "small amount of money loaned to a client by a bank or other institution" (Year of microcredit 2005, 2004). The loans can be as small as $20 for a new client and grow to the hundreds as credit history is accumulated. The logic behind these loans is that they enable the poor to make investments in their businesses. The user will reap the returns from their investment in the form of increased income while they repay the loans in weekly or monthly installments.
While traditional forms of aid provide only temporary assistance, microfinance invests in developing skills that allow the poor to provide for themselves. Compared to most conventional ways of poverty alleviation assistance microfinance is clearly superior: "Instead of relief, which only makes the recipient dependent on the gift, micro-enterprise provides small loans and business training to help the poor start income-generating enterprise" (Enterprise Development International, 1998). While the risks from lending to the poor are seemingly high, the reality is that the poor have shown the potential to consistently pay back, often at higher rates than borrowers with higher incomes. One great example of an MFI with clients who repay well is the Grameen Bank in Bangladesh, where microlending is believed to have emerged (Ferraro, 2000). Borrowers in the Grameen Bank had repayment rates above 95% and benefited from increased economic and social development.
Usually the process of taking a loan is simple. First clients should be introduced to microcredit in order to mitigate their fear of formal institutions. This can happen by an initial small loan or through educational programs offered. Next the person will apply for a loan and the bank will gather information about the potential borrower (the levels of information vary greatly and will be discussed further later). Once a person is approved for a loan they will have to meet with the MFI and agree to the terms and are sometimes asked to participate in workshops and seminars that improve their business and social skills. The MFI then disburses the loan and the client uses the money to make an investment for their small business. The MFI then continues to make continued contact with the client through visits at home or through large community meetings. The client is required to make weekly or monthly payments to the MFI in order to establish the client's credit worthiness and to maintain a continued presence in the life of the borrower. If all payments are made on time, the client is offered another loan, usually of a higher amount of money (Ferraro, 2000). The main benefit of microcredit is that it provides clients with an efficient and fair way to borrow money to invest. The technology that microcredit uses is crucial to its efficiency and to its sustainability. The technologies of credit are the combinations of actions and procedures that the MFIs adopt for the disbursement of credit. There are technologies that are based on guarantees for repayment and others that are based on the use of information and structure of incentives for repayment. Credit technologies that are based on information are more expensive than those with traditional guarantees and require that higher rates be charged (Navaja, 2003).
Some of the current technologies of microcredit show the following characteristics:
Another very important service that MFIs provide is the ability to save money. Usually this service is allowed through an account with a very low balance requirement. Therefore, any excess income that the family receives can be safely stored in a credit institution (Year of microcredit 2005, 2004). This is yet another way to increase the participation in the formal economy of people living below the poverty line. Additionally, this allows planning for the future, something that does not happen often for people living below the poverty line. The poor can address concerns for making a living once they reach old age and investing in their children. Money saved can be used to pay for educations, skills training or as future loans that enable the next generation invest in their own businesses. Savings also permit the poor to endure unexpected emergencies, something common for people living below the poverty line. Money in MFIs can be used for the medical treatment of a sick family member as well as backup money in times of bad economy or low crop output.
Microinsurance requires for individuals, businesses and other organizations to make payments to the MFI in order to share risk. Therefore, a particular group or person is entitled to receive aid when they encounter a difficulty in health, environmental conditions or other outside factors covered by the policy. Insurance is a technology that poor people have very little access to and is currently offered by only some MFIs. Other services available to the poor deal with financial transactions. Often they are allowed to send and receive remittances from family members in other parts of the world. They can also make transactions between themselves to facilitate sales (Year of microcredit 2005, 2004).
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