Fundamentals of microfinanceWhat is microfinance?The Consultative Group to Assist the Poor (CGAP) defines 'microfinance' as 'the supply of loans, savings and other basic financial services to the poor'.Different stakeholders see microfinance from their own perspective and so, tend to define it from their angle. Governments see it as social protection. Donors focus on its potential to secure poverty reduction. Commercial insurers see its potential as a way of reaching large under-served markets. Analysts use it to highlight the size of the market at the ‘bottom of the pyramid’. Academics see it as an essential financial service for sustainable economic growth. All of the definitions are similar to those for conventional insurance, except for the clearly prescribed target market: low-income people.Broadly speaking, microfinance is a set of practices developed with the objective of increasing the provision of financial services (including loans, savings products, insurance and remittance services) to low income-clients. Typically, these clients come from the poor ‘unbankable or uncreditworthy by commercial banks’ population of the world, to whom traditional sources of finance (lending in particular) are unavailable.The provision of microfinance now entails a range of possibilities and a variety of models. Microfinance models are now also being considered to finance small and medium-term enterprises (SMEs) in a number of jurisdictions all over the world and therefore, it is not just confined to the provision of financial services to the poorest in the world (which is how it originally developed). Microfinance is no longer exclusive to developing countries, however, microfinance projects have been, and continue to be, implemented in developing countries.Typical features of a microfinance transactionMicrofinance programmes need to be assessed against the relevant social, economic and political factors. Some of the most typical features of a microfinance programme include:•‘micro’ or small-scale provision of financial services—microloans may be made for as little as US$2 a day•financial services being targeted at the poor (however, this feature does not necessarily remain a fundamental feature as microfinance models are being expanded to include funding of SMEs as well, which would not fall within any definition of ’poor’)•unsecured and collateral-free loans•informal appraisal of borrowers and investments•access to repeat and larger loans, based on repayment performance•streamlined loan disbursement and monitoring•secure savings product•group lending•a focus on underserved communities such as women or the disabled that (depending on the social setup or jurisdiction) face severe restrictions in accessing finance, and/or•simple, accessible application process for loans; market-level interest ratesTypes of microfinanceMicrofinance today extends well beyond micro credit alone. Most microfinance programmes today include savings products, remittance services (with an increasing use of modern technology such as mobile banking) and insurance. It is also no longer exclusively development-focused institutions that offer microfinance services. Commercial banks and insurance companies are beginning to diversify their operations to reach new markets. Countries in which commercial banks have entered into the area of microfinance include Benin (Finance Bank), Ecuador (Banco Del Pichincha), Haiti (Sogebank) and Indonesia (Bank Rakyat Indonesia).The various ways in which microfinance aims to empower low income groups may be broadly classified into the following three categories:•microcredit•microsavings, and•microinsuranceMicrocreditThis typically includes providing funds to customers in the form of small loans.Repayment models can be classified into the following types (each based on a differed risk-sharing method):•solidarity groups—this is the classic microfinance model, often referred to as the ‘Grameen model’ after Grameen Bank, which pioneered it. It involves five-person solidarity groups, in which each group member guarantees the other members’ repayment. If any group member fails to repay their loan, the other members must repay for them or face losing out on future credit•village banking—this expands the solidarity group concept to a larger group of 15 to 30 people who are responsible for both, managing the loan and making and collecting loans to and from each other. India’s self-help groups operate according to a similar format, and•individual lending—this is simply the provision of microfinance services to individuals instead of groups. It is similar to traditional banking and can be hard to distinguish from it. This is particularly true in cases where microfinance institutions (MFIs) require collateral to guarantee loans, as collateral-free lending has traditionally been one of the hallmarks of microfinanceMicrosavingsAlthough microfinance has traditionally focussed on expanding access to credit, village savings and loan associations (VSLAs) are savings-led.Microsavings models typically include the following:•a ‘compulsory savings’ account, which can be withdrawn if and when the client leaves the organisation, on condition that the client has saved for at least five consecutive years, and•a ‘voluntary savings’ account, which at least in principle, offers microsaving clients the possibility of withdrawing from the accounts at any time during the duration of loan cyclesThe non-governmental organisation (NGO) CARE International pioneered VSLAs, which have proven to be one of the world’s most effective informal savings methods. The primary purpose of a VSLA is to provide simple savings and loan services to a community that does not have access to formal financial services. A VSLA is formed by a self-selected group, all of whose members save money in the form of shares. The savings are invested in a loan fund, from which members can borrow money at a reasonable rate of interest. Members also contribute a small sum to a compulsory insurance fund, which can be used to provide grants or no-cost loans to members in distress.All transactions are carried out at regular meetings in front of all members, with each member holding their own individual passbook. This promotes both transparency and accountability. The cycle of savings and lending is time bound. At the end of an agreed period the accumulated savings and interest earnings are shared out among the members. See CARE report—Connecting the World’s Poorest People to the Global Economy—New models for linking informal savings groups to formal financial services.MicroinsurancePut simply, microinsurance is the provision of insurance to low income households. However, despite 40 years of existence there is still no standard definition of the concept. Microinsurance can be defined as a back-to-basics campaign for insurers that enables them to reach an under-served market. It is also a mechanism that enables government social protection schemes to extend coverage to workers in the informal economy who lack benefits such as health insurance and pensions.A variety of microinsurance products for the poor are available today. Many have been developed based on the needs of the poor as they are perceived by insurers. NGOs and MFIs offer credit-life insurance to protect their own portfolios. Some of the microinsurance products that are available today and the countries in which they are offered include:Microinsurance productsCountries in which they are offeredCredit-life/life/endowment•Bangladesh, Cambodia, India, Indonesia, Laos, Nepal, Pakistan, Philippines, Sri Lanka, Vietnam•East Africa, South Africa, Uganda, West Africa, Yemen•Brazil, Bolivia, Colombia, Guatemala, Mexico, Nicaragua, Peru, VenezuelaHealth/critical illness•India, Bangladesh, Cambodia, China, Laos, Pakistan, Philippines•East Africa, Kenya, South Africa, West Africa•Colombia, Mexico•Georgia, RussiaCrop/weather•India/Philippines•Ethiopia, Kenya, Malawi•Haiti, Mexico, NicaraguaProperty/asset/livestock•Bangladesh, India, Mongolia, Nepal, Philippines•East Africa, South Africa, Yemen•Albania, BosniaFuneral•East Africa, South Africa, West Africa•Colombia, MexicoRural insurance schemes•India•Syria•Kenya, Sudan•ArgentinaGroup personal accident•West AfricaUnemployment•East AfricaFlood•China, IndonesiaEducation•India•UgandaEnvironmental•Bolivia, PeruWho are microfinance providers?Microfinance is offered by a number of different organisations. This is still an evolving space, and new participants are always entering the sector. There have also been many innovative methods of getting finance available to the poor.The various types of microfinance providers may be broadly summarised as follows:•NGOs—NGOs have been involved with microfinance since its inception. NGOs tend to assist at the grassroots level and involve the provision of social protection payments as well the set-up of self-help groups•self-help groups (SHGs)—SHGs are generally comprised of up to 20 members who pay into a pool, out of which members can take loans. The more successful SHGs then tend to try and lending to further SHGs thus expanding the SHG pool•credit unions—credit unions are best described as member-owned financial cooperatives. Credit unions are typically savings led, but allow regular saving members to take loans from the credit union•mobile banking organisations—these include the Musoni model in Kenya, which allow for repayments through the M-Pesa mobile device payment system. This in turn, greatly decreases overheads for MFIs and allows for funding in extremely remote areas•microfinance institutions—these are typically structured as commercial companies and have a clear social mission to provide their service to the poor and to assist in the alleviation of poverty. Their lending practice tends to be credit-led and their lending strategy generally takes the form of group loans or individual loans, and•commercial banks and other market-specific models—this involves both MFIs that have converted into commercial banks and still offer microfinance services and commercial banks that have entered the microfinance market. Commercial banks are now tending to see the potential profits in the large low income markets of many countries and therefore are trending into the microfinance marketsA recent development is the use of crowd-funding—that is, the collective raising and pooling together of funds usually via the internet to support efforts to provide financial solutions to the poor. This also includes innovative payments and remittance platforms that are being currently developed.Who are investors in microfinance?A wide variety of investors are involved in microfinance.Private individuals, when they are passive investors, are predominantly invested in debt funds.MFI founders and staff are active investors who often hold direct equity in their institutions. In MFIs that were converted from NGOs into commercial entities, the NGOs frequently maintain shares in the company. Then there are institutional investors who invest both in microfinance investment vehicles (MIVs) and directly. Around a hundred different vehicles invest predominantly by lending to MFIs, although the number of MIVs investing in the equity of MFIs is growing.Last and probably still the predominant drivers, are governmental and supranational development agencies. These include the International Finance Corporation, the European Investment Bank and regional development banks, as well as CDC, KFW, FMO, AECID, the Norwegian Microfinance Initiative, Proparco and BIO. These development institutions invest according to commercial principles, looking for MFIs to be profitable, without forcing them to maximise profits.Investment structures in microfinanceFixed–income investmentsA fixed income investor has a wide variety of choice of funds. In turn, these funds have a wide choice of MFIs in which to invest. Most funds are very well diversified, with investments spread over Latin America, Africa, Central and Eastern Europe, and North as well as South Asia.Private equity investmentsEquity is key to health and growth of any MFI. Equity provides money and, with that, responsibility. Unlike lenders, equity investors have a say in the company, and can determine its strategy, mission, product mix, social focus and return targets. The larger the stake in the MFI, the better one’s views translate into policies and action.Publicly traded MFIsThere are still very few publicly traded MFIs. Few have reached the size or introduced the governance that is required for a listed company.Who are microfinance clients?Microfinance clients are often described according to their poverty level (vulnerable non-poor, upper poor, poor, very poor—see CGAP website). The main clients of microfinance services generally fall within the upper poor and vulnerable non-poor categories. These categories include self-employed, 'domestic' entrepreneurs and those who have a relatively stable source of income, such as retirees and low-salaried workers.Microfinance clients come from both rural and urban centres. In rural areas, they are usually small farmers engaged in small income-generating activities such as food processing and micro-vendor trade. In urban centres, clients often run diverse 'microenterprises' including small retail shops, street vending, artisanal manufacture, and service provision.Documenting a microfinance transactionThe structure of, and documentation required for, a microfinance transaction will vary depending on the MFI involved and the jurisdiction in which the services will be provided but, the typical procedure and process for documentation is as follows.Lending criteriaAs a general standard, the loan process commences with a loan application form that is required to be submitted by the borrower for approval, which may be approved or rejected by such MFI. The MFI or micro lender assesses the application based on its lending criteria.Due diligencePrior to lending, there is a certain degree of due diligence which is conducted on the individual or borrower group. However, the level of due diligence can vary significantly depending on the MFI or micro lender involved. The level of due diligence required is also dependant on what may be customary in the jurisdiction in which the transaction takes place.DocumentationThe loan between the MFI and the borrower is typically documented by a loan agreement which sets out the terms and conditions of the loan. The agreement typically includes the terms of a loan agreement, including the interest rate, term of the loan, repayment, ability to reborrow, and any security provisions, if applicable.The interest rate is usually higher than in a conventional loan agreement, in order to cover the higher administrative costs that MFIs incur.MFI loans have predominantly been unsecured loans, although some loans may be secured against business assets, or against the assets that the loan is funding.Additionally, MFI loan documentation may have certain provisions for payment by mobile technology, such as the Kenyan M-Pesa model, as this is where the market is trending.A unique clause that is sometimes seen in MFI loan documentation is the right to picture the borrower in their place of work and to use the photograph for marketing purposes.Legal opinionsLegal opinions in respect of low value loans are often not viewed as practical so are rarely requested in microfinance transactions.Usually, legal opinions are provided in relation to documents between the MFI and its lenders, as MFIs tend to draw funds under larger facility agreements from lenders and in jurisdictions in which legal opinions are market practice.Legal opinions in respect of the laws of the jurisdictions in which MFIs tend to operate can prove more difficult. Legislation and regulation in the bulk of the jurisdictions in which MFIs operate tend to be fluid so, for example, confirming that the MFI has all the licenses and authorisations to operate in that jurisdiction can be difficult.Shari'ah-compliant microfinanceConventional microfinance can provide access to financial services to entrepreneurial but collateral-poor customers who might otherwise be excluded from the formal banking system. Like conventional banking, conventional microfinance services (microcredit in this case) also involve the collection of interest. The Islamic finance industry, however, is founded on unique structural restrictions. These represent the outer limits of financial activity that is acceptable under Islamic law (or Shari'ah). They include a prohibition on charging or receiving interest. As such, conventional microfinance is not compatible with Islamic law. Islamic law—therefore fills a gap by addressing the needs of unbanked members of society whom conventional microfinance fails to accommodate.The prohibitions of riba, maysir, gharar and haram activities require Islamic market participants to consider issues other than maximum economic success when developing and using financial instruments. It is due to these prohibitions that a series of Islamic structures have been developed Islamic scholars to allow Muslims to participate in financial activity without breaching the parameters of Islamic teachings. These structures continue to form the contractual basis for the contemporary Islamic finance industry and can be broadly classified into:•sale-based structures•partnership structures, and•lease structuresThe development of Islamic microfinance either through Islamic banks or other appropriate entities would therefore be deemed necessary in reaching the financially under-served in Muslim countries such as Iran, Malaysia, Saudi-Arabia, Bahrain, Kutwait, United Arab Emirates (UAE), Indonesia and Sudan.For more on Islamic teachings and how Shari'ah has developed, see Practice Note: Sources of Shari'ah. In addition, for more information on the prohibitions that exist under Shari'ah, see Practice Note: Key principles of Islamic finance.Rating agency view of microfinanceWith the growth of the MFI industry and its integration into the global lending market, a demand has grown for MFI’s ratings. This will allow potential investors to track the performance of MFIs and assess the potential benefits of placing funds into an MFI. Specialist rating agencies have emerged, such as MicroRate and M-CRIL, alongside traditional rating agencies such as Fitch and Standard & Poor’s.As MFIs tend to have a ’double bottom line’, they are assessed on both traditional financial factors, while also being assessed on social impact. Social indicators include the extent to which the poor are targeted to broad factors such as how the MFI utilises social responsibility towards its employees, its clients, the local community and the environment.Microfinance and SecuritisationOne of the methods that MFIs may use to meet funding requirements and obtain off-balance financing is through securitization, which is commonly used by traditional financial institutions. However, although microfinance securitisation is based on the same concept as other types of securitisation, securitisation on the back of microloans is unique owing to the nature of microfinance. In a securitisation, an MFI is the originator and is also often the servicer of the loan, as the collection of the loan receivables is highly dependent on the relationship established between the MFI and the borrowers in remote areas. This feature is one that undermines the issues of rating microloan backed security.Another feature of microloans that make them distinct is that many times they are based on loans which use a group credit mechanism to substitute for the conventional forms of collateral. This mechanism, however, still allows for risk of default and MFIs must structure their products in a way that would mitigate this risk. This could be done using the fundamental methods in securitisation—diversifying the loan portfolio and tranching the securities.Securitisation of loans to MFIs has been around since 2006 when Morgan Stanley and Blue Orchard Finance S.A. arranged a US$106m bond issuance backed by MFI loans. In the following year the pair issued another series of bonds, 'BOLD 2', backed by unsecured loans to 20 MFIs based in 12 different developing countries (Azerbaijan, Bosnia, Cambodia, Colombia, Georgia, Kenya, Mongolia, Montenegro, Nicaragua, Peru, Russia and Serbia). BOLD 2 was rated by Standard & Poors, making it the first microfinance bond to be rated. A product of microfinance securitisation that has developed in recent years is the social impact bond. In India, the securitisation of MFI’s portfolio grew by 41% in the third quarter of 2014-2015. Specific governance-related issues faced by MFIsA lot of literature in this area points to the problems experienced by the industry as a result of the evolution or transformation of MFIs from small, relatively informal organisations to larger, more regulated organisations with a more complex ownership structure. As an institution develops, more formal controls are needed to maintain it. Innovation also becomes key, allowing the institution to keep up with its competitors.Another recurring governance-related issue in microfinance is the need for the interests between the various stakeholders of the MFI to be aligned. As external investment in microfinance has increased, so has the expectation of a financial return on microfinance investments. It can be difficult to balance the expectations of investors of an acceptable financial return on their investment with the MFI’s stated social mission. On the other hand, a disproportionate focus on the social mission, without paying enough attention to ensuring that financial targets are achieved, can lead to the failure of an MFIGovernance codesAlthough the range of institutions that offer microfinance services makes it difficult to design a one-size fits all solution for governance, a small number of governance codes have been developed specifically for microfinance institutions. The Council of Microfinance Equity Funds (CMEF) guidelines are designed specifically for MFIs and examine the unique challenges they face. These guidelines focus on the internal governance controls applicable to an MFI, with a particular emphasis on the role of the board of directors. It offers advice on board composition and guidelines on board and committee meetings. It also outlines key board responsibilities and decisions.The increasingly widespread adherence to industry-wide client protection principles (such as the SMART campaign) and a growing demand from investors for social reporting and social ratings will help achieve this balance. Governance is therefore essential to the longevity of an individual MFI and to the microfinance industry as a whole in a competitive climate with other forms of impact investment for funding.Regulation of microfinanceThere is a wide range of regulatory stances concerning MFIs. They are generally:•unregulated•subject to specific regulations concerning MFIs and not other financial institutions, or•subject to the same prudential regulation as banks in specific jurisdictionsCountries that currently regulate microfinance include Bolivia, Cambodia, Ghana, India, Kenya, Myanmar, Pakistan, the Philippines, Russia, Tanzania and Uganda, albeit the laws and measures are more focused on financial requirement of MFIs than on client protection. 'Consumer protection' type laws are still needed to protect borrowers who sometimes do not understand the loans and are sometimes subject to abusive treatment by microcredit providers in certain jurisdictions.Where MFIs are regulated, the law provides that MFIs adhere to prudential requirements such as minimum capital and having reserve mechanisms for non-performing loan situations. However, it should be noted that the prudential regulation applied to banks generally makes the costs of operating an MFI prohibitive, so governments and regulators are trending towards MFI-tailored regulations and further incentives to promote microfinance.Microfinance and the role of technologyOnce seen as an expensive and cutting-edge technology, mobile banking is becoming increasingly affordable. Open source systems such as Cyclos, developed by the Social Trade organisation, greatly reduce the capital investment necessary to establish a mobile banking platform.Mobile banking technology is increasingly being used to enhance existing business models, and in some cases to create new operating models. Mobile technology enables the concept of branchless or agent banking. With it, MFIs and banks can ‘outsource’ certain activities to non-salaried agents who process transactions using low cost mobile phone technology. This increases outreach and avoids the costs of establishing and staffing bricks-and-mortar branches. Agents, who are usually shopkeepers or mobile airtime vendors, are compensated with a share of any transactions fees charges to the customer. This has made financial services viable for the first time in very remote, low-income areas.MFIs such as Musoni in Kenya now operate on a complete mobile platform, and use mobile money transfer services for all loan repayments and disbursements. Clients can top up their M-PESA account at any national agent, and then send payments to Musoni at their own convenience. Once the funds have been sent, they are deposited within seconds into Musoni’s M-PESA account, while the client receives an automated text message confirming that their transaction has been successful.Mobile banking has already met with real-world success. Following the lead of pioneering innovators such as Gcash, SMART, M-PESA, WIZZIT and others, more than a hundred mobile and branchless platforms are being developed and introduced to dozens of developing countries. Many of the players are social investors who are focused on financial inclusion, others are more aggressively commercial. Between them, and despite the many practical difficulties of implementation, it is clear that mobile banking is here to stay.Recent trends in the microfinance industryIn spite of the global financial crisis, the microfinance sector has continued to grow on a global scale. In particular:•green microfinance, which is still very much an emerging market, has been gaining momentum, particularly in Asia. It targets the achievement of the triple bottom-line results of financial, social and environmental sustainability, also called the three P’s: Profit-People-Planet. Although successful projects and programmes have been carried out in Africa, Asia and Latin America, the approach is nascent in Europe•there is an increasing involvement of strategic commercial actors in the microfinance sector including, investors with the depth, breadth and weight of financial resources•whereas microcredit dominated the microfinance sector in its early years, recent years have witnessed the continued evolution of financial products beyond micro-credit. The sector now encompasses a broad and continuously growing spectrum of products and services, including insurance products and savings programmes•the international market is becoming increasingly integrated, with investors from the international community playing a much greater role than ever before•there have been significant developments in the financing of commercial enterprises in the microfinance sector, coupled by an increase in regulation in a number of jurisdictions around the world, and•crowd-funding and mobile banking are increasingly being used to raise funds and increase access to communities in the remotest parts of the world. There are positive signs of innovative techniques being applied to reach out to the remotest parts of the world via the internet, app technology and alternative forms of currency