The existence and aim of microfinance are justified by one goal—the fight against poverty, humanity’s key concern today. Out of the 6.7 billion inhabitants on the planet, three billion people live on less than US$2 per day, and 80% of the world’s population has no access to financial services.

Microfinance has existed in different forms for centuries, but has only really started to be structured in the last 30 years. It can be defined as the provision of financial services (especially savings, credit, and insurance) to poor people, excluded from the financial sector, in particular the working poor, the microentrepreneurs, who have no access to banks and traditional financial institutions. Microfinance aims to find adapted solutions for people who live in developing countries, allowing them to start and develop a business project. It is an efficient and ethical way of giving them means to escape poverty in dignity. Today, more than 150 million people worldwide, served by more than 10,000 microfinance institutions (savings and credit cooperative, NGOs, microfinance banks, and commercial banks), benefit directly or indirectly from microfinance activities. But it is estimated that over 500 million entrepreneurs remain excluded from financial services.

Microfinancing is based on two principles which are linked to each other. First, that everyone who has an income-generating project should have the ability to become a microentrepreneur and to implement ideas and develop successful enterprises. In this way, microfinance gives an opportunity for the self-financing income generating ideas rather than providing a costless help. Secondly, we believe that the credit relationship can be based on trust. Since microfinance relies on this value, microfinance can avoid a biased relationship between credit providers and their clients, as it has been seen, for example, in the subprime crisis.

Microfinance is based on two lending models: joint (or grouped) microloans and individual contracts. Individual contracts are more similar to traditional loans—a person receives a certain amount of money and must repay it, with interest, within a relatively short period of time (a few weeks or months). The loan amount is generally higher than in joint loans. Joint microloans are granted to a group of people who are jointly responsible for repaying the loan. Individual defaults are avoided and group pressure serves as a strong incentive in ensuring responsible behavior.

Although microfinancing includes interest payment, as the loans are small and must be paid back quickly, the sums to be repaid are affordable for clients, especially considering the output of their income-generating activities. Interest rates in microfinance institutions are high, since MFIs grant many more small loans than traditional banks do, using a methodology that implies higher operating and processing costs. The interest rates cover the cost of the loan, the risk associated with nonreimbursement and expenses relating to the microcredit administrative and processing tasks. Although microcredit costs are substantially higher than those of “traditional loans,” MFIs’ loan officers appear to be far more productive. In viable MFIs, a loan officer manages an average of 359 microborrowers (Microfinance Information eXchange).

Interest rates are determined by local rules and regulations—concerning the ceiling fixed on interest rates: often, the local financial administration or central bank determines a fixed interest rate for the MFIs operating in the country. Interest rates can also be established according to the expenses related to microfinance activities, the type of institution (not-for-profit or profit-oriented MFIs), as well as by technologies or innovations that allow the MFI to enhance productivity and reduce operating costs. More has to be achieved, as far as regulations and best practices are concerned. For example, the Consultative Group to Assist the Poor (CGAP) has been working for years on the development of sound legal and regulatory frameworks for financial service providers that serve the billions of poor people who lack access to the global financial system.

Microfinance is facing new challenges today. First, more has to be done in order to reach more people. Over 500 million microentrepreneurs remain excluded from financial services and poverty is spreading in both rural and urban areas, as has been cruelly demonstrated by the ongoing agricultural and food crisis.

Reinforcing and supporting microfinance institutions enables a greater number of low income entrepreneurs to develop microenterprises and increase their income. But microfinance players need to diversify their products as well as come up with innovative ways to give more people access to microfinance. The development of mobile banking initiatives (including mobile banking credit, savings, and insurance on the use of existing mobile phone infrastructures to reduce MFI transactional costs and broaden their reach to rural and remote areas) can be an efficient and innovative way of giving access to a considerable number of people to financial services.

Microfinance can also play an important role in areas such as healthcare, education, and the environment. The development of microfinance programs associated with health and education initiatives is very positive. It allows the clients of microfinance institutions to be informed about issues that are as diverse as HIV/AIDS or malaria, or biodiversity and best practices in education.

The current financial crisis will have serious consequences for microfinancing. Microfinance represents €30 billion that could be impacted by the financial crisis. Furthermore, the coming recession will have very damaging consequences for the poorest people on the planet. Rich countries may transfer less money to developing countries, which would be negative for the development of microfinance, and local activities could be affected because of the global economic slowdown.

One could think that microfinance will be a victim of the current crisis. But I think that, if properly managed, microfinance can be one of the possible solutions to the financial crisis. This would work in two ways. Firstly, microfinance is an ethical answer to traditional finance. Therefore, it creates the conditions to help people develop the real economy. More than any other area of finance, microfinance aims to reach the 80% of the planet’s population who have no access to financial services in order to include them in the real economy.

Secondly, microfinance has a very important role to play in the resolution of the crisis because the current crisis will only be solved if the global economy is able to find new ways to grow. This growth can only be achieved if millions of people become new consumers and are included in an economy based on consumption, production, and exchanges. Only microfinance can do that. Microfinance can reach people who are excluded from our global economy and allow them to produce exchange and consume in the long term, and hence boost the global economy.

But the challenges remain. The crisis will impact microfinance, which is as threatened as the traditional financial services sector.

The erratic development, in some places, of credit for consumption is very different from the key principle of microfinance, which is to help the development of activities that generate income.

Allowing individuals to obtain credit for their daily consumption can be a real danger. Microfinance providers have to keep an eye on their clients to prevent them obtaining multiple lines of credit, even if these are for the development of income-generating activities.

The crisis should make us learn from the failures of the subprimes. Microfinance’s main aim is to help people to develop income generating activities and we must not forget that. Delinquent financial products and excessive debt are the roots of today’s global financial crisis and are now threatening microfinance as well. Microfinance providers have to be cautious to avoid repeating the same mistakes.

Finally, one must not forget that microfinancing is not, and will never be, the only solution to help the population of developing countries escape poverty. Microfinance is an essential tool in the fight against poverty worldwide but it is no panacea for the world’s poverty. Microfinance can only work alongside developments in new information technologies and democracy, which are basic conditions for poverty to be eradicated in any country.

Original article available on QFINANCE.com