The high price or outright unavailability of credit in poor urban and rural communities is certainly not a coincidence. Screening potential borrowers, monitoring borrower behavior after loans are granted, and enforcing credit agreements are all extraordinarily costly where documented credit histories do not exist, businesses are very small, and legal systems are undeveloped, unreliable, or inaccessible. Mainstream banks have experienced persistently high costs and default rates when lending in these areas and therefor regarded them as unprofitable.
The high repayment rates that micro finance have experienced (often around 95%) have puzzled many researchers, especially since MFIs charge relatively high interest rates. What is it that have made microfinance succeed where banks and government programs have failed? It seems like the key to success for the MFIs have been to adapt their products to their audience. Further, the relationship between the micro borrower and lender is built on trust rather than legal procedures, something that has proven vital in the types of markets where MFIs usually operate.
The relationship between the micro borrower and lender is built on trust rather than legal procedures, something that has proven vital in the types of markets where MFIs usually operate.
Most well-known among the strategies MFIs use is the group loan. In short, group loans are disbursed individually to a group of borrowers. The group members are together responsible for repayment – if one member defaults, the rest of the group have to repay the loan for that person. This gives the group members incentives to monitor each other and some of the operational costs can be thus be transferred to the borrowers. The groups are generally formed voluntarily and consist of members that already know and therefor trust each other.
Other common strategies is progressive lending – the practice of giving a very small first loan to new borrowers with an implicit agreement of a bigger loan in the future if the first is repaid according to schedule, and frequent repayments. Often, repayments are done as often as every week and they normally starts immediately – already in the first week is a common practice. Many of the borrowers are not used to handle large amounts of cash and frequent repayment reduces the risk of the borrowers getting tempted to spend their extra cash on something else and also protects them from friends and relatives that tries to pressure them for money.
The only cow in a family can be used of a form of collateral.
An additional success factor is a more flexible view on collaterals compared to traditional banks. Most of the micro borrowers do not own the kind of assets that normally are used for collateral. However, most still have assets that are very important for them. If for example a family has only one cow, the value of the cow for that family is high and they will do a lot to be able to keep it. Hence, the cow consists a good collateral even if the market value of the cow is lower than the value of the loan.
Interest rates are usually higher than those charged by formal sector banks, but are substantially lower than those charged by informal moneylenders. The higher interest rates persist even though the above mentioned strategies have reduced the risk compared to what is normally is associated with this type of clients. This is because the operational costs are still very high, and more important, not proportional to loan size. Rates therefore are higher for the very small loans that often are provided by MFIs. For instance, if the operational cost of a loan is $20, this means that for a loan of $200 with a loan term of six months, the interest rate have to be at least 20% per annum to cover only the operational costs. For a loan of $2 000 given out for one year on the other hand, an interest rate of 1% is sufficient for covering the operational costs.
Learn more about the different strategies MFIs use in this article:
Sengupta, R., & Aubuchon, C. P. (2008). The microfinance revolution: An overview. Federal Reserve Bank of St. Louis Review. https://research.stlouisfed.org/publications/review/08/01/Sengupta.pdf