What is Microcredit?

What is Microcredit?

microcredit, also called microbanking or microfinance, a means of extending credit, usually in the form of small loans with no collateral, to nontraditional borrowers such as the poor in rural or undeveloped areas. This approach was institutionalized in 1976 by Muhammad Yunus, an American-educated Bangladeshi economist who had observed that a significant percentage of the world’s population has been barred from acquiring the capital necessary to rise out of poverty.

Yunus set out to solve this problem through the creation of the Grameen Bank in Bangladesh. The Grameen approach is unique because the small loans are guaranteed by members of the borrower’s community; pressure within the group encourages borrowers to pay back the loans in a timely manner. Grameen’s clients are among the poorest of the poor, many of whom had never possessed any money and relied on a barter economy to meet their daily needs.

Using microloans, borrowers are able to purchase livestock or start their own businesses. By 1996 Grameen had extended credit to more than three million borrowers and was the largest bank in Bangladesh, with more than 1,000 branches.

The success of microloans in Bangladesh led to similar programs in other less-developed nations, including Bolivia and Indonesia. Some are sponsored by foundations, religious organizations, or nongovernmental organizations such as Opportunity International and the Foundation for International Community Assistance.

In 2008 the Mexican bank Compartamos was criticized for parlaying its microlending program into a profit-making operation, charging high interest rates widely regarded as usurious. An alternative approach to Grameen-style lending is stepped lending, in which a borrower begins with a very small loan, repays it, and qualifies for successive loans at higher values.

How Microcredit Works

The concept of microcredit was built on the idea that skilled people in underdeveloped countries, who live outside of traditional banking and monetary systems could gain entry into an economy through the assistance of a small loan. The people to whom such microcredit is offered may live in barter systems where no actual currency is exchanged.

See also :  What is a Refinanced Mortgage?

Modern microcredit is typically attributed to the Grameen Bank model, developed by economist Muhammad Yunus. This system started in Bangladesh in 1976, with a group of women borrowing $27 to finance the group’s own small businesses. The women repaid the loan and were able to sustain the business.

The women in Bangladesh who received microcredit did not have money to purchase the materials they needed to make the bamboo stools that they would, in turn, sell—and at the same time, each individual borrower would be too risky to lend to on their own. By borrowing as a group, the initial financing gave them the resources to begin production, with an understanding that the loan would be paid over time as they brought in revenue.

The structure of microcredit arrangements frequently differs from traditional banking, wherein collateral may be required or other terms established to guarantee repayment. There might not be a written agreement at all.

In some instances, the microcredit was guaranteed by an agreement with the members of the borrower’s community, who would be expected to compel the borrower to work toward repaying the debt. As borrowers successfully pay off their microcredits, they may become eligible for loans of larger and larger amounts.

Cons of Microcredit

There are some cons regarding microcredit, including too much pressure to repay loans, a large suicide rate among borrowers, and severe debt levels.

A contributing factor to the disadvantages is the high interest rates on some microcredit loans – rates can be 30% or even higher. Some even compare microcredit loans to loan sharks or NINJA loans, which actively take advantage of impoverished individuals.

See also :  What are Non-Financial Covenants?

Advantages & Limitations

  • The main advantage of offering microcredit is how it can improve a country’s economy. Studies show that microloans have an overall positive effect on the financial sector, making it more inclusive and helping countries to be more developed.
  • Microfinance plans such as microcredit raise the per capita consumption of the people and allow people to live above the poverty line, so it can be a real game-changer, especially to fight hunger.
  • Overall, it can also improve whole communities. For example, this study in Bangladesh tracked the program for over 20 years locally in villages in the country, and it showed how locals increased their income levels and its stability.
  • Microcredit can have a transformative effect on whole communities, essentially changing how they work for the better. Also, it helps to take people from an informal economy to a formal one (which also helps the government to raise more taxes).
  • One of the main limitations of microcredit is that the amount of money lent to the people can’t be very high. As the standards for lending are very low, most banks won’t offer a huge amount of money. So it may be a problem for people who need a more substantial investment for a start.

Another disadvantage is that people feel very pressured to pay off the loans because they have high rates.

  • The interest rates on these loans tend to be very high because of their risk factor, and it falls upon the very people who can least afford them, the poor people. Rates as high as 20% or 30% are not uncommon in these cases, which has drawn criticism about these initiatives.

Examples of Microcredit

The most famous real-world example of microcredit is the Grameen Bank of Bangladesh. This community development bank offered microloans to poor residents of villages in Bangladesh during the 80s.

See also :  What is Junior Debt?

It was based on an initial experiment made by Muhammad Yunus in the 70s, in which he lent money from his pocket to aid a group of women in a rural community. So they could start their craft, and all of them paid him later.

The result is that their lives, as well as their confidence, greatly improved after a while. People could get rid of shark-loans who took advantage of their work and started their craft by themselves.

In India, the National Bank for Agriculture and Rural Development started the Self Help Group Bank Linkage program in 1992. With this program, the government offered several microloans to poor individuals, and over $867 million were given to self-help groups.

It also aided in the construction of associations such as the Self-Employed Women’s Association, which offers microfinance aid in the country. This bank offers loans to women, mostly in rural and poor regions.

Critiques of Microcredit

There have been criticisms of microcredit and the way it can be misused. For example, in South Africa, microcredit was introduced in some of the poorest communities to encourage people to pursue self-employment. However, the way it was introduced, in some instances, led to the funds being expended through consumption spending, rather than the establishment or furthering of any form of business or employment activity.

Also, the borrowers may find themselves with a magnitude of debt they cannot repay, even with the small-scale loans offered through microcredit. The problem is that the borrowers may not have a steady income source, or they plan to use the microcredit to create an income source for themselves that would allow them to pay back the financing. As a result, some borrowers have resorted to selling off personal property and seeking new financing to cover their previous microcredit.