Microfinance is generally associated with financial inclusion and poverty alleviation. It aims to help individuals and small businesses who have limited access to conventional banking services. In a broader sense, microfinancing refers to providing financial services like access to money transfers and savings accounts, credit facilities, and insurance to the economically weaker segments (EWS) of society. However, in the world of economics, it is often used as a substitute to refer to the loans and advances extended to the lower-income groups for productive or income-generating activities.
Looking back at the history of microfinancing, one can see that the concept’s origins were microloans or microcredits. The program initially started as an experiment, providing tiny loans to financially backward women and small businesses for sustainable development in place of financial aid. Today, millions of people across nations take advantage of microloans to generate livelihood.
Characteristics of Microcredit
Microloans are probably the most significant products in microfinance as they have a considerable impact on the economic progress of their beneficiaries. Microfinance institutions (MFIs) must balance the social objectives of the lending process with the due diligence of credit appraisals to achieve profitable credit portfolios.
Microcredit is different from conventional modes of loans and advances. Therefore, credit appraisals must weigh certain factors to assess the viability and success of such decisions. Before moving on to that discussion, it is necessary to briefly re-visit the features of microloans;
1. The Lacklustre Borrower Profile
The majority of microcredit beneficiaries are from low-income families. Due to demographic or geographic factors, they have very limited or no access to formal credit facilities, proven sources of income, and, consequently, insufficient credit history. Usually, the clientele includes women, entrepreneurs, and artisans from impoverished families.
2. Loans Linked With a Livelihood Activity
The main objective of microfinance is to enable the borrower to generate income. Therefore, monies are advanced for undertaking subsistence activities. Microloans are rarely advanced for consumption purposes.
3. Small Loans for Short Durations
The ticket size of the microloan is very small, and the loan amount usually depends upon its purpose. They have short tenures and get amortised in small and more frequent instalments.
4. Unsecured Advances
Households seeking microloans, with less than INR 3 lakhs annual income, do not need collaterals to secure credit as per the Reserve Bank of India.
5. Capability for Effecting Transformations
Microlending activity can bring a positive transformation in the beneficiary community and economy. It also builds the entrepreneurs’ confidence in entrepreneurial ventures.
Making Microfinance Ethically Profitable
Uplifting the economically underprivileged segments of society is the foundation of microfinance. Traditional MFIs were non-profit, non-governmental organisations (NGOs) or small finance banks and NBFCs, dedicated solely to their social objective. But as financial markets began to evolve, large consumer finance companies and fintech lenders began to enter the micro-lending space. MFIs are now faced with the dilemma of achieving profitability without sacrificing welfare objectives. They can ethically combat the competition and become more resilient by doing the following:
1. Scaling up Their Activities
While microfinance has benefited customers, it has not made an impact on a larger scale. Achieving economies of scale in microlending will ultimately benefit the borrowers. A growing clientele base will increase the profit margins and reduce the cost of funds. MFIs can pass on a portion of these cost savings to their borrowers in the form of lower interest rates.
2. Leveraging Technologies
Fintech lenders are overtaking conventional MFIs and expanding their customer base with ease. Tech-enabled business models are more agile and scalable. They reduce the cost of operations, increase customer outreach, and promote innovation in product design, delivery, and service. MFIs can scale their operations by harnessing data and tech capabilities.
What Factors Should Be Considered When Approving a Microloan?
A microlending model sustains as long as it is viable to investors. The model will fail for the recipients if it does not work for those lending the capital. MFIs can adapt to market changes by focusing on their asset growth and returns. But such growth should not compromise their fundamental social goals.
Microfinance lenders must examine the following factors to proceed with the credit decision:
1. Identify the Target Beneficiary Group
Market segmentation focuses the resources on addressing the needs of those customers who can maximise the lender’s outreach, returns, and the social impact of the loan.
2. Determine the Amount of Loan
Lenders can bring down the cost of funds and reduce interest rates if loan ticket sizes are bigger. A study on Indian MFIs found that apart from the purpose of the loan, regional attributes, perceived income from the activity, borrower’s education, age, and loan experience and even the distance between the clients’ homes and MFIs’ offices could influence the loan amount.
3. Assess the Purpose
As microfinance lends to low-income individuals, lenders can determine if the activity will generate enough income to cover loan repayment. Moreover, lenders may be willing to advance credit for other reasons if they can relate to it on a compassionate basis, such as covering emergency medical expenses. By analysing the character of the borrower you will be able to make an informed decision.
4. Examine the Credit Score and Spending Habits
The credit score is useful in determining default risk. Microloan borrowers might have insufficient credit histories to get a credit score. Lenders can use borrowers’ bank statements to observe their spending patterns and loan repayment capacity and use it to make the final call.
5. Stay Socially Responsible
MFIs must finely manage lending to the underprivileged without compromising the due diligence of the credit process. Business growth should not dilute credit quality.
The Path Ahead
With the evolving fintech sector and faster technology adoption among the common people, the time has come for the microfinance models to upgrade their core competencies. Many digital payment systems have leveraged their capacities to offer digital microloans to their customers. MFIs must respond proactively to these changes to avoid becoming redundant.
Conventional lenders have the upper hand over digital challengers in the responsible credit delivery of microloans to the underprivileged. However, that advantage may soon vanish as digital lenders catch up. Adopting technologies and customising services according to the changing preferences of the target customers is the only step in the right direction.
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