The past three decades of experience, spearheaded by the Grameen Bank, has given those involved in developing and implementing microfinance programs a reasonably clear set of principles or “best practices.” These principles underlie almost all successful Microfinance Institutions (MFIs) systems and seem to be applicable worldwide, irrespective of the setting.
The principles presented are based largely on the Bangladesh experience and are not offered as “set in stone,” “must follow” requirements, but as a brief overview of the basic building blocks of most successful microfinance programs. They are perhaps best seen not as inviolable rules but rather as essential elements that should be incorporated into group-based microfinance system design whenever possible.
Over the last decade, there has been substantial and growing interest in “microfinance” programs. These programs are characterized by a very different approach than traditional agricultural credit programs and by their markedly superior loan recovery rates.
The Grameen Bank is the best known, and in many ways the most influential, of the microfinance institutions, and it is Grameen’s success that has spawned thousands of imitators, often using the Grameen name with little or no understanding of the principles and practices underlying it.
Let’s examine some of the principles underlying successful Grameen-influenced, group-based microfinance systems, and what are some of the now generally accepted “best practices” in microfinance.
Let’s look at the practices and principles of successful microfinance programs:
Group Formation Process
MFIs should take time with the group formation process and ensure that the groups have been adequately trained before they get access to loans. Groups must self-select on the basis of mutual trust and friendship as they are expected to provide both peer pressure and peer support as part of the group guarantee mechanism.
The importance of targeting the poor, and particularly poor women, has been demonstrated time and again. MFIs should seek to establish permanent institutions and sustainable systems that deliver quality financial services for clients (not beneficiaries).
Optimizing financial services and the systems to deliver them is best done through an investment in pilot-testing.
Finally, it should be noted that government institutions are rarely able to implement successful savings and loan programs – credit is too easily politicized and NGO workers are generally better motivated to work with the poor.
Promoting Savings Before Loans
MFIs should promote saving before they issue loans – it promotes discipline and provides some of the capital necessary to finance the loan portfolio. Open-access savings facilities also provide an important service to the risk-averse poor and will result in the MFI attracting a larger number of better-satisfied clients.
Loans should be delivered at full cost, on an individual (not group) basis but using a group guarantee mechanism (while recognizing the time-bound limitations of group guarantee).
Repayments should be scheduled on a small regular basis – often weekly – this breaks down the loan into small, manageable installments that can be paid from the regular household budget.
Given that money is fungible within households, tying loans to “productive” purposes is largely meaningless, possibly even counter-productive – MFIs would do better to recognize the needs of the poor and provide loans irrespective of purpose.
Loans should be given for short time periods – rarely for more than a year, often less – as short-term loans generally carry a lower risk. Finally, as with formal sector banking, credit history should give clients access to larger loans over time – this is often an important incentive to repay.
Proper Group Formation
Like many traditional agricultural credit programs, groups are often (but by no means always) the basis of many microfinance systems. However, the process of group formation, and the nature of the resulting groups are markedly different.
Take Time
Organizations implementing microfinance programs take time to analyze the need for financial services in the community. Using participatory techniques, they review the “financial landscape” to develop appropriate systems or “products” (see Quality Financial Services below).
In the process, they generate interest and awareness among the target group (see Importance of Targeting the Poor below) without using the lure of loans to attract beneficiaries.
Thereafter, a great deal of time and effort is spent to pilot the activities (see Pilot-Tested Activities below) and to train the groups.
Usually, group members are required to meet regularly (generally weekly) and to save regularly for around 3-6 months before they are able to take the “accreditation” or “recognition” test (which ensures that they know the rules of the microfinance system). Thereafter, only if they pass the test do the group members become eligible for loans.
Self-Selection by Groups
Because of the group guarantee system and the regular meetings (see Peer Pressure and Peer Support below), groups must self-select. That is to say that the groups are formed by the members of the community themselves not by an outside agency.
The result is small groups (typically of 5-15 members) of people who trust each other – often based on existing indigenous groups (in the case of the Cordillera, usually “gawai” groups).
These groups, because they are drawn from trusted friends and neighbors, are more resilient and willing to help each other out during the inevitable times of stress.
Peer Pressure and Peer Support
Peer pressure and support are the basis of the discipline of the typical microfinance group. Experience has shown that with a group of 5-15, the group is small enough to effectively enforce group peer pressure and collective responsibility, and large enough to handle the repayment of missed installments when a member defaults (see Group Guarantee below).
If the number is greater, it is harder for the group to maintain peer pressure and collective responsibility. Similarly, the compact closeness of a group allows peer support when any one member of the group falls on hard times or faces social or economic difficulties.
The Filipino Development and Social Welfare Department’s (DSWD’s) slogan of “All for one and one for all” is appropriate.
Many microfinance programs also have a special “Emergency Fund” jointly owned and managed by the group to help members facing problems with repaying their loans.
These Emergency Funds are generally used to advance interest-free loans to group members facing legitimate problems repaying their loans and further reinforce the peer support element of the group dynamics.
It is because of the peer pressure element of the group’s responsibility that close relatives are generally barred from being members of the same group by microfinance institutions. It is also very difficult to enforce group peer pressure effectively when close relatives belong to the same group.
For example, if a daughter and her mother were in the same group, it is difficult for the daughter to apply pressure to her mother if the mother was willfully not repaying her loan.
In some settings, however, because of the size of families and the scattered population, it is difficult to implement this principle and (for example) the Central Cordillera Agricultural Programme (CECAP) is experimenting with a policy that no two members of the same household can be in the same group.
Importance of Targeting the Poor
Successful microfinance institutions make special efforts to target the poor. There are several reasons for this. The first is the desire to address the needs of the more disadvantaged members of the community. The second is that the poor are better credit risks.
Throughout the world, the richer elite of communities has become expert in “capturing” credit, particularly any subsidized or low-cost credit, offered by agencies and organizations. The elite is more easily accessible, better educated, more articulate, and more powerful – and thus easier to lend to and more difficult to recover from.
On the other hand, the poor are usually in greater need of and with less access to credit (and indeed financial services as a whole).
The need of the poor for these services (and thus the desire to comply with their terms and conditions in the hope of getting further access to them), together with their relative powerlessness, has meant that they have proved to be better credit risks and much more “credit-worthy” than the rich elite.
Importance of Targeting Women
Throughout the world, women tend to run the day-to-day household budget and are primarily responsible for the well-being and development of their children.
These two factors make them the best focus for microfinance programs – they have consistently proved themselves to be better at saving, and at repaying loans on time, and the profits they make on their business activities are invested in their family, and not gambling, drinking, cinemas, or cigarettes.
Permanent Institutions and Sustainable Systems
Successful microfinance programs start with a clear objective to set up permanent institutions or systems designed to provide financial services on a long-term sustainable basis.
This objective implies several key things – good quality financial products or services, delivered by an appropriate institution on a profitable basis to satisfied clients who continue to value and use those services.
Quality Financial Services
Quality financial services reflect the needs of the community not the financing institution. The needs of the poor in the community that the microfinance program is planning to serve should have been determined during the participatory techniques used to review the “financial landscape” (see Take Time above).
Financial services include not just credit, and indeed often stress savings over loans – particularly for the risk-averse poor.
For example, in the Cordillera, the Central Cordillera Agricultural Programme’s work has shown that the key cash expenditure item for the poor (and the one that drives them to the informal money-lenders and 10% interest per month most often) is education expenses – particularly the expenses at the beginning of the school year, payable in May/June.
A savings facility to allow people to put money aside before then would greatly help them manage their household income and expenditure patterns more effectively – and save them a great deal in interest payments, thus increasing net wealth.
For Clients, Not Beneficiaries
Microfinance organizations with a commitment to sustainability serve “clients” who pay for the financial services they receive, not “beneficiaries” receiving subsidized loans. This distinction is tremendously important since it dictates the attitude of the microfinance organization’s staff to the group members (clients are served, beneficiaries
are patronized), and the attitudes of the members toward the organization (clients are buying services, beneficiaries are expecting hand-outs).
These attitudes make the difference between a successful and sustainable, business-like financial services organization and a failure – handing out loans with little commitment to, or expectation of, recovering them.
Pilot-Tested Activities
In order to optimize the savings and credit system, it is always a worthwhile investment to spend some time pilot-testing the program. This will allow the implementing organization an opportunity to “learn by doing,” another of the characteristics common to successful microfinance institutions throughout the world.
Pilot-testing provides the organization an opportunity to explore the optimal implementation methodology and monitoring and evaluation systems in a tightly controlled and supervised area. In addition, the pilot-test sites provide opportunities for on-the-job training for staff.
Institutional Framework
Successful microfinance programs have usually been implemented by independent non-government organizations dedicated to serving the poorer parts of the community.
The former ensures that they are free from political influence and intrusion (for throughout the world politicians have always used credit – particularly subsidized or practically non-repayable credit – as a tool for political, rather than economic, ends) and thus free to make objective, business-based decisions in the best interests of the institution.
The latter ensures that they conscientiously target the poor and can rely on motivated and committed field workers. In addition, it is important that the institution is well-governed (at Board of Trustees/Directors level) and managed (on a day-to-day basis), and has well-trained staff to implement the system.
This latter aspect in particular is common to successful programs worldwide: all have invested heavily in the development of their field staff and the field manuals they have to work from.
Balance of Savings and Credit
Traditionally, the Grameen Bank has placed more emphasis on the credit aspects of its program. However, this is changing, and Grameen is now following other more progressive microfinance institutions and moving away from compulsory, locked-in savings (levied as part of the loan and not available for withdrawal) to voluntary, open-access savings (deposited at will by the members and available for withdrawal, usually on demand).
Savings First
Even under the original Grameen system, group members had to save for several months before they were eligible to borrow. This allows the members to develop the discipline of meeting and of putting some small amount of money aside regularly.
The requirement to save first also results in an investment in the institution that will then lend to them – thus the loans they receive are financed not just by a faceless outside agency but also by their own savings and those of their friends and neighbors.
This idea is often referred to as “Hot vs. Cold Money.” The money provided by outside agencies is “cold,” but that provided by oneself and immediate friends and neighbors is “hot.”
Borrowers are much more likely to be committed and conscientious about repaying “hot” money … indeed many of the large financial services organizations in India (credit unions, etc.) are unwilling to accept outside “cold” money for fear of reducing the discipline within their members.
In addition, appropriate emphasis on savings can reduce the overall level of outside capital needed by the microfinance institution – thus allowing precious development funds to be spread further, and permitting the institution more flexibility in its working methods.
The Risk-Averse Poor
Savings play another very important role. For the very poor, the prospect of having to find the money to repay a loan according to a specific and fixed schedule is a very risky one indeed. These very poor people often prefer to avoid increasing (or “leveraging”) their risk through taking loans and would much rather develop a lump sum through careful and painstaking savings.
In this way, the very poor can, little by little, as the circumstances of their household income and expenditure flows permit, build up a useful sum of money … without the additional risk and cost of taking a loan.
Attention Loan Repayment.
The credit side of the microfinance institution’s activities is its source of income, and therefore of particular importance. As the source of income, and thus the basis of the sustainability of the organization, particular attention has been focused on ensuring that loans are repaid.
Full-Cost Loans
As noted above, all successful microfinance institutions are designed from the outset to be sustainable and thus to be financially viable – and as such provide loans on a full-cost basis (usually an effective rate of around 24-36% per year, or 2-3% per month).
It has been shown from South America to Asia that what matters to the poor is not a few percentage points of interest, but the regular and secure availability of loans. After all, the competition is the informal sector moneylenders typically charging 10% per month.
Subsidized interest rates tend to attract the wrong type of borrower and encourage the wrong type of attitude toward the rationale for offering the loan, thus resulting in poor repayment records.
Individual Basis
International experience has shown that loans given on an individual basis are more easily collected. This is for several reasons.
First, group-operated projects tend to run into one of two problems
- either the project is dominated and run (“captured”) by one individual within the group, or
- there are disputes within the group on who has what responsibility for the implementation of the project.
Second, the group guarantee principle depends on individuals pressuring one another or supporting one another to repay their individual loans … at the extreme, group loans could encourage group support not to repay.
Thirdly, the “covariant” risk of group loans means that the group members have “all their eggs in the same basket” – if the project is successful, all well and good, if it goes badly, then they are all in trouble.
Finally, with individual loans, the lending institution knows exactly who is responsible for the repayment of the loan and does not get lost in a maze of group members referring to or blaming one another.
Group Guarantee
The group guarantee is the mechanism that will enable the microfinance institution to lend to group members without stringent loan collateral requirements (e.g. real estate and chattel mortgage).
A group guarantee means that the group members commit themselves to repay the loan borrowed by any of their members to the lending institution if the said members default. It makes use of both peer pressure and peer support to bring about strict credit discipline.
The joint and several liability implied in the group guarantee means that a loan of one member is, likewise, an obligation of each member of a group.
This means that when a member defaults on his or her loan, the microfinance institution can lien the assets of the group as well as the personal assets of the group’s members (including their individual share capital and/or savings deposits) to recover the loan. This mechanism is further strengthened by the 2:2:1, staggered loan disbursement method.
Under this method, two members must make all their repayments on time for four weeks before the next two loans are released, and those four must continue to make all their repayments on time before the final loan is released. This is also a mechanism for peer pressure.
The other group members who have not received their loans have to ensure that those who already received their loans do not fail to pay their weekly loan amortization, lest their borrowing privileges are suspended.
Small Regular Repayments
One almost standard feature of successful microfinance institutions throughout the world is a loan repayment schedule based on small regular (often weekly) repayments.
This repayment schedule seems strange to those used to traditional agricultural credit programs which have balloon repayment schedules under which the loan principle is repayable after the harvest. The regular repayment schedule is designed to break the repayments down into small, manageable installments that can be saved out of the flow of income and expenditure in the household economy.
Thus this repayment schedule recognizes that the typical farm household has many and varied sources of income and types of expenditure. Managing these to repay the loan in small installments is far easier for farmers than having to find large sums of money to finance balloon repayments at a later date.
Flexible Purpose
The discussion in Small Regular Repayments above also touched on another important issue – that of “loan diversion.” Credit projects throughout the world have faced loan diversion – borrowers using their loans not for the purpose given on the loan application form or proscribed by the project, but for another more pressing purpose.
Often loans are diverted for “providential” or “non-productive” purposes, to meet emergency medical or education expenses (both of which, incidentally, can also be seen, in the long run at least, as “productive”), but loans are also often diverted because the farmer sees another more viable or lucrative opportunity.
Given that cash is “fungible” and the complexity of farmers’ household economies, it is increasingly clear that trying to tie loans to specific uses without addressing other needs and opportunities is naive at best.
In the Cordillera, given the people’s remarkable and commendable commitment to education, it is not surprising that loans earmarked solely for agriculture are (in part at least) diverted to finance schooling costs.
It is for this reason that successful microfinance institutions worldwide do not tie their loans to specific types of projects, and where their policies insist on providing their general loans only for “productive” purposes, almost invariably have a mechanism to provide credit facilities to meet providential needs, or simply turn a “blind eye.”
Short Loan Duration
Microfinance (and indeed agricultural credit) practitioners across the globe have found that longer-term loans are usually, if not inevitably, associated with poorer repayment. This is particularly the case if the interest accruing on the loan is not collected regularly. The collection of interest (and indeed shorter loan duration) keeps the loan “in front of the borrower” – so that he/she is always aware of the liability and obligation to repay.
The alternative approach to reducing lender’s risk on longer-term loans is, of course, to insist on physical collateral.
This approach has two disadvantage:-
- firstly, it almost automatically excludes the poor from participating in the program for want of physical collateral; and
- secondly, the collection and disposal of collateral is a difficult proposition for formal sector financial institutions – what hope for the small, rural, often illiterate, non-collateralized farmer?
Progressive Lending
Finally, successful microfinance institutions have found that as clients repay their loans, they should be eligible for larger loans. This makes sense on several levels.
Firstly, it recognizes that the clients are already a good credit risk (since they have repaid at least one loan already), and secondly, it provides a powerful incentive for timely repayment (since they will be eligible for larger loans in the future if they do so).
However, it is important to monitor the progressive lending carefully since the level of repayments on the larger loans may be different from those on the smaller loans.
Tackling Ongoing Problems and Constraints
There are many problems and constraints facing microfinance programs.
Politicians and Their Desire for Credit
For centuries, politicians have been using credit, and particularly subsidized or low-interest credit, as a tool for political ends. The sad fact is that what is good politics is very often bad economics, and nowhere more so than with credit.
Politicians get elected by handing out loans, not by demanding them back. Thus credit is almost inevitably politicized, and any successful credit program will become a political football.
The result is that the rural poor are usually excluded from access to credit because the politicians have got there first and captured all the cheap loans for their political cronies.
Credit is almost always provided to the richer and more articulate elite who can pressure the politicians into giving it to them, and who are then able to default on the loan without penalty. Those organizations seeking to implement credit programs must be very aware of the potential for political interference and design their programs and organizations to be as resistant to this as possible.
The Need for Quality Financial Services
The poor are usually in much greater need of, and have less access to, financial services than the rich. This is true throughout the world.
However, in most instances, the formal sector is unable to provide financial services to the rural poor. Banks are centralized institutions and usually only operate in towns, and even then are often reluctant to lend to the rural poor.
Even when they are willing to lend, the requirements for collateral, documentation, etc. are often beyond the reach of the poor.
On the other hand, informal sector money-lenders are usually unwilling to lend for productive purposes (though they will happily lend for consumption purposes, at extortionate rates of interest). This has meant that there is a real gap in the market for quality financial services for the rural poor.
Microfinance institutions that recognize this gap, and are prepared to put in the effort to serve the rural poor, are likely to be successful. There are numerous examples throughout the world of microfinance institutions filling this niche, and thriving.
Access to Information
Access to information is often a real constraint for the rural poor. This is particularly true in the Cordillera, where the people are often scattered across mountainous terrain with poor communications infrastructure.
Poor access to information about markets and prices means that the poor are often selling their products at un-remunerative prices and buying goods and services at inflated prices.
Poor access to information about new technologies and techniques means that the poor are often using outdated and inefficient technologies and techniques to produce their goods and services. These are constraints on the rural poor that have been recognized by the successful microfinance institutions.
These institutions often provide information services to the rural poor – about markets and prices, new technologies and techniques, and other development information. Indeed, in some cases, these information services are the “hook” that is used to draw the poor into the microfinance program.
Unsuitable Products
The formal sector, with its centralized institutions and standardized products, often provides unsuitable products to the rural poor. This is a particular problem with credit, as discussed above. However, it is also a problem with other financial services such as savings.
The poor often have variable and unpredictable incomes, which means that they need flexible savings products that allow them to save when they can afford to do so, and withdraw when they need to.
The formal sector usually only provides locked-in, fixed-term savings products that are inappropriate for the poor. Microfinance institutions that recognize this constraint, and are prepared to provide flexible financial services that meet the needs of the poor, are likely to be successful.
The Need for Ongoing Monitoring and Evaluation
The success of a microfinance program is critically dependent on the ongoing monitoring and evaluation of its performance. This is necessary to ensure that the program is meeting its objectives, and to identify any problems or constraints that need to be addressed.
This is particularly important in the case of group-based microfinance programs, where the success of the program is critically dependent on the discipline and commitment of the group members.
Microfinance institutions that recognize the importance of ongoing monitoring and evaluation, and are prepared to invest the time and effort necessary to do this, are likely to be successful.
Conclusion
Microfinance institutions that follow the principles outlined above are likely to be successful. These principles are based on the experience of successful microfinance institutions throughout the world and have been shown to be applicable in a wide range of settings.
They provide a framework for the design and implementation of microfinance programs that meet the needs of the rural poor and are sustainable in the long term.