1. Background of microfinance
Microfinance consists of the provision of financial services in small increments, typically to very poor people.
The beginnings of the microfinance movement are most closely associated with the early 1970’s and economist Muhammed Yunus, who was a professor in Bangladesh. Bangladesh was a very poor country at the time so he began making small loans to poor families in neighboring villages in an effort to break their cycle of poverty. The experiment was a surprising success, with Yunus receiving timely repayment and observing significant changes in the quality of life for his loan recipients. He grounded the Grameen Bank with the help of governmental financing. In order to focus on the very poor, the Bank only lent to households owning less than a half-acre of land. Repayment rates remained high, and the Bank began to spread its operations to other regions of the country. In less than a decade, the Bank was operating independently from its governmental founders and was advertising consistent repayment rates of about 98%. In 2006 Yunus was awarded the Nobel Peace Prize.
Institutions replicating its model sprang up in virtually every region of the globe. Between 1997 and 2002, the total number of MFIs grew from 618 to 2,572. Altogether, these institutions claimed about 65 million clients, up from 13.5 million in 1997 and still growing at 35% a year. The amount of money flowing to clients also continues to climb rapidly and the Grameen Bank has extended over $750 million worth of credit in the past two years alone.
Alongside the explosion of the microfinance industry in absolute terms, there has been a steady growth in private financing for MFIs. The bulk of microfinance funding is still provided by development-oriented international financial institutions and NGO\’s. Yet estimates place demand for unmet financial services at roughly 1.8 billion individuals. Commercial financing has grown most rapidly in Latin America, where regulated financial institutions now serve 54% of the continent\’s microfinance clients and, importantly, are now responsible for 74% of the region\’s loans. Overall, 2005 saw private lending to MFIs jump from $513 million to $981 million.
This jump in investment is a reflection of an increasing number of sustainable MFIs worldwide. In addition to earning a profit, sustainable microfinance providers are in a better position than their subsidized peers to expand their operations and share of the market. Thus in a study by the Consultative Group to Assist the Poor (CGAP) in which operationally sustainable MFIs represented only 46% of the sample, they accounted for 77% of borrowers served. The push towards sustainable institutions and the resulting growth of commercial financing raise some important questions about the true mission of MFIs and how best to expand their reach. These issues are further developed in the materials below.
1.2. Benefits of microfinance
The very poor are unusually susceptible to income shocks. Death, illness, natural disaster, or other catastrophes can have devastating effects on households existing at or just above a subsistence level. With no asset base on which to draw in the crisis, they may be forced to severely reduce their level of consumption, which can be dangerous if it means forgoing basic healthcare and nutrition. Additionally, they may sell off important, income producing assets, exacerbating their economic difficulties well into the future.
Financial services that allow poor people to save in times of prosperity and borrow or collect insurance when necessary allow them to maintain a consistent level of consumption without selling off income-producing assets. Microfinance can also provide an opportunity for expanding or pursuing new business opportunities that allow poor people to increase or diversify the sources of their income.
It has also been argued by advocates that microfinance can also promote the development of a traditional financial sector. Most obviously, by alleviating poverty, microfinance can deepen the market for more traditional financial services. In addition, MFIs and their clients can lobby for the creation of clearinghouses for information on borrowers\’ credit histories, easing of interest rate controls, greater foreign ownership of financial institutions, and opening local capital markets beyond a country\’s political elite, among other reforms. Such improvements could strengthen the financial sector as a whole, creating a feedback loop that could serve to lift even more families out of poverty.
Microfinance can also generate important non-economic benefits. For instance, many microfinance programs are aimed specifically at women. It has been suggested that access to financial services enhances women\’s power and influence in the household. Their ability to make decisions over certain purchases and their new status as important household earners has been linked not only to increased bargaining power, but also to a decreased incidence of domestic violence. (Lower incidences of abuse could also be the result of third party scrutiny from loan officers and, in the case of group lending, fellow borrowers.) Furthermore, the opportunity to pursue business opportunities may make women more likely to use contraceptives and lower fertility rates.
In addition, many MFIs couple their loan programs with educational efforts. For example, loan officers may provide information on contraceptive use or disease prevention or domestic economics as well as methods of controlling saving and spending habits and various aspects of small business management.
1.3. Challenges associated with lending to the poor
Ultimately, microfinance is designed as a tool to reach impoverished households that are not otherwise served by more traditional financial institutions. There are several reasons why it is difficult to lend money to the poor.
1.3.1. Hidden information
The primary problem with lending to the poor, and the main obstacle that microfinance is designed to overcome, is banks\’ lack of information about the inherent riskiness of potential clients. The transaction costs of evaluating individual borrowers are very high relative to the size of the loans likely to be made to poor borrowers. This means that to cover the expense of screening individual borrowers banks would be forced to charge correspondingly high interest rates to their clients. Moreover, it is doubtful whether screening will provide accurate information given that potential borrowers have incentives to misrepresent their credit history and the risks of their respective projects. Without accurate information, banks will still charge high rates to cover the frequent incidence of default among the risky borrowers that will inevitably join their client base. Either way, interest rates will be high enough to drive borrowers with safe but relatively low returns out of the market. This problem is referred to as adverse selection.
Governments sometimes respond to this problem by imposing restrictions on interest rates charged by financial institutions in the form of usury laws or interest rate caps. With rates constrained, it would become impossible to provide banking services to the poor without significant and costly subsidies.
1.3.2. Moral hazard
Even borrowers whose projects are not inherently risky may refuse either to use their loans productively or, if they do use the loans productively, to repay their loans if their lenders have no means of enforcing their obligations. This problem of moral hazard may arise because, for instance, local judges are biased in favor of debtors or police forces are stretched too thin to provide assistance. This problem can be exacerbated by competition among lenders, as in the absence of competition a lender can encourage repayment by refusing to provide future credit.
1.3.3. Absence of credit history
In societies with developed credit markets, problems stemming from inadequate information and moral hazard are mitigated by the fact that lenders routinely investigate borrowers\’ credit histories. . A record of a borrower\’s repayment history provides lenders with valuable information about the likelihood of future repayment. In addition, the ability to tarnish a borrower\’s credit history and thereby limit the borrower\’s access to future credit provides lenders with leverage that they can use to induce repayment.
1.3.4. Lack of collateral
Another response to problems of hidden information is to require that borrowers provide collateral, meaning an asset that the lender can easily seize and, perhaps, sell in the event of default. This allows banks to charge low interest rates even in the face of poor information about the borrower\’s prospects. But many of the impoverished borrowers that microfinance seeks to reach lack assets that can effectively serve as collateral. When they do have assets, they are often illiquid. Livestock, for example, is not only subject to destruction, but can be very difficult to convert on the market for a traditional bank inexperienced in selling it. Furthermore, among these sorts of clients the only assets they have may be critical to their means of subsistence and legal or ethical restrictions may prevent banks from foreclosing upon them.
1.4. Typical features of microcredit
MFIs employ several innovative contractual devices, including group lending, progressive lending, short-term contracts, and targeting of women, in efforts to overcome the obstacles that have traditionally discouraged lending to the poor.
1.4.1. Group lending
Perhaps the most important of the microfinance innovations, and certainly the one for which it has received the most recognition, is lending to solidarity groups. Though many MFIs have departed from it, the original Grameen model required that loans not be made to individuals or singular families, but instead to a solidarity group of five women. As each group member was required to vouch for the creditworthiness of the others, these women were all likely to be from the same village and would self-select one another for membership. All members received equal financing and made repayments on the same, fixed schedule. Most importantly, if one member of the group defaulted on their payments, no other member of the group could apply for another loan until the default was cured.
Group lending provides several benefits to both lenders and borrowers:
• When the members of the group are self-selected from the same village, their knowledge of one another\’s habits and awareness of each member\’s propensity for risk will largely obviate extensive screening by the lender. Safe borrowers will select one another for membership and the MFI can avoid a highly costly and inaccurate interview process. Additionally, risky borrowers will be forced to select one another. As they will have to pay more often for their frequently defaulting peers, they will indirectly pay a higher effective interest rate. The risk for such borrowers is thus shifted from the MFI to the borrowers themselves. As a result, a lower nominal interest rate can be charged to all parties and a much wider segment of society can gain access to credit.
• The group members can also monitor one another much more effectively than the lender, and group lending gives them an economic incentive to do so. This monitoring can take two forms, the first being ex ante observation to ensure that group members are putting their money towards appropriate uses. Ex post, members will also ensure that returns from a loan-funded project are going towards repayment. They can report to the MFI on members who are withholding payments despite an ability to pay.
• Group members can help lenders overcome limitations of formal mechanisms for enforcing obligations. Members are able to exert pressure on each other, be it social, cultural, or even religious, that traditional institutions are unable to bring to bear. Also, under the Grameen model, a solidarity group of 5 women was a part of a larger village group, allowing for community leaders to pressure defaulting borrowers into repayment.
It is important to note though that borrowers only have incentives to screen and monitor their fellow group members if they expect to repay their own loan and obtain additional funding in the future. To the extent they plan to default, these incentives are no longer in place. Furthermore, if the group\’s losses are expected to outweigh the borrower\’s return on their own investment, the borrower has no reason to attempt to cover those losses. She will lose all of her own profits, but as the loan will not be paid in full, she will see none of the gains that come with timely repayment, namely an increased loan amount in the next cycle. Additionally, borrowers may not be able to effectively evaluate either the inherent riskiness of their partners or the riskiness of each other’s projects.
1.4.2. Progressive lending
Some MFIs adopt the policy that once a debt is repaid in a timely fashion the group will be eligible not only for a new loan, but for a larger loan as well. This structure creates opportunity costs for non-repayment, as a borrower stands to lose substantial future credit if they chose to default. A loan-ladder also gives MFIs the opportunity to “test” their borrowers with smaller loan packages, helping the institution to gather information about their potential clients. As loan sizes increase, the average costs of servicing those loans decrease, making the MFI itself more profitable. Although there is still opportunity for a borrower to strategically default, waiting until loan sizes have grown substantially larger before failing to make payments, the reputational constraints discussed above operate to reduce the frequency of this problem.
1.4.3. Short-term contracts
Finally, in yet another substitute for an MFI\’s lack of information about its clients, most microfinance loans have very short repayment periods, with cycles lasting as little as a week. As each payment is made directly to an officer of the MFI, these frequent meetings assist in monitoring investments and keeping track of repayment. Keeping the loan size small also limits the MFIs exposure in the event of borrower default or economic shock to a particular group or village. It is also important to observe that many microfinance clients report that they find it easier to repay their loans on shorter schedules.
1.4.4. Targeting women
Empirical evidence has demonstrated that women are more effective targets for microfinance than men, despite the fact that men are typically the targets of formal sector commercial institutions in developing countries. Women are not only more likely to repay their loans, they are also more likely to spend loan proceeds on their families basic needs, education, and health care, leading to a greater impact on household welfare. It has been suggested that women provide better targets for microfinance for a variety of reasons: They are typically less mobile than their husbands. As a result, the monitoring costs for bank managers are lower. Because they are less mobile, they are also more susceptible to the peer pressure that is critical to securing repayment in group lending contracts. Finally, as women have been traditionally relegated to small industry, they have a comparative advantage in the very businesses to which microfinance is targeted. While microfinance could thus, arguably, be seen to further entrench women in their traditional roles, as a counterargument these women have few opportunities outside of the home. Microfinance allows them to take the fullest advantage of chances that are available to them, limited as they may be.
2. Micro financing practices in the world
Today, more than 150 million people worldwide have access to microcredit, the industry’s flagship product – roughly equivalent to half the population of the United States. From the perspective of microfinance institutions (MFIs), this growing market has been successful. Loans are being repaid, and many lenders are generating profit. It’s clear that the foundation for microfinance has been established, but there is still plenty of room for growth. After all, 2.6 billion people; over 40% of the world’s population, still live on less than $2 per day and more than 2 billion remain “unbanked” (without access to traditional financial systems).
An exceptional rate of growth has brought the microfinance industry to its current size. In 1997; only 19 years ago, slightly more than 13 million people had access to microcredit. The market nearly doubled by 2000, and registered a tenfold increase by 2006. Few markets have grown as quickly in such a short period of time.
Even considering the industry’s profound recent rate of growth, there remains plenty of room for more. If we assume (somewhat conservatively) the total market for microfinance product purchasers (excluding children and the infirm) consists of about 1.5 billion people, market penetration is only around 10 percent. While the immediate potential to generate profits from this untapped space is enormous, the development of financial capabilities amongst customers at the bottom of the socioeconomic pyramid will also create a platform for future wealth generation, which in turn will create the need for more robust financial services. Put simply, today’s low-income client will be tomorrow’s middle-income client. Companies entering the market now have a unique opportunity to build brand loyalty and familiarity with these customers as they move up the socioeconomic ladder. This will likely yield substantial long-term opportunities especially for early movers, which will result in market preeminence as targeted economies develop.
2.1. European Union
We can find four different forms of microfinance business models existing in Europe:
• NGOs with a microfinance driven approach
• NGOs with a target group driven approach
• Support programmes initiated in existing institutions and development banks
• Specialised units of banks
NGOs with a microfinance driven approach focus on serving clients with mainly financial services. Some of these also have a very clear social mission. Well-known examples are Adie (France), ANDC (Portugal), Aspire (UK, Northern Ireland) and Street UK (UK).
In the second model, NGOs serve specific target groups (women, unemployed, ethnic minorities, micro entrepreneurs, migrants, youth) with a range of services usually related to employment. These NGOs include financial services in their overall programme. Examples include institutions such as the microloan fund of the city of Hamburg (Germany), Weetu (UK), IQ/Enterprise (Germany), Hordaland Network Credit (Norway).
The third model refers to existing institutions and development banks that have integrated support programmes for micro and small enterprises in their regular portfolio. These organisations have established special microcredit windows. Examples are the micro and small enterprise programmes of Finnvera (Finland), KfW Bankengruppe (Germany), BDPME- Oséo (France) and ICO (Spain).
The fourth model is the most recent. Here specialised units within banks disburse microloans directly or through partner organisations. The model is prevalent in Spain, where savings banks such as La Caixa, Caixa de Catalunya, BBK or Caja Grenada have played a leading role in developing the sector.
To the above four models we should add a fifth. Whilst not active in all countries, credit unions are particularly important in countries such as Poland and Romania and to a lesser extent in Ireland and the United Kingdom. At present there is little information available on their microcredit activities. Most of their lending is restricted to credit union members and for purposes other than business start-up or development.
Two other types of actors could be also added here: mainstream banks and financial institutions that provide consumer loans used for business creation or development. At present, data is not available for their loans worth EUR 25,000 or less and whether these are used for business development and creation.
According to the most recent EMN survey 92 % of respondents have not-for-profit status and four out of ten are non-governmental organisations. The latter are responsible for half the loan volume in Europe. By country, NGOs dominate especially in France, Spain and the UK.
In the European Union, microcredit remains the main financial service offered. Microfinance, a broader concept integrating financial services such as savings, micro insurance or transfers, is very limited. NGOs in the UK and savings banks in Spain are the primary providers of this wider spectrum of services. This is mainly due to the fact that, on one hand, the financial services sector is well developed in the EU countries. On the other, in many countries regulatory environments restrict the financial activities of non-governmental organisations.
The average microloan size across the EU 25 is EUR 7,700. In the EU 15 the average microloan value is EUR 10,240 and in the new member states it is EUR 3,800. Loans are reimbursed at the latest after five years. Micro lenders focus on start-up businesses and small microenterprises, those with five or fewer employees. Clients targeted in order of importance are financially excluded individuals followed by women, unemployed persons, the self-employed and immigrants. There is considerable overlap among many of these groups.
The most important strategic issues for the sector are related to funding and sustainability. Funding operational costs is a significant challenge for lenders. Not a single lender in the EU 15 is operationally self-sustaining at present, although sustainability is a long-term goal for many. EU 15 lenders rely primarily on public and private funds to cover operational costs. In the new member states, operational costs are covered by earned income, public subsidy and private charity funds. Some lenders in the EU 15 are covering all their operational costs through earned income. These institutions are mainly banks, using their existing facilities. In the new member states, several organisations are even operationally sustainable. These lenders manage large microloan volumes and charge interest rates that cover operational costs and risk. Loan capital is funded, in order of frequency, by the public sector, private sector and private charities. Accessing loan capital is less of a challenge than accessing money to cover operational costs.
3. Micro financing in Bosnia and Herzegovina
3.1. Financial system in Bosnia and Herzegovina
Economic and financial activity in Bosnia and Herzegovina (B&H) remains stuck in a low gear since the global financial crisis, reflecting weak external demand, tighter funding conditions, and deep-seated structural issues. Bank governance problems, related-party loans and inadequate corporate resolution and insolvency frameworks are obstacles to addressing asset quality problems and re-establishing bank profitability. Institutional fragmentation is delaying much-needed financial sector reforms. Aggregate solvency and liquidity indicators appear broadly sound, but significant pockets of vulnerability exist. The banking system is more than 80% foreign-owned banks. The average regulatory capital adequacy ratio exceeded 16% as of end of 2014. However, the dispersion among banks is wide, ranging from about 7% to 48%. Vulnerabilities are concentrated within domestically owned banks, some of which are struggling to meet capital requirements, while some others are relying on public support.
The Federal Republic of Bosnia and Herzegovina (B&H) is split in two Entities: Federation of Bosnia and Herzegovina (FBH) and Republic of Srpska (RS) and specific rules apply for the self-governing Brcko District. B&H has 3.79 million people; however, many Bosnians are still working or living abroad. B&H is regarded as an upper middle income-economy with a GDP per capita of BAM 6.862 (EUR 3,508) in 2013. Despite the country’s location in Southeast Europe, its population still suffers from poverty and a highly skewed income distribution. This is mainly due to the fact that a major part of the population lives in rural areas that are less developed and that official unemployment rates are extremely high (above 30%).
Bosnia and Herzegovina had experienced strong growth prior to the global financial crisis. Sizable inflows into the banking system fueled a credit boom, while the introduction of value-added taxation in 2006 allowed for large increases in public sector employment and in public wages and social benefits. But as incomes rose, so did domestic and external vulnerabilities. When output collapsed in the aftermath of the global crisis, the current account and budget deficits rose sharply, and with that public debt. Growth was lackluster following the crisis, with several starts and stops, reflecting weak activity across Europe and deleveraging by foreign- owned banks.
After these difficult years, the recovery is showing signs of taking a firmer hold. As economic activity is projected to pick up in Europe, growth in Bosnia and Herzegovina is expected to rebound to over 2% this year. Industrial activity and exports will gather momentum, and together with the decline in fuel prices, this will boost incomes and consumption.
As of 30th September 2015, there were 17 banks with a banking license in the Federation of B&H. In the first three quarters of 2015, there was no major expansion of the banks’ network of organizational units, chiefly attributable to the financial crisis and the reduced volume of the banks’ business activities.
Banks have reorganized their networks of organizational units by changing the organizational form, membership or address of their organizational parts. This also entailed mergers and closings of some organizational parts, all for the purpose of business rationalization and operating costs reduction. There were a total of 24 such changes among banks in the Federation of B&H (21 changes on the territory of the Federation of B&H, 2 in Republic Srpska, and 1 in Brčko District): 3 new organizational units were established, 9 organizational units were closed, and 12 underwent changes.
Subsequent to such changes, banks in the Federation of B&H had a total of 566 organizational units as of 30th September 2015, down by 0.9% compared to 31st December 2014.
The number of organizational units of banks from Republic Srpska in the Federation of B&H, which of now is 36, changed compared to 31st December 2014, when there were 32 organizational units, which is an increase of 12.5%.
As of 30th September 2015, seven banks from the Federation of B&H had 49 organizational units in Republic Srpska, and 9 banks had 12 organizational units in Brčko District. Four banks from Republic Srpska had 36 organizational units in the Federation of B&H. All banks had licenses to effect interbank transactions within the domestic payment system, and 16 banks had secured deposits.
3.2. Ownership structure of the banks in Bosnia & Herzegovina
The ownership structure of banks as of 30th September 2015, assessed on the basis of available information and reviews conducted in the banks themselves, is as follows:
• In private or mostly private ownership: 16 banks (94.1%)
• In state or mostly state ownership: 1 bank (5.9%)
Out of the 16 banks in mostly private ownership, 6 banks are in majority ownership of local legal entities and natural persons (residents), while 10 banks are in majority foreign ownership.
If observed solely from the perspective of foreign capital, using the criterion of the shareholders’ home country, the conditions as of 30th September 2015 changed compared to those as of the end of 2014 as a result of recapitalizations and changes in the ownership structure of two groups (transfer/acquisition among group members): the largest share of foreign capital in the amount of 57.1% refers to shareholders from Austria (share down by 5.6 percentage points), followed by shareholders from Croatia with 15.2% (share up by 7 percentage points) and Turkey with 9.4% (share up by 5.3 percentage points). Other countries hold individual shares below 6%.