Everything I always wanted to know about microfinance …

As we look back at the milestones leading to microfinance as we know it today, an exciting and impressive chapter in the history of development cooperation unfolds. Here is the chronicle in a nutshell.

In simplified terms, during the sixties and seventies, the donor countries injected capital on an immense scale into the development banks of Third World countries under the catchword “financing development”. In turn, these banks allocated the funds to small entrepreneurs and farmers via heavily subsidised credit programmes, many of which must ultimately be deemed failures.

In the eighties, the absence of financial systems increasingly came to be seen as an obstacle to development. At the same time, however, the pendulum swung towards the promotion of isolated loan programmes launched as revolving credit funds by non-governmental organisations within the scope of integrated poverty reduction projects. Important business and regulatory criteria were disregarded, the result being the successive evaporation of these funds, leaving little in the way of sustainable results in their wake. The nineties ushered in a widely applauded paradigm change in the finance sector of development cooperation. Nowadays, many people even hail it as a “microfinance revolution”.

Two aspects were of paramount importance in this regard:

1. The prevailing opinion that the poor needed subsidised financial services was shattered. Instead, development cooperation practitioners realised that the core elements of “sustainability“ and “viability” are completely compatible with “pro-poor” strategies. In other words, it became obvious that financial systems and services for low-income groups can be designed and offered on a viable basis, i.e. with a view to covering costs and making profits (“development finance”).
2. The poor need a wide range of financial services. Empirical evidence has demonstrated – quite surprisingly – that the poor are first and foremost seeking suitable and diversified savings facilities. In fact, this demand can outstrip the demand for loans (see the piggy bank cartoon, representing a broad variety of different savings facilities). (Link)

To sum up, perhaps the chief conclusion drawn by the microfinance profession is that the poor are potentially "bankable". The conviction has grown that the poor can be regarded as equal business partners, even for profit-oriented financial institutions. The root of the problem, however, is the lack of or inadequate customer orientation and financial technology on the side of the financial institutions. Simple, quick, readily available, market-oriented and competitive financial products and procedures will help to overcome the perceived core problems of "high costs" and "high risks" associated with the poor.

At the forefront of the discussion on microfinance is the Consultative Group to Assist the Poor (CGAP). (Link) CGAP is a consortium of 28 public and private donors and development institutions (such as ILO, the World Bank, UNDP, BMZ, KFW, GTZ, etc.) and has established itself as the leading and most influential think tank on microfinance. Among other things, CGAP has come up with recommendations and criteria for development organisations and donors active in this sector.

CGAP summarised the following key principles of microfinance in the most recent edition of the so-called Pink Book in 2004:

1. Poor people need a variety of financial services, not just loans. In addition to credit, they want savings, insurance and money transfer services.
2. Microfinance is a powerful tool to fight poverty. Poor households use financial services to raise income, build their assets and cushion themselves against external shocks.
3. Microfinance means building financial systems that serve the poor. Microfinance will reach its full potential only if it is integrated into a country's mainstream financial system.
4. Microfinance can pay for itself, and must do so if it is to reach very large numbers of poor people.
5. Microfinance is about building permanent local financial institutions that can attract domestic deposits, recycle them into loans, and provide other financial services.
6. Microcredit is not always the answer. Other kinds of support may work better for people who are so destitute that they are without income or means of repayment.
7. Interest rate ceilings hurt poor people by making it harder for them to get credit. Making many small loans costs more than making a few large ones. Interest rate ceilings prevent microfinance institutions from covering their costs, and thereby choke off the supply of credit for poor people.
8. The job of government is to enable financial services, not to provide them directly. Governments can almost never do a good job of lending, but they can set a supporting policy environment.
9. Donor funds should complement private capital, not compete with it. Donor subsidies should be temporary start-up support designed to get an institution to the point where it can tap private funding sources, such as deposits.
10. The key bottleneck is the shortage of strong institutions and managers. Donors should focus their support on building capacity.
11. Microfinance works best when it measures – and discloses - its performance. Reporting not only helps stakeholders judge costs and benefits, but it also improves performance. MFIs need to produce accurate and comparable reporting on financial performance (e.g. loan repayment and cost recovery) as well as social performance (e.g. number and poverty level of clients being served).

In the Pink Book, CGAP stresses that a number of what it calls ‘frontier issues’ remain unresolved, for which effective and replicable strategies must be developed. These include services in connection with rural finance, microinsurance and remittances to poor customers, where innovative solutions are still required.

In order to do justice to the growing role of the instrument of microfinance as a contribution to the Millennium Development Goals, due to be met by the year 2015, UN Secretary-General Kofi Annan declared 2005 the International Year of Microcredit. The United Nations is thus urging development cooperation players to:

•  raise awareness of the importance of microcredit in the fight against poverty
• support, identify and communicate promising models of sustainable support for pro-poor financial services and
• promote the ongoing development of the microfinance sector.

It would be a misconception today to consider microfinance as a theme relevant only to development cooperation. A growing number of people in industrialised countries are also excluded from formal financial services such as loans and insurance. It is gradually becoming evident that urgent action is called for in this sphere. Accordingly, the German Microfinance Institute (DMI) is developing and disseminating new instruments for financing small loans for business start-ups by unemployed persons. The DMI is drawing on the experience gained in development cooperation to this end.