What is microfinance?

Microfinance is the supply of loans, savings and other financial services to the poor. The term “micro” is in reference to the small amounts typically involved in the practice. These services are small – “micro” – because a person who does not have a lot of money most likely will not need a loan of several thousand dollars. However, a loan of a few hundred dollars may make a huge difference in their lives, giving them the ability to purchase livestock for a small farm, a sewing machine to help make accessories and clothes, or supplies for a small store, for example.

The poor throughout the developing world frequently are not part of the formal employment sector. They may operate small businesses, work on small farms or work for themselves or others in a variety of businesses. Many start their own “micro” businesses, or small businesses, out of necessity, because of the lack of jobs available.

What is a microfinance institution?

A microfinance institution (MFI) is an organization that provides microfinance services – loans, savings, maybe even insurance – to the world’s poor. An MFI can operate as a nonprofit such as a non government organization (NGO), credit cooperative, non bank financial institution (NBFI), or even a formal, regulated for profit bank.

MFIs differ in size and reach; some serve a few thousand clients in their immediate geographical area, while others serve hundreds of thousands, even millions, in a large geographical region, through numerous branches. Many MFIs offer services beyond loans and savings, including education on business and financial issues and social services focused on health and children.

Why don’t poor people just use traditional banks?

Poor people in developing countries usually do not qualify for any type of services from the formal banking sector: they typically have no credit history, and most are not employed in the formal sector, so there is no record of employment. Moreover, they are unable to provide collateral. And in many parts of the world, opening a savings account at a traditional bank requires a certain amount of money be deposited, and poor people, although statistically excellent savers, do not have the large sum of money required to open a savings account.

Yet, people living in poverty, like everyone else, need access to a diverse range of financial services to help run a small business, manage risks, and plan for a more stable future.

Why are microcredit interest rates so high?

Like other financial institutions, MFIs charge an interest rate for the loans they give their clients. This is a way for the MFI to be self-sustaining so that it can be a stable, long term provider of finances in its area of operations. A self-sustaining MFI is critical to the health of the sector and for it to continue to provide microfinance services to its clients. However, because managing many small loans costs more money for any institution than managing one large loan, an MFI typically needs to charge higher interest rates to cover their costs.

What are some of the ways that people use their microfinance loans?

The ways in which people use their loans vary as much as the ways people earn a living. Some buy livestock; a sewing machine and fabric to make cloths and accessories; stock for a local store; a tractor or seed and other farming equipment and supplies. The possibilities are endless as to what a micro-entrepreneur can do with his or her loan.

Are poor people able to repay their loans?

Microfinance clients have excellent track records for repayment. Repayment rates for microfinance loans on a global level average about 97 percent.

Aren’t the poor too poor to save?

The poor already save in ways that we may not consider as “normal” savings - investing in assets, for example, that can be easily exchanged for cash in the future (domestic animals for instance). After all, they face the same series of sudden demands that we all face: illness, housing repairs, school fees, burial fees.

Does microfinance really help solve poverty?

Poverty is a very complicated issue, and many different approaches and tools are required to address it. Microfinance is one tool that is appropriate for millions of the working poor to lift themselves out of poverty. However, microfinance is not the only answer, and in fact is not always appropriate. For instance for the extreme poor, or those who are sick and/or unable to work, microfinance may not be an appropriate tool.

What does SKS do?

Our core business is distributing income generation and productivity loans that begin at Rs. 2,000 to Rs.12,000 (about $44-$260) to poor women so they can start and expand simple businesses and increase their incomes. Their micro-enterprises range from raising cows and goats in order to sell their milk, to opening a village tea stall. SKS does not distribute consumer loans to buy, for example, gold, televisions or clothing.

SKS also distributes and administers micro-insurance to the poor as well as financing for other goods and services that can help them combat poverty.

Who are SKS’s customers? How do they get loans?

SKS offers loansonly to poor women in India who typically make less than $2 a day when they join as borrowers. The majority of SKS customers are in rural India, across 19 states. Loan officers assess whether potential borrowers fall below the poverty line.

SKS uses the joint liability group lending model where women guarantee each other’s loans. Over three days, borrowers undergo financial literacy training and must pass a test before they canapply for loan. SKS approves new loans based on initial screening ofthe applicant and approval of the other members in the group. . Weekly meetings with borrowers in their villages follow a highly disciplined approach. Re-payment rates on our collateral-free loans are more than 99% because of this systematic process.

Why does SKS lend only to women?

There are three reasons why SKS lends only to women. Women tend to use resources more productively than men; they are more likely to invest most of their income back into the household; and they are more likely to avoid risky ventures and instead use loans to undertake small, manageable activities. Women have demonstrated themselves to be excellent microfinance customers. By providing loans to women, SKS expects to see a rise in household income that benefits the entire family.

What does SKS do besides distribute loans?

Through its distribution network, SKS also distributes and administersmicro-insurance to the poor as well as financing for other goods and services that can help them fight poverty. We work with Indian insurer Bajaj Allianz to offer life insurance to our borrowers, and with Nokia and Airtel to help borrowers finance mobile phones. SKS is working with Metro, the German wholesaler, to help finance quality inventory for the small shops of our borrowers so poor people can access quality goods at lower prices. We are piloting housing loans with technology and financial assistance from HDFC and have also piloted financing of water purifiers and solar lamps.

What is your interest rate?

"SKS charges 19.75% of annual effective interest rate.(excluding processing fee)"

This seems high. How do you set your interest rates?

At face value, these rates may seem high but it is expensive to distribute micro-loans, which is why many conventional banks don’t do it themselves.

In India, government regulations prohibit microfinance institutions from accepting savings deposits. Therefore, we have to borrow funds from commercial banks to on-lend to our customers. Banks typically charge us 11-14% interest to borrow funds.

Next, our loan officers must travel to remote rural villages by motorbike and manually distribute loans and collect payments from our women borrowers at their doorstep each week. This is a labor-intensive and costly process.

Can a poor person pay off a loan with such a high interest rate?

They can and do. At SKS, re-payment rates are more than 99%. For many poor people, their only option for financial services is a local moneylender who can charge rates as high as 40%-70% or more.

Our borrowers can comfortably repay because when they start a micro-business -- whether selling vegetables or raising livestock -- their return on investment (ROI) is very high, This is because they have low overhead costs, no tax or legal costs, and are able to quickly increase their incomes with even a small amount of start-up capital.

Even if a poor person has access to a rural bank, they have to pay transportation costs to reach the branch and often lose wages because of the time spent traveling from village to bank. Considering these factors, the cost of a bank loan, or “total cost of borrowing”, is higher than its stated interest rate.

SKS hopes to lower interest rates and has already done so in states where we have reduced our cost of operations. We have urged the Indian government to allow banking via mobile phones and we recommend that microfinance institutions be allowed to accept savings. These kinds of policy reforms would bring down the cost of microfinance loans and allow SKS to pass savings on to borrowers by lowering interest rates.

Is over-indebtedness a problem among microfinance borrowers?

We are very concerned when borrowers cannot comfortably repay their loans and we try our best to protect the interests of our borrowers and ensure that defaults do not occur. But although there are incidences of default, these cases are a small percentage of the overall loan portfolio at both SKS and in the industry.

SKS served 5.3 million clients as of September 2009 and has maintained repayment rate of more than 99%.

Microfinance institutions in India served 22 million clients in 2009 and have consistent repayments rates of 95% and above—repayments that clients could not make if they were not generating regular income, given the weekly repayment schedule that most microfinance institutions follow.

The Microfinance Information Exchange (MIX), the Washington-based non-profit information platform, reports that the average repayment rate of leading MFIs in India which have the lion’s share of clients— is 98%.

How do you know a borrower understands the terms of her loan? How do you protect the interests of your
   clients and ensure against over-indebtedness?

We have many measures in place to protect the interests of our borrowers. We first require potential members to take financial literacy training and pass a test over three days to demonstrate they understand interest rates, loan installments, and re-payment schedules. We make small loans exclusively for income-generating activities, not for consumption. We lend only to women who borrow in interdependent groups of five. Women tend to be more careful with their use of loans than men.

Our loan officers have never been incentivized by collection rates or the size of loans disbursed. SKS emphasizes fair loan collection practices when we train loan officers. We condemn strong-arm collection practices.

SKS is committed to transparency on interest rates. Loan officers disclose interest rates to potential borrowers and we print this information in the SKS passbooks carried by each customer.

SKS has also taken the lead on transparency and code of conduct initiatives, such as the global Smart Campaign launched in 2009 by the Center for Financial Inclusion in Washington.

SKS is also part of MFIN, a new microfinance industry association launched in India in early 2010. MFIN has adopted a self-regulatory code of conduct, which includes limiting borrowers’ group loan sizes to less than Rs. 50,000 total from three microfinance institutions; sharing data with credit bureaus; and a whistleblower policy on code of conduct violations, among other guidelines. MFIN has also pledged investment of Rs. 2 crore (about $434,000) to set up a new microfinance credit bureau, which aims to check over-indebtedness and multiple borrowing.

Are there research reports and studies that show the impact of microfinance?

There are several studies that are publicly available. The Small Industries Development Bank of India (SIDBI) in 2008 released a seven-year survey that suggested significant improvement in the households of microfinance borrowers.

The Maturing of Indian Microfinance, 2004. A five-year commissioned study by consultancy EDA-Rural Systems surveyed approximately 5,400 households to compare conditions of microfinance borrowers and non-borrowers. The results suggest that there are material poverty-reducing effects from microfinance.

Profiling of Micro Enterprises in Tamil Nadu and Uttar Pradesh, 2005, a report by the Institute for Financial Management and Research Centre for Micro Finance in Chennai , shows how borrowers profited from their micro-businesses.

The 2008 Report of the Committee on Financial Inclusion from the Chairman of the Prime Minister’s Economic Advisory talks broadly about the importance of financial inclusion for the poor.

How has SKS created a scalable model of microfinance?

Most microfinance institutions have difficulty in scaling up. SKS identified and addressed three constraints to scaling up: capital, capacity and costs.

Capital: In 2005, SKS transformed into a non-banking financial company, which helped attract commercial capital and increased access to debt through banks. With access to capital, the organization was able to grow geographically and increase its reach.

Capacity: By adopting best practices from the business world, SKS has been able to scale up operations. Processes were standardized, beginning with loan amounts and loan collection. A disciplined methodology of distribution and payment is instilled in loan officers and borrowers.

Costs: Early on, SKS launched a robust database to make collection and accounting more efficient, accurate and transparent. Standardization was also applied to recruitment and training of employees.

Since distributing loans to the poor is an expensive and labor-intensive process, SKS uses technology to bring down transaction costs and manage huge databases with minimum error. A major early investment in a robust IT system and database helped to make the business more efficient.

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