Microfinance

Microfinance is the delivery of financial services in very small amounts to people and enterprises outside the reach of conventional banking, most often a working-capital loan of a few hundred to a few thousand dollars, and frequently alongside savings accounts, insurance, or payments. It is a distribution model rather than an asset class: what makes it distinctive is how the lender underwrites, disburses and collects when the borrower has no collateral, no credit file, and no audited accounts.

Two terms travel together and are not interchangeable. Microcredit names the lending specifically, which is why the research literature evaluating loan access uses that word. Microfinance is the broader label covering the same customers' savings, insurance and payment services as well. Neither word is defined in the Small Business Administration's own rules; the closest domestic definition there is "Microloan," which 13 CFR 120.701 defines as "a short-term, fixed interest rate loan of not more than $50,000 made by an Intermediary to an eligible small business."

The mechanics exist to replace collateral. A conventional lender manages risk with security, a credit history, and financial statements. A microlender usually has none of those, so the model substitutes other things: lending to a group whose members are jointly answerable for repayment, a repayment schedule of small and frequent installments that surfaces trouble early, loan sizes that step up only after a clean record, and a loan officer who visits rather than a branch the borrower visits. Those substitutions are labor-intensive by design, which is the source of the cost problem below.

Why the rates look punitive and why the comparison is not straightforward. A large part of the cost of making a loan is fixed per loan: assessing the borrower, disbursing, collecting, and following up. Those costs do not fall in proportion to principal, so the same dollars of cost sit on top of a much smaller loan and have to be recovered as a much larger percentage. An annual percentage rate computed on a $500 loan repaid weekly over six months therefore looks nothing like a rate on a mortgage, without either lender being unusual. The United States program concedes the point in its own design: 15 U.S.C. 636(m) authorizes the SBA both to fund loans through intermediaries and, separately, to make grants that "will enable such intermediaries to provide intensive marketing, management, and technical assistance to microloan borrowers." The assistance is paid for with appropriated money rather than out of the interest, because the interest cannot carry it.

The origin, and the reason the field is contested. The Norwegian Nobel Committee awarded the 2006 Nobel Peace Prize jointly to Muhammad Yunus and Grameen Bank "for their efforts to create economic and social development from below." That recognition, and the claims made around it, set an expectation that access to small loans would lift households out of poverty at scale. The strongest evidence available does not support that expectation at that strength. Summarizing six randomized evaluations across six countries on four continents, published together in the American Economic Journal: Applied Economics in 2015, Banerjee, Karlan and Zinman wrote that the studies show "a consistent pattern of modestly positive, but not transformative, effects." The honest reading is that expanded access to credit is a real service that people use and value, and that it is not, on this evidence, a poverty cure.

How a United States reader actually encounters it. Three ways, and they are different from one another. The SBA Microloan Program lends federal money to nonprofit intermediaries, which relend it to small businesses; 13 CFR 120.701 defines an Intermediary as "a private, nonprofit community development corporation or other entity" and a Specialized Intermediary as one "which maintains a portfolio of Microloans averaging $10,000 or less." Community development financial institutions, certified by the Treasury Department, do similar lending with a broader mandate. And retail products exist that let an individual put money into a microfinance portfolio, either as a donation, as a zero-interest recycled loan on a platform, or as a note that pays interest and carries credit risk. Those three are not the same transaction, and the third is an investment with the ordinary consequences of one.

A group-lending cycle is the classic form and it runs in a fixed order. A loan officer forms or accepts a group of borrowers who agree to stand behind each other's repayments. Each member receives a small loan, usually for working capital rather than consumption. Repayment starts almost immediately and happens weekly or every two weeks at a group meeting, where a missed payment is visible to everyone present. A member who completes a cycle cleanly becomes eligible for a larger loan next time, and that expectation of a bigger loan is the enforcement mechanism doing most of the work.

A hypothetical shows why the percentage looks the way it does. Suppose it costs a lender $120 to originate and service one loan for six months, regardless of size, and the lender has to cover that cost plus the money itself. On a $500 loan, the $120 is 24 percent of principal for a six-month term, before any cost of funds or loss provision. On a $50,000 loan, the same $120 is 0.24 percent of principal. Nothing about the lender changed; the denominator did. This is a hypothetical illustration, not a quoted rate, and it is why comparing a microloan's annual percentage rate with a mortgage rate compares two things the arithmetic never made comparable.

On the United States side, the flow of money has one more step than borrowers expect. The SBA does not lend to the business. It lends to an intermediary, and the intermediary sets its own rate, term and underwriting within the program rules and does the lending. That is also why the technical assistance arrives: the intermediary receives a separate grant to provide it.

Pros

• It reaches borrowers a conventional lender will not underwrite, which for many is the difference between some credit and none.
• Frequent small repayments match the cash-flow pattern of a small trading business better than a single large installment.
• Bundled technical assistance is often worth more than the loan, and in the US program it is funded separately so it does not have to be priced into the rate.
• Savings, insurance and payment services attached to the same relationship address risks that credit alone does not.
• Repayment performance builds a record where no credit file existed, which is the on-ramp to larger and cheaper borrowing.

Cons

• Rates are high in absolute terms, and a borrower comparing them with ordinary consumer credit will be shocked whether or not the lender is behaving well.
• Group liability transfers the collection problem to the borrower's neighbors, which is effective and can be coercive.
• The evidence base does not support transformation. Treat any claim that small loans reliably lift households out of poverty as unsupported by the randomized evaluations.
• Frequent repayment schedules suit trading and services and suit agriculture and manufacturing badly, because those have long gaps between outlay and revenue.
• A retail product marketed as microfinance may be a donation, a recycled interest-free loan, or a credit investment, and the three have completely different downside.