Web Lesson1

Fundamental Concepts In this Lesson This lesson introduces you to the world of microfinance. It highlights the fundamental concepts and provides the building blocks for subsequent lessons. Microfinance aims to reach the poor with financial services; this outreach goal can only be met on a sustainable basis through permanent, viable institutions. Microfinance operations that respect core principles can both attain this objective and have a sustainable impact on their clients and the local economy as a whole. Microfinance has taken up this challenge, and in doing so has evolved from directed credit programs towards market-responsive financial institutions.

In Depth Microfinance Many associate microfinance with the provision of small loans to the poor. Both the product (loans) and the market (the poor) fall within the purview of microfinance, but they are more its origins than its present and future. The microfinance industry has developed from a history of microcredit programmes; yet, today, it has grown to cover a broader range of products and services, from credit and savings, to insurance and money transfers. Today, many speak in more general terms of microfinance as the provision of financial services to those excluded from the formal financial system. This broad definition pushes thinking about products as well as the markets that they serve. The services noted here hint at the potential breadth of 'microfinancial' services. Reaching "those excluded from formal financial services" means an expanding focus for microfinance. Systems of exclusion are based not just on lack of wealth, but also on social, cultural and gender barriers to financial services. Effective microfinance is positioned to overcome a variety of access barriers to a wide range of financial services for the many different customers who are excluded from the formal financial system.

Microfinance reaching down Recent research highlights the various levels of poverty of the client groups reached by microfinance services. Importantly, this research recognizes that poor and low-income people slip from one poverty category to another as opportunities and risks change. This is particularly so for the "vulnerable non-poor", who are positioned just above the poverty line. This client research helps shed light on the levels of poverty at which more poor people are reached by today's successful MFIs. Interestingly, in client self assessments, most microfinance customers identified themselves in the groups just above or below the poverty line. Sustainable microfinance services rarely reached the destitute. As later discussions will suggest, the lack of economic opportunity would preclude debt from being a valuable tool for this group. A loan is a valuable financial tool for those who have the capacity to repay it.

Debt and economic opportunity A shift from the concept of ‘credit need’ to ‘repayment capacity’ limits risk to MFIs and lowers unbearable debt burdens for their clients. Incurring debt involves payment of principal as well as the costs of the lender to administer it. Only investments with pay offs that can cover these costs should be considered for debt financing. These investments can be immediate or in the future, individual businesses or a range of household economic activities. These economic opportunities are the primary targets for credit services.

Viability, self-sufficiency and microfinance terminology This lesson has presented the concepts of viability and self-sufficiency related to the goals of microfinance. Institutional viability and financial viability are key concepts in microfinance. Two concepts first introduced by donors, operational self-sufficiency (OSS) and financial self-sufficiency (FSS) were also explored. Definitions of operational self-sufficiency (OSS) vary. As presented here, OSS includes all the cash costs of running an MFI, as well as depreciation, and the loan loss reserve. In other instances, some donors will exclude the cash costs of funds from their analysis. They do so because those MFIs that begin to access the commercial financial markets and pay a cost of capital would look relatively worse than other institutions with the same costs and outreach, but who have remained reliant on donor capital to fund their portfolio. These two variant, yet common uses of the same term underscore the need to always understand the equation behind ratios when comparing numbers across institutions. These terms, created by donors, serve as benchmarking standards for comparison across the industry. More conventional financial terminology, such as Adjusted Return on Assets, is presented in later lessons. Use the glossary in the back of this workbook, or click on the “ABC” icon on your CBI to familiarize yourself with these terms as they are used in the world of microfinance.

Financial viability and access to capital markets A financially viable institution covers its operational and financi al costs. Covering financial costs is a necessary hurdle for access to capital markets: equity investments, savings deposit mobilization, and accessing commercial liabilities. Access to capital means that an MFI can grow with its clientele, increasing its loan portfolio fewer capital constraints or less reliance on donor capital. Though financial viability is a necessary conditi on for accessing commercial capital, it is not a sufficient condition. Many financially viable MFIs still struggle to secure co mmercial debt as their portfolios of unsecured lending are still viewed as risky by many traditional banking establishments.

Current Discussions Over the years, the dual goal of sustainability and outreach has generated considerable debate within the microfinance field. Some argue that the two goals are not complementary, but rather the pursuit of sustainability undermines the institution’s ability to serve the poor. Does a focus on sustainability really secure access to quality financial services for those who are excluded from the financial system, including the poorest? As institutions move toward profitability, do they move away from the poor clients Those who contend that there is a trade-off between sustainability and outreach argue that the push for MFIs to cover costs, become sustainable and wean themselves from donor financing moves MFIs away from providing services to the poor. The poorest clients, some argue, cannot afford to pay for the full cost of these services in the long run. The argument follows that the push for sustainability and the demands this places on the institution will decrease outreach, leaving the poor unserved by new MFIs, and abandoned by those MFIs who counted the poor among their clients when the MFI was subsidized by donors For proponents of sustainability, large-scale outreach is possible only through building permanent, viable institutions that respond to the demand for financial services by their customers. Only MFIs with a long-term horizon can make a dent in the huge demand for financial services for the vast majority of poor and low-income people who lack access to formal financial services. Relying on subsidies in the long term, they argue, allows donors and governments to build weak institutions that respond to the sponsors, not the customers. These institutions remain isolated from the financial system and will vanish when the subsidy stops. Sustainable, donor independent MFIs will have the market responsiveness required to continue services to their original customer base as well as expand services to similar customers elsewhere. Each of these arguments is rooted in the underpinning philosophies of microfinance. On one side of the spectrum is a philosophy that views microfinance as the commercialization of social welfare. Here, microfinance is viewed in the larger context of resource distribution to the poor. In this sense, microfinance as a public good requires direct intervention to ensure that those who benefit are the poorest members of society. On the other side of the spectrum is a market-oriented philosophy that views microfinance as deepening the financial system. Microfinance is another segment of the market for financial services— a market segment that has been excluded because the financial system is dysfunctional or formal sector institutions have not yet been able to reach this market because of lack of know-how. With initial public sector investment,

a variety of sustainable institutions offering microfinance products and services will contribute to a healthy financial system that serves the majority of poor and low-income customers, and over the long run the financial sector will generate public sector resources through the tax base. For an excellent discussion of this topic, read Elisabeth Rhyne’s article on the poverty and sustainability debate

Recommended Reading Rhyne, Elisabeth. “The Ying and Yang of Microfinance: Reaching the Poor and Sustainability”, MicroBanking Bulletin, No. 2 (July 1998), pp. 6-9.

Additional Reading Objectives of microfinance CGAP. “Financial Sustainability, Targeting the Poorest, and Income Impact: Are There Trade-offs for Micro-finance Institutions?” Focus Note No. 5, December 1996. (*) Christen, R.P, Rhyne, E, Vogel, R, McKean, C. Maximizing the Outreach of Microenterprise Finance: An analysis of successful microfinance programs. Washington, D.C.: USAID Program and Operations Report No. 10, 1995. (*) Gulli, Hege. Microfinance and Poverty. Questioning the Conventional Wisdom. Washington, DC: Interamerican Development Bank, 1998, pp. 17-45. Schreiner, Mark. “Aspects of Outreach: A framework for the discussion of the social benefits of microfinance” Paper for Discussion, 1999. (*)

Traditional credit and the new approach to microenterprise finance Christen, Robert Peck and E. Rhyne. “Microfinance Enters the Marketplace,” USAID Microenterprise Publications. (*) Von Pischke, J.D. Finance at the Frontier. Debt Capacity and the Role of Credit in the Private Economy. Washington, D.C.: World Bank / Economic Development Institute, 1991, pp. 41-64. Robinson, Marguerite S. The Microfinance Revolution: Sustainable Finance for the Poor. Washington, D.C.: World Bank and Open Society Institute, 2001.

Characteristics of successful microfinance offerings Dunford, Christopher. “In Search of ‘Sound Practices’ for Microfinance,” Journal of Microfinance, 2:1 (2000), pp. 6-12.

Contrasting view on objectives of microfinance Morduch, Jonathan. “The Microfinance Schism,” World Development, 28:4 (2000), pp. 617-629. Wright, Graham A. N. “How Poor Must You Be? Client Selection by MicroFinance Institutions,” Journal of Small Enterprise Development, 11:4 (2001).

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