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Definitions & Functions of Micro Finance

Paper Type: Free Essay Subject: Economics
Wordcount: 2375 words Published: 22nd Sep 2021

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Microfinance is viewed to be a cure against poverty in the world. In each country and region having diverse demographics, microfinance is being utilized to combat poverty. It is a quite recent concept in banking and financial sectors.

Microfinance is to allot very small loans to poor people with the aim of aiding them to start their own enterprises so as they can come out of poverty. That is microfinance is not a hand out, instead it is a hand up that permit the poor, mostly women, to attain continuous financial triumph.

The Journal of Microfinance describes it as what “is arguably the most innovative strategy to address the problems of global poverty” (Woodworth and Woller, 1999). The General Secretary of the United Nations, Kofi Annan, stated in 2002 that microcredit is a critical anti-poverty tool and a wise investment in human capital (Annan, 2002).

“Microfinance has evolved as an economic development approach intended to benefit low-income women and men. It refers to the provision of financial services to low – income clients, including the self employed” (Ledgerwood, 2000).

Microfinance is defined as formal scheme designed to improve the well being of poor through better access to saving and services loans (Schreiner, 2000).

The word “microcredit” was not existent before the seventies. But now it has turn out to be a buzz-word among the development practitioners. It is normally characterized as making small loans available directly to small-scale entrepreneurs to enable them either to establish or to expand micro-enterprises and small businesses. Microcredit is normally applied to target groups that would otherwise not qualify for loans from formal institutions. This includes the majority of those living below the poverty line (Commonwealth Secretariat, 2001).

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Microcredit differs from microfinance in that microcredit refers to very small loans for unsalaried borrowers with little or no collateral, provided by legally registered institutions. Currently, consumer credit provided to salaried workers based on automated credit scoring is usually not included in the definition of microcredit, although this may change. Whereas Microfinance typically refers to microcredit, savings, insurance, money transfers, and other financial products targeted at poor and low-income people.

Microfinance is a highly common way of lending as lot of people require to borrow money rapidly and in little amount. In the case of macro loans, banks enquire about the person’s credit history and people have to pass through lots of procedures before the approval of the loan amount.


According to (Murray, U and Boros, R, 2002), there are many activities and characteristics are included in microfinance. Some are:

  • Small amounts of loans and savings.
  • Short- terms loan (usually up to the term of one year).
  • Payment schedules attribute frequent installments (or frequent deposits).
  • Installments made up of both principal and interest, which is amortized over the course of time.
  • Higher interest rates on credit (higher than commercial bank rates but lower than loan-shark rates), which reflect the labor-intensive work associated with making small loans and allowing the microfinance intermediary to become sustainable over time.
  • Easy entrance to the microfinance intermediary saves the time and money of the client and permits the intermediary to have a better idea about the clients’ financial and social status.
  • Application procedures are simple.
  • Short processing periods (between the completion of the application and the disbursements of the loan).
  • The clients who pay on time become eligible for repeat loans with higher amounts.
  • The use of tapered interest rates (decreasing interest rates over several loan cycles) as an incentive to repay on time. Larger loans are less costly to the MFI, so some lenders provide large size loans on relatively lower rates.
  • No collateral is required contrary to formal banking practices. Instead of collateral, microfinance intermediaries use alternative methods, such as the assessments of clients’ repayment potential by running cash flow analyses, which is based on the stream of cash flows, generated by the activities for which loans are taken.


Microfinance is established as an efficient way to eradicate poverty by offering financial services to those poor people who cannot reach or are ignored by banks and financial institutions.


Poor people have necessary skills and knowledge to start their own enterprise, the only thing is that they do not have resources (especially finance) to do so. Thus microcredit helps them to accomplish their vision by providing them with micro loans. According to Ahmad (2000), it is acknowledged that people living in poverty are innately capable of working their way out of poverty with dignity, and can show creative potentials to improve their situation when an enabling environment and the right opportunity exists. It has been noticed that in many countries of the world, micro-credit programmes, give access to small capitals to people living in poverty.

Microfinance is an promising tool for economic development, poverty lessening, empowering of low income communities and giving a new role in micro-entrepreneurship (Mondal, p.1-3). The MFIs take into account the need of their customers concerning micro loans so as they can carry on their enterprises.

There are two types of microfinance borrowers; Micro borrower and Micro entrepreneur. A micro borrower has mind like capitalist who is intend to gain profit while doing business. Therefore a micro borrower gets finances from MFIs, and after reimbursing, they will obtain finances again but only if the purpose is to earn profit and not any entrepreneurial achievement. In contrast, a micro entrepreneur funds his business and brings modernism, originality and distinction from others (Mondal, p.3).

Microfinance bestow empowerment to women. Misra (p.3) describes empowerment as a strength to the people and self governance. He quoted “Empowerment builds self-reliance and strength in women, preparing them towards gathering the ability to determine the choice of life. This adds to the command over resources outwit insubordination and signify their social role.”

According to PREM,WB (2002,p.11), “Empowerment is the expansion of assets and capabilities of poor people to participate in , negotiate with , influence, control, and hold accountable institutions that affect their lives.”


A microfinance institution (MFI) is an organization that offers minor loans to the needy people. The framework of the loan differs from organization to organization as every institution has their own procedures and conditions to supply credits. Nevertheless, the core purpose is to grant financial assistance to the underprivileged.

When talking about MFIs, we can think about non-governmental organizations (NGOs) which also provide loan facilities to the poor. During the 1990s, many NGOs were converted into formal financial institutions so as to access and on-lend client savings, as a result improving their outreach.

There are also other kinds of microfinance institutions such as credit union or cooperative housing society. These organizations are different in every country (Rehman, 2007). Nowadays even commercials banks are moving towards the concept of microfinance. They are doing this to attract new clientele who wants to start a business but does not have enough funding to do so.


Formal providers are sometimes defined as those that are subject not only to general laws but also to specific banking regulation and supervision (development banks, savings and postal banks, commercial banks, and non-bank financial intermediaries). Formal providers may also be any registered legal organizations offering any kind of financial services. Semiformal providers are registered entities subject to general and commercial laws but are not usually under bank regulation and supervision (financial NGOs, credit unions and cooperatives). Informal providers are non-registered groups such as rotating savings and credit associations (ROSCAs) and self-help groups.

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Ownership structures: MFIs can be government-owned, like the rural credit cooperatives in China; member-owned, like the credit unions in West Africa; socially minded shareholders, like many transformed NGOs in Latin America; and profit-maximizing shareholders, like the microfinance banks in Eastern Europe. The types of services offered are limited by what is allowed by the legal structure of the provider: non-regulated institutions are not generally allowed to provide savings or insurance. (www.cgap.com)


Accepting or paying interest while lending or borrowing money is forbidden according to the Islamic law. However the borrower will share the profit that he will obtain from his business with the lender.

Money is not an asset for earning profit (Duhmale, Sapcanin, p.1). Islam emphasizes on social, ethical, moral factors for distribution of wealth and guide towards social and economic justice. Islam encourage profit rather than interest because earning profit evolve productive activity and involve in profit and risk sharing between lender and borrower (Dhumale, Sapcanin, p.1-2). The purpose of Islamic microfinance is to provide small loans to poor people without interest. This concept benefits the borrower as microfinance interest rates are relatively high.

There are several means to proceed with the interest-free microfinance but we will talk about three of them which are:

MUDARABA (Participation Financing)

Here deal takes place between the lender and the borrower. No interest will be charged, however profit will be shared by both the loan provider and the borrower. According to Zaher, Kaber, ” Mudaraba is a trust based financing agreement whereby an investor(Islamic bank) entrusts capital to an agent(Mudarib) for a project. Profit will be shared on an agreed ratio and the contract is similar to a western type of limited partnership where one is injecting money and the other one controls the business. In case of losses, the lender receives no return and the borrower no recompense for his work (Segrado, 2005, p.11).


According to Segrado (2005), ” Two parties provide capital for a project which both may manage. Profits are shared in pre-agreed ratios but losses are borne in proportion to equity participation”. As we can see, here it is not established on profit sharing but depends on evaluation and administration competence and part in business.


Here the lender will purchase goods and sell them to the borrower after adding a reasonable profit. The lender will stay the proprietor of the goods until imbursements are cleared. Dhumale, Sapcanin (p.10) describe Murabahah as “the Murabahah contract is similar to trade finance in the context of working capital loans and to leasing in the context of fixed capital loans”.



The terms “microfinance” and “micro credit” were not on screen before 1980s 0r 1990s (Robinson, 2001). It all started with the return on Muhammad Yunus to Bangladesh after teaching in the U.S for a few years.

In 1974, during a trip in a relatively poor village in Bangladesh, Muhammad Yunus came across Sufiya , a stool maker, who had to borrow money from a local lender so as to buy raw materials. She had to repay the lender with high interest rates which sometimes exceeded the initial amount. After repayment, she was left with practically nothing to meet her basic needs. Dr. Yunus was disappointed by what he saw and lent a small amount of money to 42 rural basket-weavers. He found that his action encouraged them to work more and they were enthusiastic to repay their loan (Roy, Mark A, 2003).

After two years, there came the establishment of the Grameen Bank where Dr. Yunus introduced the “Grameen Model” which is now the buzzword in the world of microfinance. Since its start in 1976, it has grown to over 1084 national branches in over half the villages of Bangladesh. The concept of this model is to provide loan facilities to poor people, especially women, so that they can carry out their small enterprises and manage their livelihood (Roy, Mark A., March 2003).

The procedure of the “Grameen Model” is that borrowers should form a group of five members. After the loan application, the first two people will obtain the loan. If they repay their loan successfully, then the other two members will get their loan amount. The last member will be granted the loan when the previous two members clear their debts. If this group was a good payer, therefore they will be eligible for future loans. However, if one of them fail to pay the loan, the whole group will be disqualified for further loan (Rehman, 2007).

As we can see, the approach of group lending is applied. This approach has many advantages. Firstly, members of a group are acquainted to each other, therefore if one is absent in the group meeting, another one can pay its installments. Furthermore in South Asia, especially in Bangladesh, there exists some kind of social pressures. If a member of a group does not repay his loan, he will be pressurized by the other members and also his neighborhood will get to know about it. So he will have to make an effort to repay his loan to avoid this kind of situation (Sengupta, Aubuchon, 2008).


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