Question

'vulnerability is said to be a state where the poor lack adequate economic and social capacity and where they can easily slip in and out of poverty. Discuss the role of formal, semi-formal and informal providers of microfinance services in reducing the vulnerability of the poor (15mks)

Answer 1

Microfinance is the supply of basic financial services to poor and low-income households and their micro-enterprises. Microfinance comprises several financial tools such as savings, credit, leasing, insurance and cash transfers. These services are provided by a variety of institutions, which can be broadly divided into banks, NGOs, credit and savings cooperatives and associations, and non-financial and informal sources.

Providing financial services for small-scale enterprises is a powerful tool for poverty reduction, enabling poorer households to build assets, increase incomes and reduce their vulnerability to economic stress and external shocks. Microfinance helps rural households to plan and manage consumption and investments, cope with risks and improve their living conditions, health and education by smoothing household cash flow and increasing disposable family income

The rural poor and their forest-based enterprises need a variety of financial services, not only microcredit but also savings, credit, leasing, insurance and cash transfers. To successfully address these needs, microfinance services must be convenient, flexible, of easy and rapid access, and reasonably priced

The provision of microfinance services can be facilitated by business development services. These services can help build financial and business management capacity of rural households, improve their technical skills, provide local support services for enterprises with emphasis on marketing, and establish linkages between forest communities and microfinance services. Business development services should grow with the development of small-scale enterprises and cater to their evolving needs

Formal and semi-formal microfinance institutions fall into three categories:

• banking institutions (formal);
• NGOs (semi-formal);
• cooperatives, savings and credit associations (with varying degrees of formality).

Formal and semi-formal microfinance institutions present different advantages and disadvantages, linked to their outreach and social focus, on the one hand, and to the extent of effective regulation and corporate governance, on the other.

Government and donor programmes in support of rural microfinance expansion usually avail themselves of these formal and semi-formal institutions in order to reach out to rural households, depending on specific local constraints and the prevailing situation. At times, development projects provide money or establish revolving funds for microcredit initiatives, usually managed by a selected microfinance institution. In some cases, the revolving funds may be directly administered by one administration agency, which may be assimilated to the provision of microfinance services by NGOs, or devolved to specifically created savings and credit associations or credit unions, which are the least formal type of credit cooperatives. Provision of microfinance services under government projects is therefore not treated separately here, but is looked at from the point of view of the institution used.

Experience shows that the performance of microfinance government and donor projects is usually better, and the sustainability prospect higher when existing and efficient microfinance institutions are utilized and possibly strengthened through specific technical assistance. When new credit associations are established, or government agencies used for credit provision for project purposes, the lack of specific financial management skills is likely to endanger the soundness and performance of the initiative.

In addition to the formal and semi-formal microfinance institutions, pawnshops and other non-financial and informal sources of microcredit such as money lenders, traders, relatives and neighbours also play a very important microfinance role, especially in areas little penetrated by more formal institutions.

A variety of banks may provide microfinance services, such as state-owned banks, commercial banks, savings banks, postal banks, regional banks, rural banks and thrift banks. With microfinance proving to be a profitable business , many banks have been expanding the scope of their operations into microfinance by downscaling and establishing linkage programmes with semi-formal sources of different types.

Depending on the size and network of the institution, banks may follow a strategy of direct provision of microfinance services, or act as wholesaler providing apex services and refinancing to smaller local microfinance institutions

NGOs widely comprise institutions that are not regulated by banking laws and provisions, and which usually have a developmental or social objective in addition to a financial objective. Most often, a solid financial performance is a means and not an end in itself. The primary objective is non-financial; extending outreach in areas or to families not normally served by banks and bank microfinance institutions. Such institutions tend to be focused on poor people and low-income households, and not only those without access to banks.

Given their social objectives, expansion of outreach among poor people is often rapid, limited only by the availability of resources. NGOs may have several other advantages: they are grassroots-based and therefore have an information advantage and network benefits; they have expertise in forming groups, introducing disciplines, transferring know-how and skills; and they can undertake vocational training activities at the same time

Credit unions and cooperative financial institutions collect savings and provide loans to their members. In many rural areas credit unions are still the only source of deposit and credit services, apart from the informal financial market. Because membership is usually based on some common bond, such as living in the same village or common employment, credit unions tend to be relatively small. Groups with longer traditions of mutual trust and close-knit communities that enable resource users to reciprocate in behaviour are more likely than others to succeed in devising and sustaining successful credit unions. At the same time, successful cooperatives are likely to strengthen the social capital of their members.

Pawnshops can be a very important source of microcredit for low-income and poor households. The major reasons for their success among poorer families are their easy access - no loan application forms to fill in but only an identification card and the item to be pawned - and the very quick processing of the loan. For rural households, especially those engaged in non-wood forest product activities with little access to assets and collateral, small pawn loans can be a valuable means to address emergency shortages in family cash flows, being less expensive and more reliable than money lenders. Strengthening sound and efficient pawning institutions, and supporting the development of products targeted to poor people, can therefore be an effective means of expanding microcredit outreach and serving rural households

For most poor and low-income households in rural areas, microfinance services are supplied mainly by informal sources, such as self-financing through family and relatives, friends and neighbours, or borrowing from money lenders and traders. Poor people tend to be too wary of risks to borrow for promotional measures (that is, investment in the future). They prefer gathering their own resources or resources from family and close friends first in order to finance most rural investments

Despite the substantial worldwide expansion of microfinance in the last two decades, an overwhelming number of poor people continue to lack access to basic financial services. This expansion has reached mainly urban households and micro-enterprises with regular income flows. With activities that may require comparatively larger loan amounts, forest-based small-scale enterprises and rural households have less frequent revenue flows, need longer repayment terms and are still largely unserviced. Even rural microfinance institutions still focus mainly on trading and other non-agricultural activities that have a shorter turnover.

Successful outreach expansion can be achieved through the entry of financial intermediaries not previously serving micro-clients, or through the broadening and deepening of the coverage of services by already existing microfinance institutions.

In rural and remote access regions, strengthening and expanding operations of existing microfinance institutions may work better than trying to lure urban commercial banks to rural areas. The lack of rural lending experience of these banks may constitute a formidable barrier to their entry in rural markets. Microfinance experience shows that the forced expansion of lending operations under supply-led regimes typically leads to poor microfinance institution performance, with declining repayment rates as the quality of the borrowers and the loan portfolio are sacrificed in favour of quantity. In the forest sector, due to the peculiarities of the investments, microfinance institutions without experience in the sector or without support from government specialized agencies will likely lack the necessary expertise to understand and assess small-scale enterprise investments.