The bank for a changing world

How does an MFI work?

  • 30.06.2016

A microfinance institution (MFI) grants microloans and, sometimes, can even offer certain savings solutions. For that reason, these institutions can seem a lot like traditional banks. However, an MFI operates in some very different ways, especially when it is registered as a non-profit, mutual fund, or cooperative.

What is microfinance ?

The term microfinance refers to all financial products and services developed for those excluded from traditional banking channels. Microfinance encourages social and banking inclusion, by enabling socially vulnerable people to benefit from productive loans, savings solutions and more.

Their crucial difference from “classic” products and services: the relatively small amount of the actual loan. For example, in India, the average for a 2-year loan is $200 USD. Microfinance institutions offer “microloans” to borrowers along with assistance (financing a new business or an expansion plan, paying for urgent family needs, facilitating mobility to obtain a job, etc.), despite the fact that these borrowers do not offer a solid guarantee of repayment.

Income generated by microloan borrowers’ economic activity enables them to pay off the loan balance. 

What are IMF ?

MFIs can operate under different statuses. They may function as: 

  • a non-profit (often an NGO),

  • a mutual fund or cooperative

  • a commercial company (banks or other companies such as non-banking financial companies (NBFCs). 

There are also other local initiatives with no legal standing, though they still active in dispersing microcredit, such as tontines in Africa and self-help groups in India: these are groups of people who pool their savings, in order to finance projects led by one or more of their members. Strictly speaking, these initiatives do not constitute “MFIs,” and the way they operate differs from one entity to the next. 

From time to time, MFIs may change their status in order to expand the range of services they provide. For example, a non-profit cannot collect savings from its customers. However, in some countries it can request to convert into a regulated company that is authorized to perform this transaction.  

What regulations apply to MFIs?

MFIs are subject to regulations that vary based on their status. A microfinance bank will have to comply with banking regulations and will be placed under the supervision of the same oversight authorities as other banks. NGOs, mutual funds and cooperatives are not subject to these regulations (though some are regulated by other oversight authorities).

A unique operating model

While MFIs offer a solution to banking exclusion, they also play a vital role in society, which forces them to operate differently than traditional banking institutions:

  • the eligibility criteria, assessed before granting each loan, do not focus on strong financial guarantees (salary, assets, etc.), but rely instead on more “human” criteria: if the loan under consideration will help launch a new activity, its viability evaluation will also include several interviews with the borrower in addition to the application form.

  • the real guarantee, required by banks in order to grant a loan, may be replaced by a group solidarity mechanism. For example, with mutual funds or cooperatives, each borrower serves as a guarantor for the other members within a “solidarity guarantee group” such as self-help groups.

  • MFIs build close relationships with beneficiaries of microloans, while providing strong support to borrowers, in order to help them succeed in their projects, manage their budgets, etc. In this way, in addition to classic banking services, the MFI may offer training programs focusing on credit or family budgeting, developed solely for educational purposes.

  • the repayment methods for each loan may be adapted to suit the target audience, such as using weekly payment dates.

  • the products are adapted to the target audience in a way that has no real equivalent in the traditional banking world. This is notably the case for group loans: the MFI requests to constitute a group of borrowers and grants a single microloan to the entire group. Typically offered to the poorest borrowers, group loans do not require any guarantee, but instead rely on the solidarity of all group members. This creates a kind of “social guarantee”: the members are responsible to the MFI, as well as to their co-borrowers.  

How are loans granted?

The tontine system in Africa, an ancestral practice that is still common today, relies on an individual’s belonging to a group, which helps to forge relationships of trust and solidarity: in this case, social ties seal the relationship, while trust builds the contract. In some cases, tontines even operate among a group of people who all already know each other, and involve offers of interest-free loans.

MFIs transpose this informal yet efficient principle, by developing a solidarity economy that always relies on mutual confidence. Before granting microloans, requests are examined by a committee, which evaluates the borrower’s eligibility based on human and social criteria (motivation, competence, experience, etc.), as well as the project’s viability and repayment capacity. It’s a method that works: the repayment rate for microloans is near 97% in emerging countries!

Sometimes, an “oversight mechanism” is imposed, which functions through social pressure, as is the case in Bolivia with its system of publically indicating “bad borrowers.” 

Where do MFIs get their funding?

MFIs secure funding from a variety of sources, which depend in part on their status.

In this way, money granted through microloans may come from:

  • grants and subsidies, particularly during the MFI’s creation, 

  • member and customer deposits, for MFIs organized as cooperatives or mutual funds, as well as microfinance banks that also offer savings products,  

  • the MFI’s own capital, generally supplying a small portion of funding,  

  • loans granted by one or more partner banks

  • funding from public investors, typically comprising bilateral or multilateral organizations like the European Investment Bank (EIB), IFC, KFW, AFD, Proparco, etc. 

  • private investors, supplied directly or through investment funds specializing in microfinance (microfinance investment vehicles, or MIVs), which serve as the intermediary between the MFI and investors searching for a socially responsible investment.

The latter two options provide a source of long-term funding. 

BNP Paribas and MFIs

BNP Paribas has a long history of supporting financial inclusion by financing microfinance institutions, both in developed and emerging countries. In addition, it creates investment funds partially made up of microfinance investments.

Supporting Microfinance is one of the Group’s 12 CSR commitments outlined in the category of Civic Responsibility: “Products and services that are widely accessible.”

To this end, BNP Paribas has set an objective in its management dashboard to increase the number of its microloan beneficiaries from 250,000 microloan borrowers in 2015 to 350,000 by 2018.