Various studies have been carried out on the impact of microfinance in developing countries. At one extreme end are studies arguing that microfinance has a very beneficial impact to developing countries in terms of economic empowerment.

At the other end is few writers who caution against such optimism and point out to the negative impacts that microfinance have on economic development.

In the ‘middle’ is the work that identifies beneficial impacts but argues that microfinance does not assist/empower developing countries, as is so often claimed.

We will like to consider the facts showing clearly the negative impact of microfinance in developing countries.

• What is Microfinance?
• What Is the Purpose of Microfinance?
• What Are The Negative Impact of Microfinance in Developing Countries?
• What is an Example of Microfinance?
• What Are the Benefits of Microfinance?
• What is The Difference Between a Microfinance and a Macrofinance?
• What is the Difference Between Microfinance and Commercial Bank?
• How can Microfinance Operations be Improved?

What is Microfinance?

Microfinance is a category of financial services targeting individuals and small businesses who lack access to conventional banking and related services.

Microfinance includes microcredit, the provision of small loans to poor clients; savings and checking accounts; microinsurance; and payment systems, among other branches. 

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Microfinance services are designed to reach excluded customers, usually poorer population segments, possibly socially marginalized, or geographically more isolated, and to help them become self-sufficient.

Microfinance initially had a limited definition: the provision of microloans to poor entrepreneurs and small businesses lacking access to credit.

The two main mechanisms for the delivery of financial services to such clients were: (1) relationship-based banking for individual entrepreneurs and small businesses; and (2) group-based models, where several entrepreneurs come together to apply for loans and other services as a group.

Over time, microfinance has emerged as a larger movement whose object is: “a world in which as everyone, especially the poor and socially marginalized people and households have access to a wide range of affordable, high quality financial products and services, including not just credit but also savings, insurance, payment services, and fund transfers.”

Proponents of microfinance often claim that such access will help poor people out of poverty, including participants in the Microcredit Summit Campaign.

For many, microfinance is a way to promote economic development, employment and growth through the support of micro-entrepreneurs and small businesses; for others it is a way for the poor to manage their finances more effectively and take advantage of economic opportunities while managing the risks.

Critics often point to some of the ills of micro-credit that can create indebtedness. Due to diverse contexts in which microfinance operates, and the broad range of microfinance services, it is neither possible nor wise to have a generalized view of impacts microfinance may create. Many studies have tried to assess its impacts.

What Is the Purpose of Microfinance?

The purpose of microfinance is to provide financial services to people “generally excluded from traditional banking channels because of their low, irregular and unpredictable income,” according to ING, a global financial institution with a strong European base.

In other words, the purpose of microfinance is to help disadvantaged households and entrepreneurs gain access to affordable financial services to help them finance income-generating activities, accumulate assets through savings, provide for family needs, and protect themselves against the risks of daily life, such as illness, death, theft, natural disasters, says ING.

Whether for-profit or nonprofit, microfinance seeks to assist the poor, and indeed, microfinance institutions seek to be the bankers of the poor.

For-profit microfinance companies see this sector as underserved and a great way to make a profit. By contrast, nonprofit microfinance companies seek to help the poor for altruistic reasons.

Microfinance was developed by a Bangladeshi economist Muhammad Yunus, says ING, adding that he came to be known as “the banker of the poor.” In 1976, Yunus established Grameen Bank in Bangladesh, which provided “microcredit,” literally the extension of loans to impoverished borrowers.

Before that, banks had generally concentrated only on lending to middle- and upper-income clients, as well as the very rich, of course. Yunis’ idea of microcredit caught on quickly.

It was so popular that it led to similar microfinance institutions springing up all over the world, eventually evolving into what is today known as microfinance.

For his efforts, Yunus won the 2006 Nobel Peace Prize. In awarding Yunus the peace prize, which was actually awarded jointly to Yunus and his bank, the Nobel committee noted that it was honoring Yunus and his bank “for their efforts to create economic and social development from below.”

In other words, the committee paid homage to Yunus’ concept of creating economic opportunity from the ground up.

What Are The Negative Impact of Microfinance in Developing Countries?

There is no doubt that microfinance has helped numerous people. Although the exact quantification of the impact remains difficult and contentious, many scholars take on a critical view and underestimate the potential of microfinance.

The difficulty in quantifying the impact of microfinance creates difficulties in judging the merits of the two opposing sides on the significant impacts of microfinance.

1. The international experience shows that countries with a significant presence of microfinance have not been the leaders of insecurity and poverty reduction. Eastern Asian countries with limited or no presence of microcredit have had dramatic success in reaching this target.

Research proves that this is down to egalitarian distribution achieved by radical land distribution and improved healthcare and education. 

2. An entrepreneur in a developing country faces many difficult challenges like power cuts and delivery breakdowns. Although they seem to overcome them, while an average American businessman would not be able to do so.

Also as mentioned before there are more people in entrepreneurial businesses in poor countries than rich countries. But these countries still remain poor. 

This is because countries become rich because they have the ability to channel individual entrepreneurial sources to one collective and productive enterprise.

While on the other hand a poor nation needs help to build effective and collective entrepreneurial organizations. There are many limitations in the developing nations to support individual talents.

3. Competition increases among these small businesses as more people follow the entrepreneurial path. The problem is that there are limited ranges of simple businesses in developing countries that the entrepreneurs can take on, and there is a large number of entrepreneurs in developing countries.

As all of them start a business of the same kind, competition increases enormously. Causing income to fall dramatically. These people do not own enough knowledge and education to overcome this competition, resulting in a failed business.

4. The other worse problem is that without governmental support and international donors, microfinance institutions have to charge high interest rates. 

In some countries like Mexico the interest rate can be as high as 100%. It has been proven Grameen Bank can only charge reasonable amount of interest rates because of the governmental support and international donor aid.

When in the late 1990s, Grameen Bank came under the pressure of giving up its governmental subsides, it was forced to re-launch itself and charge interest rates of 40-50%.

5. Most of the loans given by the microfinance institution are used to fulfil daily needs. For example borrowing to pay for their daughter’s wedding. But then after they have spent that money they do not have enough money or profit to repay these loans.

6. Microfinance has its own breed of loan sharks. One of Yunus’s goals was to eliminate loan sharks; lenders who grow rich by preying on the poor. But then he did not know that microfinance would breed its own loan sharks.

Trouble in microfinance began in 2005, when lenders started seeking profits on the loan by changing their status from non-profit organizations to commercial enterprises.

What is an Example of Microfinance?

For a period of time from the 1980s to the early 2000s, “microloans” were all the rage in international development.

The idea was simple enough: By giving a very small loan to someone living in a poor country, you could help them expand a small business, which would lift their family out of poverty. When they pay back the loan, the money can be cycled to more borrowers, getting more families out of poverty.

Organizations offering microcredit to poor borrowers — many living on $2 or less per day — took off in those decades. Investors and donors poured money into microcredit, hundreds of organizations offered loans, and the number of borrowers worldwide skyrocketed to 211 million by 2013.

The microcredit movement has been undeniably successful in opening up financial services to poor people across many countries. But what has its track record been when it comes to lifting people out of poverty?

Over the past decade, this question has occupied researchers, who have conducted randomized studies across a variety of countries and settings. The findings have not supported the original hope for microcredit: They can’t find evidence that the loans have been lifting families out of poverty on average.

Many concluded that the classic conception of microcredit was based much more on anecdotes than on robust evidence. Those results have in turn cooled the development community’s enthusiasm for microcredit.

But does this mean that microcredit has been a failure? Hardly.

Rather than see microcredit as it was portrayed in its heyday — as a way to get people out of poverty — we should see it through a different lens: as a way to expand options for poor people by offering more reliable financial services.

Extremely poor people need these services just like everyone else, and the availability of capital to deal with irregular and at times unpredictable incomes is a huge help to them. This benefit, along with its impressive growth around the world, arguably makes microcredit a success.

Financial diaries of people living on $2 or less per day have shown that microcredit helps many families deal with emergencies, make critical purchases that they couldn’t otherwise afford, and put food on the table in times of scarcity.

While the new story about microcredit isn’t the one that propelled it to such heights, it’s much more grounded in evidence and, in many ways, it’s still inspiring.

What Are the Benefits of Microfinance?

There are literally dozens of benefits for microfinance, but the key pluses involve the role of microfinance in economic development. Vitanna.org and Plan International provide possibly the top benefits of microfinance:

1. It allows people to provide for their families. Through microfinance, more households are able to expand their current opportunities so that more income accumulation may occur, says Vitanna.org, a financial services website.
2. It gives people access to credit. “By extending microfinance opportunities, people have access to small amounts of credit, which can then stop poverty at a rapid pace,” says Vitanna.org. Plan International, a global organization dedicated to advancing children’s rights and equality for women, agrees, stating: “Banks simply won’t extend loans to those with little or no assets, and generally don’t engage in the small size of loans typically associated with microfinancing. Microfinancing is based on the philosophy that even small amounts of credit can help end the cycle of poverty.”
3. It serves those who are often overlooked in society.  About 95 percent of some loan products extended by microfinance institutions are given to women, as well as those with disabilities, those who are unemployed, and even those who simply beg to meet their basic needs, Vitanna notes. Microfinance services can help recipients take control of their own lives.
4. It creates the possibility of future investments. Microfinance disrupts the cycle of poverty by making more money available. When basic needs are met, families can then invest in better housing, health care, and even, eventually, small business opportunities.
5. It is sustainable.  There’s little risk with a $100 or loan, says Vitanna, adding: “Yet $100 could be enough for an entrepreneur in a developing country to pull themselves out of poverty.” Plan International agrees, stating that a $100 loan can be enough to launch a small business in a developing country that could help the benefactor pull herself and her family out of poverty.
6. It can create jobs. Microfinance is also able to let entrepreneurs in impoverished communities and developing countries create new employment opportunities for others.
7. It encourages people to save. “When people have their basic needs met, the natural inclination is for them to save the leftover earnings for a future emergency,” says Vitanna.
8. It offers significant economic gains even if income levels remain the same. The gains from participation in a microfinance program including access to better nutrition, higher levels of consumption, and eventually, growing economies, even in small and impoverished communities.
9. It leads to better loan repayment rates. “Microfinance tends to target women borrowers, who are statistically less likely to default on their loans than men. So these loans help empower women, and they are often safer investments for those loaning the funds,” says Plan International. 
10. It extends education. Families receiving microfinance services are less likely to pull their children out of school for economic reasons, says Plan International.

Microfinance, then, may involve very small loans and financial services, but it has a worldwide impact over the last four-plus decades.

What is The Difference Between a Microfinance and a Macrofinance?

Microfinance and macrofinance represent two types of funding-related activities. The difference lies in their scope.

Microfinance is an individual-focused, community-based approach to provide money and/or financial services to poor individuals or small businesses that lack access to mainstream or conventional resources.

By contrast, macrofinance deals with an economy or an overall social structure. It involves drafting policies, initiating programs like subsidies, or funding and operating multi-year economic development plans and projects that will generate employment or kick-start industry.

A $100 loan to an uneducated slum-dweller enabling her to buy necessary equipment for making ceramics would be an example of microfinance; a government financing the construction of a million-dollar hydropower dam that employs thousands of people would constitute macrofinance.

Other major differences between microfinance and macrofinance include the following:

• Microfinance institutions (MFI), self-help groups (SHG), and non-governmental organizations (NGO) are the primary funders in the microfinance sector. However, public sector banks, for-profit organizations, and private consumer finance companies are starting to be involved as well. On the other hand, macrofinance involves bigger entities such as governments, local authorities, large corporations, banks, and established businesses.
• The amount of money involved in macrofinance is significantly larger than that in microfinance initiatives. And the scale of operations varies widely: Microfinancing can provide a $300 loan to a work-for-hire mason to set up his own brick kiln, while macrofinancing for large projects like a dam or road construction offers hundreds of local masons employment for a few years.
• Microfinancing is usually a continuous ongoing activity without any defined end. A $50 loan available today to a fisherman for buying fishing nets can be extended to $500 tomorrow to help him buy a boat; or, once this fisherman becomes self-reliant and repays his microfinance loan, the money can be moved to another eligible individual. However, macrofinance projects have a definitive time period, such as subsidies offered only for three years or a road-building project to be completed in five years. 
• Microfinance aims at making individuals self-reliant. Say a Bangladeshi tailor takes a $100 loan to buy a sewing machine. As her tailoring business progresses, she may establish a showroom and even employ a few individuals. On the other hand, macrofinance aims to improve the overall economy. For example, the government offering subsidies on fertilizers to all cotton farmers aims to increase cotton cultivation, build a textile industry, and help everyone economically. 
• Microfinancing carries the risk of default by individuals, while macrofinancing faces challenges from corruption or non-implementation of efficient policies.
• Microfinancing offers other social benefits imposed by terms of the loan. For example, the terms might stipulate that borrowers save a part of their income for the future or spend no part of the loan on alcohol. Macrofinancing, on the other hand, enables large-scale employment and development of new sectors and businesses but does not guarantee the betterment of an individual.

What is the Difference Between Microfinance and Commercial Bank?

Microfinance institutions all begin with value capital. Aid organizations, depositors and banks all borrow them money.

They borrowed according to their ability in terms of payback schedule, amount and interest rate without going beyond thresholds risk put up by conglomerates of lenders, the board of directors and management, also not breaking regulations set by local banking.

Microfinance bank owns divisional offices that being headed by credit officers who have cordial affairs with members of the community to deliberate on microfinance institutions’ products loan with them.

They also take back interest and major payback if those that borrow money must pay back in cash, which they have no means to take it to the divisional offices. The head office and marketing department are the determinants of the loan approval processes.

Which is subsequently implemented by the marketing department, department of operations, credit, and product department at the head office, divisional office staff inclusive.

There are microfinance that are non-profit oriented, but these are just an exception, not the norm. Although many microfinance kick-off as non-profits later transformed to for-profits. Investors are profit-motivated such are microfinance owners.

Sometimes socially motivated funds are used by the owners to make investments, not always the norm. Microfinance heads such as CEOs, COOs and CFOs are in mindsets similar to the managers of same sized banks in countries like U.S or another country.

They give back value to shareholders through planning to execute plans drafted with the concerted effort of the board of directors. To achieve this there is need to build a profitable, effective and lasting organization that earns respect and trust from its customers, lenders, workers and rural regulators.

Some managers do feel concerned on building their countries to create opportunities for their people. While some don’t care. Putting their interest rates may be thirty percent annually and their motives for profit-making, the importance of microfinance is obvious looking at the other options costumers would opt-in for if microfinance are not in existence.

These other options could be local money lenders that lend money at an interest rate not less than 500% per annum.

Commercial banks as a financial institution are established based on the banking regulation act. They function solely to accept money and lend money out to costumers. Other functions include brokerage, insurance, stocks, security, etc.

All of these are non-banking activities. Commercial banks are profit-oriented. Among the characteristics of commercial banks are dividends, payment of tax, registration, etc.

Microfinance is not profit-minded. The activity in microfinance is done more in a group. Each member of the group has savings, thus the microfinance aims at giving the loan to any member of the group.

The group ensures the money is being used and the group member earns profit from any income making enterprises they engage in. Each and every member of the group is entitled to loan or perhaps get a loan.

This, in turn, self-sustain the group. Unlike a commercial bank, microfinance is devoid of registration, dividends, and taxation.

GENERAL DIFFERENCE

They deal with different costumers in terms of definition. Microfinance renders financial assistance and or gives loans to low-income earners of local families. While commercial banks, on the other hand, give loans to people and big organizations that open accounts with them. The worth of note is that their difference per se is based on the costumers they deal with not even the magnitude of the loan.

SPECIFIC DIFFERENCE

MFIs basically lend money, funded by private equity holders and or individuals. So, sources of funds for microfinance institutions can different from private equity holders to individuals. Commercial banks offer financial services range from lending, savings to insurance and pensions. Commercial banks are funded through stock markets.

Microfinance services are DOOR STEP that is, their staffs take financial services to customers ’ doorsteps. Whereas commercial bank services are BANK DOOR services, that is, the costumers have to go to the bank to carry out any financial services.

Commercial banks’ loan risk is quite low. Thus, charge lower interest rates ranging from 10% to 16%. This low loan risk is predicated on the fact that they deal with people of high level of income. Contrastingly, the microfinance loan interest rate is high say 20%-25% due to the fact that they operate collateral-free loans, also the loanees are riskier.
Among other differences are dynamics in manpower, structures of governance, use of or ICT use, physical presence, etc.

History recorded that in India, commercial banks do not understand the requirements of the local market. This birth the idea of micro-financial institutions. They offer financial help to local families of low income that couldn’t transact business with commercial banks. With free collateral loans, they offer financial services to several poor people.

Whereas commercial banks cannot cope with the high risk of the given loans to the poor that residents in rural areas whose small loans are hard to maintain in terms of cost. The challenges of commercial banks, microfinance rose to conquer by giving loans to the destitute.

Microfinance help the poor in the remote areas to scale up their business by giving them small loans. No provision of other facilities like insurance, cash withdrawal from automated teller machines, credit/debit card provision, etc. Whereas such services are available in commercial banks. Commercial banks also help to manage customer cash, give reports on their accounts, etc.

There is no collateral-free loan in commercial banks. Microfinance give collateral-free loans. There’s extensive scrutiny in commercial banks before issuing out the loan. Such scrutiny is not available in Microfinance.

In terms of deposit, some amount has to be deposited to the microfinance before they give out loans to any group members. Whereas in commercial banks the depositor is required to pay a fixed rate of interest corresponding to specific amount to be given out as a loan

Microfinance seek to bridge the gap in the segment of the society not touch by commercial banks which exposed them to private borrowers. Commercial banks’ lending operations cover areas like renewable energy, agriculture, housing, micro, small and medium enterprises, education, etc.

They also differ in their approaches to risk management. Microfinance manage risk by contacting their customers often. Also, train their staff (off-field staff) and customers. Self-deserved, as well as an imposed risk management system that is advanced, are used in commercial banks.

To meet up with their cost and make service available are reasons microfinance charge rates are higher than other banks.

However, the local money lenders whose interest rates can be up to thousands received far above this from people.
The microfinance still face challenges sustaining themselves in the rural areas. A case study that exposed the microfinance environment is the Andhra Pradesh microfinance saga.

Microfinance are not profits oriented, experts in giving loans to people in local communities, be it group or individual. They are into micro-financing and do not lend huge money to customers.

On the other hand, commercial banks do a wide range of financial services corporate bodies and individuals. They are profit-minded. They offer other financial services like guarantees, savings, credits letters, etc.

How can Microfinance Operations be Improved?

Agents instead of branches

Agents can help microfinance operate more efficiently and increase their customer outreach if managed well. A recent publication from the International Finance Corporation based on its work with nine microfinance in Africa, shows the cost of handling transactions via agents is about 25 percent lower than through branches.

Yet managing an agent network can still be costly, so it is important to do it carefully and build slowly. GSMA estimates that mature mobile network operations run by mobile network operators (MNOs) on average pay out 54.4 percent of total revenues in agent commissions. This is an expensive business to run.

The focus should be on recruiting active agents who deliver volume rather than on boosting agent numbers. It is a classic mistake to try to grab market share by opening as many agents as possible all at once. Many big players, including banks, MNOs and MFIs, have failed by making this mistake.

Agents introduce new risks for microfinance, particularly operational risks, and these should be thoroughly understood before moving into agent banking.

Invest in a flexible IT solution

IT systems, not bricks and mortar, are the biggest legacy costs of banking. You can close a branch relatively easily, but as anyone who’s been through an IT system migration knows, it’s a lot harder to switch IT systems. Most MFIs have IT systems that are cobbled together, don’t speak to each other and require work-arounds.

Invest in a good IT system that has the flexibility to grow with the business into the future. There are good companies out there that can provide useful services in this area, including companies that specialize in technology solutions for microfinance.

Digitize your data going forward, not backward

Many MFIs still keep paper records. They have an incredible amount of data collecting dust on their shelves. While digitizing all of that data might be useful, it can also be overwhelming. Rather than getting bogged down with digitizing old data, microfinance should prioritize investing in data management systems that will allow them to start capturing data going forward.

Figuring out how to structure the data so they are useful and finding ways to efficiently and accurately collect data electronically should be the priorities. Digitizing the old data is a bonus.

Given the challenges of digitizing their own data, some microfinance has explored algorithmic scoring of unstructured third-party data, such as call records and social media feeds. We would suggest that microfinance might want to invest in using their own data well before exploring third-party data sources.

Microfinance’s own data are likely to be of higher quality and more predictive, and they own the data and can use the data as they wish — for credit underwriting, but also for gaining better insights into customers and understanding the impact that taking credit has on their lives. Data will be a powerful driver of financial services delivery in the future, so the sooner microfinance grasp this nettle, the better.

Be customer-centric

Really understand your customers’ needs and build your digital products and services around fulfilling them. Think of this not only in terms of what services you provide, but also how you provide them. Research shows that there is a strong link between customer satisfaction and business performance. 

CGAP’s Customer-Centric Guide addresses some of the core challenges and opportunities financial institutions face. Remember that one of microfinance’s comparative advantages is precisely that it is not an algorithm. Microfinance are close to their customers and know their needs, and this potentially gives them a longer-term advantage over new digital rivals.

Interestingly, a recent CGAP study on digital credit in Tanzania showed that two-thirds of digital credit borrowers had not reduced their use of formal loans after taking digital credit, and 60 percent of digital credit borrowers surveyed used formal loans for business purposes such as investment or payroll. Digital credit is not necessarily a substitute for microfinance.

Access digital infrastructure through partnerships

MFIs are never going to be systematically important payments players like MNOs and banks, but that does not mean they cannot leverage this digital infrastructure through partnerships. Microfinance have two things that these large organizations want and need: a license and a customer base.

It is worth remembering that CBA, a small corporate bank in Kenya, became the country’s largest bank by customer numbers virtually overnight thanks to its partnership with M-Pesa on M-Shwari. But it is also worth remembering that the big players are rarely going to knock down microfinance doors to work with them.

Read Also: Foreign Investment and its Effects on Economic Growth in Developing Countries

And if they do, they will be negotiating from pure self-interest. Most microfinance are ill-equipped to handle these negotiations, so it is important to stay educated about the larger ecosystem and the technological and business trends driving it.

Finally

Microfinance has a relatively good track record of serving the poor in a socially responsible way. But it must adapt to continue serving those customers in the face of new and very different competition. To be successful, microfinance will need to tackle this challenge head-on.

For a small business that needs just a bit of extra cash or credit to secure a new opportunity, microfinance may be just the ticket. And for a small lending or banking business looking for new opportunities, microfinance literally offers a world of opportunities – one small loan or financial service at a time.