Microfinance is a way of bringing small-scale banking to the poor. The poor, especially in the third world, normally lack access to capital and usually have no formal property rights. This structural problem limits their options in life. Microfinance gives the promise of finance to those without sufficient collateral or income to participate in normal banking or market activities.

In the third world, many earn less than $2 a day. Microbanks offers them loans of less than $100, which can help them start small businesses. And it offers microsavings for others.

Microfinance was first used in Bengladesh by the Grameen Bank.

Grameencredit is based on the premise that the poor have skills which remain unutilised or under-utilised. It is definitely not the lack of skills which make poor people poor. Grameen believes that the poverty is not created by the poor, it is created by the institutions and policies which surround them. In order to eliminate poverty all we need to do is to make appropriate changes in the institutions and policies, and/or create new ones. Grameen believes that charity is not an answer to poverty. It only helps poverty to continue. It creates dependency and takes away individual’s initiative to break through the wall of poverty. Unleashing of energy and creativity in each human being is the answer to poverty.

This bottom-up method of development works well with Hernando de Soto’s work on the informal economy.

It encourages self-employment through micro-businesses rather than handing out charity. The Grameen Bank in Bangladesh makes small direct loans under $200 to the poor. It provides microcredit, microsavings, and microinsurance.

Managing a multitude of tiny accounts drives up the cost of business for any bank, so normal banks avoided microfinance. Another problem is the lack of formal property rights, so the poor have no collateral, and legal contracts cannot be enforced. The poor in Bengladesh and elsewhere literally live outside the legal economy.

In Bangladesh, over five million persons use the Grameen Bank services, and the majority are women. The loan repayments are at 95%.

This is interesting because microfinance requires entirely new methods of banking. New technology allowed the management of more accounts at cheaper costs. But the real innovations were the social mechanisms that adapted banking to the needs of the poor.

Most distinctive feature of Grameencredit is that it is not based on any collateral, or legally enforceable contracts. It is based on “trust”, not on legal procedures and system.

It was initiated as a challenge to the conventional banking which rejected the poor by classifying them to be “not creditworthy”. As a result it rejected the basic methodology of the conventional banking and created its own methodology.

This “trust” is a unique way of getting around structural problems.

Bank loans are made to individuals who want to start a business, but responsibility for payment is placed on groups of about 5 debtors. So if you want to get a loan, you have to join a group. The group is collectively responsible for repayment. If one defaults, all are denied future loans. This places social pressure to create insurance and enforcement mechanisms to ensure repayment and that the money is handled properly within the community.

You have to pay off the prior loan before you can take out additional loans. Repayments are made usually on a weekly or biweekly process. The interest rate is often over 30%, so there is a good incentive to repay early and often. The poor are sometimes obliged to open microsavings accounts along with their loan.

Microfinance banks deal with large risks, but have learned to mitigate them. They are quite different than normal banks – particularly the collective responsibility for loan repayment. Yet it seems to work reasonably well.

Microfinancing creates shifts in attitudes as income rises and individuals can create a sustainable income beyond poverty levels. There is also the added psychological effect of upward momentum, encouraging greater hope for poor families. This results in a greater desire for education, a decreased reliance on child labor, and greater freedom for women in traditionally restrictive societies.

The idea is simple. A poor woman can take out a loan for $100 along with 4 others. She starts her small business and makes regular weekly repayments to the bank. Each of the five have their own separate business or perhaps they pooled their capital to run a small company. The five debtors will look after each other to make sure each meets their obligations. If one falls behind or their business fails, all will be punished, so they have an strong incentive to assist each other. This communal responsibility reduces risk for the bank.

Microfinance banks appeared in South America, Africa, and Asia. The attraction is both economic and political. Politically, microfinance can be run by the home state, without increasing foreign debt. Heavily indebted African nations are especially interested in development tools like microfinance.

One word of caution – it’s difficult to empirically evaluate microfinance. Most banks are not profitable and still require government subsidies to operate. It is difficult to evaluate the exact extent of improvements due to the lack of controlled experiments. Microfinance gateway offers resources about microfinance.

Microfinancing offers a creative alternative to traditional government aid loans for poverty relief. It works best when coupled with many other structural reforms.