Microcredit: lending to the unlendable

In 2008, a bank called Grameen America opened its first branch in Queens, New York. This year, it plans to open a branch in Washington DC.

But unlike the banks recently dominating the headlines, Grameen has a clear social agenda – “to alleviate poverty and spur entrepreneurship.”

Since it began, Grameen America has lent over US$5 million to 2,500 borrowers, and maintained a repayment rate of over 99%.

What makes it unique is that Grameen is in the microfinance game. It lends only to people it calls “low-income generators” (poor people), and it lends only small amounts.

The purpose of the loan is to generate income through a business idea. For example, in 2009 Grameen lent $2,000 to Ecuadorian immigrant Delia, who used the money to quit her factory job and buy an ice-cream cart from which to run her own business.

Grameen says Delia would never have been able to afford the cart and escape her factory job had she not had access to the loan.

Origins of microfinance

The invention of microcredit or microfinance is largely attributed to both a Latin America based non-governmental organisation called ACCION, and a Bangladeshi economics professor called Muhammad Yunus.

In 1974, Yunus met a single mother called Sufia Begum, who made a living making woven bamboo chairs on the streets of Yunus’ home town. Begum borrowed bamboo from chair sellers who bought the completed chairs back off her for 2 cents more than she had paid for the bamboo.

She explained to Yunus that she couldn’t borrow money to buy the bamboo herself because no bank would lend it to her, and the interest rates from black-market (illegal) money lenders were punishingly high.

Begum would need only US$27 in order to buy enough bamboo to set up her own chair selling business and break the poverty cycle.

As an experiment, Yunus lent US$27 to forty two families in his community to help them set up their own businesses, telling them to pay him back when they could afford to.

The experiment was a success and Yunus went on to found the Grameen Foundation (for which he won the Nobel Peace Prize in 2006 and of which Grameen America is an offshoot).

In the meantime, ACCION was busy lending small amounts to Latin American women, helping them to earn their way out of poverty.

Today’s microcredit system works along the same lines. Poorer citizens are loaned small amounts of cash to use as capital (start-up money) for small businesses.

Even tiny businesses can have a huge impact on the income of the people who run them, and in turn, on their local economies.

Where does microfinance fit in?

Normal banks don’t bother loaning such small amounts, in part because the risk that a loan won’t be repaid is too high, and in part because the administration costs of processing such a small loan means the loan won’t be profitable for the bank.

Unfortunately where banks won’t step in, money lenders or loan sharks charging exorbitant interest rates will.

In contrast, microfinance lenders have low interest rates and short repayment periods. Borrowers typically use the money to establish a business and are quickly able to pay back the loan from the business’s profits.

Banks also require collateral (i.e. property) as security for a loan in case of a default. Because the types of people applying for microcredit usually don’t have any assets, they’re not eligible for a bank loan.

So why do microfinance loans get paid back?

Microfinance organisations instead use a strategy called “solidarity groups”, where the money is loaned to a group of people rather than an individual.

In those cases, where a repayment is missed the whole group is penalised – which means the others in the group pressure their peer into meeting his or her repayment obligations.

Importantly, microfinance institutions loan primarily to women. Yunus’s theory is that women are more likely to live in poverty than men and have less access to education, but are better at repaying loans than men.

Victim of its own success

Ironically, the key problem with microfinance stems from its success.

As microfinance institutions become more successful, the pressure to increase profit margins intensifies. And as microfinance lenders try to increase profit, they give out riskier loans.

In addition, there have been recent reports that certain mosque leaders in India have called for Indian families to stop borrowing from microfinance organisations because the debt creates stress in the family.

This is true to some extent, although many believe it’s just an indirect attempt to disempower women.

The challenge for microfinance providers is to remember the purpose of the practice stated clearly by the Grameen Foundation, to provide “banking for the unbanked.”

By Natalya King

Photo – Grameen Bank founder Muhammed Yuns congratulated by his daughter after winning the 2006 Nobel Peace Prize.