Unit 1: Introduction to Micro Finance LH 5

Concept, Definition and principles of microfinance, Characteristics and importance of

Microfinance, Historical Background, Role of microfinance for elevation of poverty, Linkages
between mainstream financial services & micro-finance

1. Introduction to Micro-finance

Microfinance is the provision of loans and other financial services to the poor. Microfinance has
evolved due to the efforts of committed individuals and financial agencies to promote self-
employment and contribute to poverty alleviation and provision of social security. Microfinance
provides financial services to those whose income is small and unstable. These people need credit
facilities for several reasons.

• Their needs are small and arise suddenly

• The institutional providers of finance namely the banks demand collateral
security which they cannot provide
• Most of the time, they are in needs of funds to meet their consumption demands, for example,
to meet expenses related to education, illness, funerals, weddings for which it is difficult to
obtain institution finance
• For investment in income generating activities.

2. Concept

Microfinance is a concept that helps the poor create economic opportunities. It is the efforts for rural
development, women empowerment, and wealth generation by providing small scale savings, credit,
insurance, and other financial services to poor and low-income households. Microfinance thus
empowers the poor and provides a valuable tool to help the economic development process. The
concept of micro financing and self-employment activities in rural areas has developed over the last
two decades. It is working neither on charity nor on subsidy. It is rotational investment done to
motivate the poor to empower themselves and practice the dictum 'Save for the future and use those
resources during a time of need. Theoretically, microfinance, also known as microcredit or micro
lending, means making provision for smaller working capital loans to the self-employed or self-
employment seeking poor.

“Microcredit, or microfinance, is banking the un-bankable, bringing credit, savings, and other
essential financial services within the reach of millions of people who are too poor to be served by
regular banks, in most cases because they are unable to offer sufficient collateral. In general, banks
are for people with money, not for people without.”

3. Definition

Microfinance refers to a range of financial services provided to low-income individuals, households,

and small businesses that typically do not have access to traditional banking services. These financial
services include microcredit, savings accounts, insurance, and other financial products tailored to
meet the specific needs of people living in poverty.

Microfinance institutions (MFIs) provide these services to help the poor improve their living
standards, start, or expand small businesses, and build financial resilience. The primary focus of
microfinance is to provide small-scale financial services to the unbanked or underbanked population,
who do not have access to formal banking channels due to their low income, lack of collateral, or
inability to fulfill the stringent requirements of traditional financial institutions.

Micro financing loans are small loans granted to the basic sectors, based on the borrower's cash flow
and other loans granted to the poor and low-income households for their microenterprises and small
businesses to enable them to raise their income level and improve their living standards. These loans
are typically insecure but may also be secured in some cases.
 4. Principles of Micro-finance

i. The poor need a variety of financial services, not just loans.

Just like everyone else, poor people need a wide range of financial services that are
convenient, flexible, and priced. Depending on their circumstances, poor people need not only
credit, but also savings, cash transfers, and insurance.

ii. Microfinance means building financial systems that serve the poor.
Poor people constitute most of the population in most developing countries. Yet, an
overwhelming number of the poor continue to lack access to basic financial services to
achieve its full potential of reaching many of the poor, microfinance should become an
integral part of the financial sector.

iii. Microfinance is a powerful instrument against poverty.

Access to sustainable financial services enables the poor to increase incomes, build assets,
and reduce their vulnerability to external shocks. Microfinance allows poor households to
move from survival to future planning, investing in better nutrition, improved living
conditions, and children’s health and education.

iv. Financial sustainability is necessary to reach significant numbers of poor people.

Sustainability is a microfinance provider's ability to cover all its costs. It allows the continued
operation of the microfinance provider and the ongoing provision of financial services to the
poor. Achieving financial sustainability means reducing transaction costs, offering better
products and services that meet client needs, and finding new ways to reach the unbanked
poor.

v. Microfinance is about building permanent local financial institutions.

Building financial systems for the poor means building sound domestic financial
intermediaries that can provide financial services to poor people on a permanent basis. Such
institutions should be able to mobilize and recycle domestic savings, extend credit, and
provide a range of services.
 vi. Microcredit is not always the answer. Microcredit is not appropriate for everyone or
every situation.
The destitute and hungry that have no income or means of repayment need other forms of
support before they can make use of loans. In many cases, small grants, infrastructure
improvements, employment and training programs, and other non-financial services may be
more appropriate tools for poverty alleviation.

vii. Interest rate ceilings can damage poor people’s access to financial services.
It costs much more to make many small loans than a few large loans. Unless micro lenders
can charge interest rates that are well above average bank loan rates, they cannot cover their
costs, and their growth and sustainability will be limited by the scarce and uncertain supply
of subsidized funding.

viii. The government’s role is as an enabler, not as a direct provider of financial services.
National governments play a key role in setting a supportive policy environment that
stimulates the development of financial services while protecting poor people’s savings.
Government funding for sound and independent microfinance institutions may be warranted
when other funds are lacking. When governments regulate interest rates, they usually set
them at levels too low to permit sustainable microcredit. At the same time, micro lenders
should not pass on operational inefficiencies to clients in the form of prices (interest rates
and other fees) that are far higher than they need to be.

ix. Donor subsidies should complement, not compete with, private sector capital.
Donors should use appropriate grant, loan, and equity instruments on a temporary basis to
build the institutional capacity of financial providers, develop supporting infrastructure (like
rating agencies, credit bureaus, audit capacity, etc.), and support experimental services and
products.

x. The lack of institutional and human capacity is the key constraint.

Microfinance is a specialized field that combines banking with social goals, and capacity
needs to be built at all levels, from financial institutions through the regulatory and
supervisory bodies and information systems, to government development entities and donor
 agencies. Most investments in the sector, both public and private, should focus on this
capacity building.

xi. The importance of financial and outreach transparency.

Accurate, standardized, and comparable information on the financial and social performance
of financial institutions providing services to the poor is imperative. Bank supervisors and
regulators, donors, investors, and more importantly, the poor who are clients of microfinance
need this information to adequately assess risk and returns.
5. Characteristics and Features of Micro-Finance

Characteristics Distinguishing Features

Type of Client 1. Low Income
2. Employment in informal sector; low wage
bracket
3. Lack of physical collateral
4. Closely interlinked household/business
activities
Lending Technology 1. Prompt approval and disbursement of micro
loans
2. Lack of extensive loan records
3. Collateral substitutes; group-based
guarantees
4. Conditional access to further micro-credits
5. Information-intensive character-based
lending linked to cash

Loan Portfolio 1. Highly volatile

2. Risk heavily dependent on portfolio
management skills
Organizational Ideology 1. Remote from/non-dependent on
government
2. Cost recovery objective vs profit
maximizing
Institutional Structure 1. Decentralized
2. Insufficient external control and regulation
3. Capital base is quasi-equity (grants, soft
loans)
 6. Importance of Microfinance:

Microfinance plays a significant role in promoting financial inclusion, reducing poverty, and
improving the economic and social well-being of low-income households and small
businesses. Here are some of the key reasons why microfinance is important:

i. Financial Inclusion:
Microfinance institutions provide financial services to people who do not have access to
traditional banking services. By offering microloans, savings accounts, and other financial
products, microfinance helps to promote financial inclusion and expand access to financial
services for the unbanked and underbanked population.

ii. Poverty Reduction:

Microfinance helps to alleviate poverty by providing financial resources to low-income
individuals and small businesses to start or expand their own businesses. This leads to job
creation, increased income, and improved standards of living for the beneficiaries of
microfinance.

iii. Empowering Women:

Microfinance has been found to be particularly effective in empowering women, who are
often excluded from financial services. Microfinance helps women to start and grow their own
businesses, become financially independent, and improve their status within their families and
communities.

iv. Building Financial Resilience:

Microfinance institutions help their clients to build financial resilience by providing access to
savings accounts, insurance products, and other financial services. This helps low-income
households and small businesses to manage risks and cope with unexpected events such as
illness, crop failure, or natural disasters.
v. Social and Economic Development:
Microfinance helps to promote social and economic development by enabling low-income
individuals and small businesses to participate in the formal economy. This leads to the
creation of jobs, increased income, and improved access to essential goods and services.

7. Historical Background

The concept of microfinance is not new. Savings and credit groups that have operated for
centuries include the "susus" of Ghana, "chit funds" in India, "tandas" in Mexico, "arisan" in
Indonesia, "cheetu" in Sri Lanka, "tontines" in West Africa, and "pasanaku" in Bolivia, as
well as numerous savings clubs and burial societies found all over the world. Formal credit
and savings institutions for the poor have also been around for decades, providing customers
who were traditionally neglected by commercial banks a way to obtain financial services
through cooperatives and development finance institutions. One of the earlier and longer-
lived micro credit organizations providing small loans to rural poor with no collateral was the
Irish Loan Fund system, initiated in the early 1700s by the author and nationalist Jonathan
Swift. Swift's idea began slowly but by the 1840s had become a widespread institution of
about 300 funds all over Ireland. Their principal purpose was making small loans with interest
for short periods. At their peak they were making loans to 20% of all Irish households
annually.

In the 1800s, several types of larger and more formal savings and credit institutions began to
emerge in Europe, organized primarily among the rural and urban poor. These institutions
were known as People's Banks, Credit Unions, and Savings and Credit Co-operatives. The
concept of the credit union was developed by Friedrich Wilhelm Raiffeisen and his supporters.
Their altruistic action was motivated by concern to assist the rural population to break out of
their dependence on moneylenders and to improve their welfare.

Between the 1950s and 1970s, governments and donors focused on providing agricultural
credit to small and marginal farmers, in hopes of raising productivity and incomes. These
efforts to expand access to agricultural credit emphasized supply-led government
interventions in the form of targeted credit through state-owned development finance
 institutions, or farmers' cooperatives in some cases, that received concessional loans and on-
lent to customers at below- market interest rates. These subsidized schemes were rarely
successful. Rural development banks suffered massive erosion of their capital base due to
subsidized lending rates and poor repayment discipline and the funds did not always reach the
poor, often ending up concentrated in the hands of better-off farmers. These "microenterprise
lending" programs had an almost exclusive focus on credit for income generating activities
(in some cases accompanied by forced savings schemes) targeting extremely poor (often
women) borrowers.

8. Role of Micro-finance for elevation of poverty

Microfinance helps mitigate poverty by providing low-income individuals and groups, who
typically do not qualify for traditional bank loans due to lack of collateral, with credit they
can use to start or expand businesses. Once their earnings grow, these individuals and groups
can invest in education and other income-boosting activities. Because of the vulnerability and
variability of their income, poor people must regularly save and borrow to meet their daily
needs, such as buying food; the savings and credit services microfinance institutions provide
are thus extremely useful in this regard, notes the Consultative Group to Assist the Poor. These
services increase financial stability by smoothing out income fluctuations that the poor tend
to experience. However, despite these and other benefits of microfinance, there is no
compelling evidence that the practice leads to sustained poverty reduction, according to the
Brookings Institution. Part of the problem is a paucity of high-yield investment opportunities.
Despite this, demand for microfinance remains high among low-income individuals and
groups, which is a sign that they find the services valuable, notes the Consultative Group to
Assist the Poor. Borrowers consistently apply for new loans after repayment, which is another
indication that the poor find microfinance useful.
 Here are some of the ways that microfinance helps to alleviate poverty:

i. Provides small loans to start businesses:

Microfinance institutions provide small loans that can be used to start or expand small
businesses, which can create income-generating opportunities and help people to move out of
poverty.

ii. Promotes financial inclusion:

Microfinance helps to promote financial inclusion by providing financial services to people
who may not have access to traditional banking services. This can help to reduce poverty by
giving people the tools they need to manage their finances and plan.

iii. Encourages savings:

Microfinance institutions often encourage their clients to save money, which can help people
to build assets and create a safety net for emergencies.

iv. Empowers women:

Microfinance can be particularly empowering for women, who often have limited access to
financial resources and are more likely to live in poverty. By providing financial services to
women, microfinance can help to promote gender equality and reduce poverty.

v. Increases resilience:
By providing access to credit and financial services, microfinance can help people to cope
with financial shocks and crises, such as illness or crop failure. This can help to reduce the
impact of these events on people's lives and livelihoods.

9. Linkages between mainstream financial services and micro-finance

Microfinance today is a far-ranging and dynamic sector that offers loans, provides savings
and remittance services, and sells insurance to more than 100 million poor people.
Microfinance companies have increased in complexity and diversity in the income levels of
the customers they serve, their use of subsidies, regulation and governance structures, and the
breadth and quality of services offered.

Until recently, these organizations devoted themselves to filling market niches, with little
interaction with the rest of the banking system. Nonetheless, in the last few years, the
microfinance industry has expanded and broadened its focus. Within the microfinance
landscape and measured by loan size and target customer, two groups of institutions are
beginning to become apparent: the microfinance commercial bank and the microfinance
nongovernmental organization (NGO). The average loan size provided by microfinance NGO
is less than a quarter the size of the average loan provided by a microfinance commercial
bank. Smaller loan sizes translate directly into higher relative costs. Since poorer clients take
smaller loans, reaching the extremely poor is associated with higher average costs per loan
which need to be covered with higher interest rates and/or subsidies. Therefore, while
microfinance commercial banks can attract investors seeking commercial returns, NGOs
(Non-Governmental Organizations) will usually depend on subsidies.

In parallel with the expansion in complexity and diversity of microfinance institutions,

mainstream commercial banks have started targeting those at the upper rungs on low-income
markets. In particular, the best clients from microfinance commercial banks are now able to
signal their creditworthiness to mainstream commercial banks. Moreover, since these clients
have now generated financial information, the mainstream commercial bank will not need to
rely on ’soft’ information in their analysis of the customer. As a result, the prospect for
interaction and direct competition has increased sharply. Microfinance and mainstream
commercial banks have recently started to consider the competitive interactions between these
two groups and have begun to shape their products and target segments accordingly. Hence,
we are currently seeing how microfinance and mainstream commercial banks are evolving in
a direction charted by their joint strategic interaction by playing to their competitive strengths'
vis-à- vis the opposing group.

However, it would be a mistake to believe that the relationship between microfinance and
mainstream commercial banks can only be of a competitive nature. The fact that each group
possesses different competitive advantages lays the ground for a cooperative relationship in
 which each can contribute its own strengths. Microfinance commercial banks’ own customer
platforms are characterized by an excellent capillarity and the generation of useful financial
information out of the ’soft information’ gathered from their low-income customers (the
potential of these platforms was profiled in a previous post here). Mainstream commercial
banks have more extensive internal resources and capabilities that can be devoted to offering
more comprehensive financial services and simultaneously improving customer risk
assessments.

Microfinance and mainstream commercial banks have a lot to learn from each other. Although
it has been barely analyzed, their competitive relationship is already shaping the microfinance
landscape. It is to be expected that, as the microfinance product portfolio becomes more
sophisticated and complex, the interaction between these two groups will become increasingly
relevant in the direction the industry takes in years to come.

Mainstream financial services and microfinance are two distinct types of financial systems
that have emerged to serve different markets. While mainstream financial services focus on
providing access to formal financial services for individuals and businesses, microfinance
aims to provide financial services to people who are typically excluded from the mainstream
financial system, such as low-income individuals, women, and those living in rural areas.

However, there are linkages between these two financial systems that can help bridge the gap
between formal financial services and the underserved population.

Here are some of the ways in which mainstream financial services and microfinance are
linked:

i. Referrals:
One way that mainstream financial services and microfinance are linked is through referrals.
Mainstream financial institutions may refer clients to microfinance institutions if they do not
meet their eligibility criteria for loans or other financial products. In turn, microfinance
institutions may refer their clients to mainstream financial institutions if they are ready to
graduate to more formal financial services.
 ii. Co-lending:
Another way that mainstreams financial services and microfinance are linked is through co-
lending. In this model, a mainstream financial institution and a microfinance institution
collaborate to provide loans to clients who would not qualify for a loan from the mainstream
financial institution alone. The mainstream financial institution provides most of the loan,
while the microfinance institution provides a smaller portion and may also provide additional
support, such as financial education or business training.

iii. Cross-selling:
Mainstream financial institutions may also cross-sell microfinance products to their existing
clients, such as microinsurance or micro savings products. This can help to increase the reach
of microfinance institutions and provide additional services to mainstream financial
institution clients.

iv. Digital solutions:

The rise of digital solutions has also helped to link mainstream financial services and
microfinance. Many microfinance institutions are using digital channels, such as mobile
banking or online platforms, to provide financial services to their clients. Mainstream
financial institutions can also leverage these digital solutions to reach underserved populations
and provide more inclusive financial services.

Overall, the linkages between mainstream financial services and microfinance can help to
expand access to formal financial services and promote financial inclusion. By working
together, these two financial systems can help to address the financial needs of a wider range
of individuals and businesses.
 Unit 2: Approaches to Micro-finance LH 6

Saving led and credit led, Practices and different models (Special reference to Nepal) Grameen
replication, Co-operative, FINGO and Self-Help Groups (SHG), Strengths and weaknesses of
the various approaches, Social Banking VS Commercial Banking, Financial access Vs Financial
inclusion.

1. Saving led approach to Micro-finance

First save and then lend (credit) approach. Savings-led microfinance is an approach to financial
services for people, who are excluded from the access of formal services, through credit or loan. Most
savings led approaches to microfinance are community-based, driven by the innovation and
leadership of poor people who are underserved by formal financial institutions. Savings activities
make credit and financial capital accumulation possible, since loans are made internally from
members’ pooled savings and interest charged on the loans increases the overall wealth of the group.
However, savings-led microfinance does not ignore credit, insurance, or the other kinds of financial
services that the members need. Savings-led microfinance simply involves the voluntary association
of individuals who agree to save money together and make loans to one another from their savings.
To be successful, these groups must be well-organized, and rule bound. They do not require highly
specialized knowledge like credit-driven models linked to formal financial institutions.
How does saving-led approach work?
• People from the same community who know one another well organize themselves into small groups
(ideally between 10-30 members) for the purposes of saving and lending money.
• Members of the group establish ground rules: who can belong to the group, when it meets and where,
how much members will save, how much members can borrow and for what purposes, how and when
members will repay their loans and at what interest rate etc.
• Group members elect their own manager.
• Members save lesser amounts of money regularly
• Once the group has saved enough money, it begins to make loans to members.
• The loans are repaid with interest, expanding the group’s financial assets.
• Existing groups expand participation in the model by helping other groups
 2. Credit led approach to Micro-finance

MFIs (Micro Finance Institutions) lead with credit products, that part of the MF sector is often termed
“credit led.” The key element of credit-led microfinance is that self-help group formation is generally
an originator to the injection of working capital by the NGO (Non-Governmental Organizations) or
donor. Group cohesion is often not a requirement prior to the injection of external capital. Savings
may or may not be a feature of these groups. Use of capital by groups is generally in the form of
individual loans taken out by group members. Group members do not generally control interest rates
or repayment terms. Credit-led microfinance is the Grameen Bank model of microfinance that has
experienced global popularity. The credit-led approach typically involves an MFI (Micro Finance
Institutions) using donor funding to capitalize and then offering small loans, sometimes based on
group- or joint-liability lending. Most of the activity on the ground and donor funding is in support
of the credit-led approach (If the poor had savings, then they would already be leveraging them and
would not need microcredit.)

3. Practices and Different Models of Microfinance

There are quite a few prominent models of microfinance in the country. Each model has different
operating style and structure; they are highlighted below:

I. Donor funded micro-credit programs in Nepal

Microfinance has been a key tool in poverty alleviation in Nepal. Donors have played a significant
role in the development of microfinance in Nepal, providing funding and technical assistance to
microfinance institutions (MFIs).

Some major donors funded micro-credit programs running in the country, some of which are now in
inactive stage.

a. Production Credit for Rural Women (PCRW)

The Ministry of Local Development (MLD) in collaboration with UNICEF, NRB, CBs and ADB/N
initiated the first women focused socio- economic program "Production credit for Rural Women
(PCRW)" in 1982. It is a gender-based program. This program involved organization of poor women
 into small credit groups and appropriate skill training by the MLD staff and extension of group-based
loans by the participating banks.

The main objective of this program is to uplift the socio-economic status of rural women. For this,
the program increases the income of rural women by participating them into productive activities
associating with regular credit facilities and other technical services. It needs to form the self-reliance
women's group because in its women can tackle their problem and fulfil their needs. The program
also strengthens the ability of the banks to serve women in rural areas.

b. Micro-Credit Project for Woman (MCPW)

Learning lesson from the PCRW program, micro-credit project for women (MCPW) was initiated in
1994 by the government of Nepal under financial assistance of Asian Development Bank (ADB) with
an objective of developing NGOs as appropriate financial intermediaries that would provide quality
micro-credit services to the rural poor women over time. ‘The project is under implementation
through 95 NGOs in 12 districts and 5 municipalities. As of 31December, 2001, these FIs had 1619
borrowers with an outstanding loan of Rs18.13 million’. Nepal Rastra Bank (NRB), however,
occupies sole responsibility to administer these programs by channeling funds through commercial
banks, agricultural development banks, Nepal Bank limited (NBL), and FI-NGOs. And it is noted
that bank loan is made available to women beneficiaries initially through WDS in the
recommendation of NGOs.

To provide an access of credit to the women in both the rural and urban areas is the primary objective
of this program while issues like poverty reduction and human development are regarded as
secondary objective. The overall objective of this program is however to improve the socio-economic
status of women and promote their participation in national development. In order to achieve this
goal, the aim of this project is to generate income and employment in selected rural and urban areas.
c. Poverty Alleviation Project in Western Terai (PAPWT)

The Poverty Alleviation Project in Western Terai (PAPWT) was a project funded by the Asian
Development Bank (ADB) and the Government of Nepal. It was implemented from 1997 to 2005.
The long-term development objective of the project was to realize the sustainable increases in income
and well-being of target group households in project area communities. The strategies adopted to
achieve this goal were to increase the empowerment and awareness of the poor by strengthening,
mobilizing, and focusing their demands, ensuring their participation and utilization of available
resources at village and district level whether in the government or private sector. Project
components: i) Credit Services; ii) Group Shallow Tube Wells (GSTWs); iii) Extension and skill
training iv) Community development; v) Institutional strengthening; and since 2000, following the
Technical Follow-up Mission's recommendations, vi) Kamaiya rehabilitation.

The project objectives converge with GON's poverty reduction strategies and IFAD aims.

The project is considered to be the first of its kind in Nepal, which utilized the existing agencies
(DDCs, VDCs, LDOs), and their practices and procedures. Instead of creating its own structures to
deliver the project components, the existing institutions were used - further consolidating their
practices in relevant components. This had a tremendous cost minimizing effects for the project.
95.59% of appraised IFAD loan was spent till project completion date 15 July 2005. The farmers'
contributions were not recorded in monetary terms; however, their labor input was much higher than
expected. Despite this, the fact that the project achieved its objectives only partly and, in some cases,
did not reach the expected target group makes it partly inefficient.

d. Third Livestock Development Project (TLDP)

To increase the income & employment of the rural poor by engaging them in livestock management
& productivity the Third Livestock Development Project (TLDP) was implemented from 1997 to
2004.

The third Livestock Development Project (TLDP) was a people-cantered project. This ADB project
promoted the Systems Learning Approach (SLA)” of Livestock Sector (LS) in the country. TLDP
 programs have been implemented in 19 districts of Western (12 districts), Mid-Western (3 districts),
and Far Western (4 districts) regions of Nepal.
The TLDP is a participatory community focused program. It was designed to implement demand
driven livestock development and marketing activities based on location specific potentialities. It is
participatory in the sense that the beneficiaries and other stakeholders make decisions on what and
how they want to achieve. The project has also anticipated a significant participation of the private
sector in rendering services related to livestock and establishing agro-processing and marketing
outlets.

e. Rural Microfinance Project (RMP)

The government launched the Rural Microfinance Project (RMP) of US$ 20 million with funding
support from ADB for a period of 1999-2005 to back up MFIs with wholesale loan for on lending to
the poor in rural areas and to build up their institutional capacity. With the project, there was the
establishment of a wholesale microcredit institution called RMDC in October 2000. Rural
Microfinance Development Center (RMDC) implemented the credit component.

RMP aimed at improving the socioeconomic status of poor women through wholesale credit to
Private Finance Initiatives (PFIs) for on-lending to income generating activities and institutional
strengthening of MFIs.

f. Community Ground Water Irrigation Service Project (CGISP)

The Community Ground Water Irrigation Service Project (CGISP) is a project funded by the Danish
International Development Agency (DANIDA) and the Government of Nepal which was launched in
March 1999.

To increase the agriculture productivity by providing the irrigation facilities to the deprived
community's farmers for the poverty alleviation program through community- based shallow tube-
well irrigation system, Government introduced CGISP in 12 districts of eastern and central Terai in
March 1999.
II. Grameen Bank Model

The Grameen Bank model is a microfinance model that was developed by Muhammad Yunus in
Bangladesh in the 1970s. The model is based on the idea that poor people can be successful
entrepreneurs if they are given access to small loans. The Grameen Bank provides loans to poor
people, mostly women, who are unable to get loans from traditional banks. The loans are used to start
or expand small businesses, such as businesses that make handicrafts, sell food, or provide services.
The loans are repaid with interest, and the repayment rates are extremely high.

The Grameen Bank model has been successful in helping poor people lift themselves out of poverty.
The bank has provided over $10 billion in loans to over 9 million people, and it has helped to create
over 8 million jobs. The Grameen Bank model has been replicated in many other countries and is
considered one of the most successful poverty alleviation programs in the world.

Key features of the Grameen Bank model include:

a. Targeting the poor: Grameen Bank primarily focuses on serving the poorest of the poor, particularly
those living in rural areas. The bank provides loans without requiring collateral or any formal
financial background, making it accessible to those who would typically be excluded from traditional
banking.

b. Group lending: Grameen Bank employs a group lending methodology where borrowers are
organized into small groups of five to eight individuals. These groups act as a support network and
are jointly responsible for loan repayments. This system fosters social cohesion and encourages
accountability among borrowers.

c. Creditworthiness assessment: Instead of relying on traditional creditworthiness measures such as

collateral or credit history, Grameen Bank assesses the borrowers' character and their willingness to
engage in income-generating activities. The bank believes in the inherent entrepreneurial abilities of
the poor and provides them with opportunities to demonstrate their potential.
d. Gradual disbursement: Grameen Bank often disburses loans in multiple small installments rather
than a lump sum. This phased approach helps borrowers manage their funds more effectively and
minimizes the risk of misusing or losing the loan amount.

e. Social development and empowerment: Grameen Bank emphasize social development alongside
financial inclusion. It encourages borrowers to participate in social development programs, such as
education, healthcare, and women empowerment initiatives. The bank also encourages borrowers to
save regularly to build financial resilience and escape the cycle of poverty.

f. High repayment rates: Grameen Bank has achieved remarkably high repayment rates, often above
95%. This success is attributed to the group lending model, peer pressure, and a strong emphasis on
borrower training, regular meetings, and social support.

Here are some of the benefits of the Grameen Bank model:

a. It helps poor people to start or expand their businesses.

b. It creates jobs.
c. It helps to reduce poverty.
d. It empowers women.
e. It is sustainable.

Here are some of the challenges and opportunities facing the Grameen Bank model today:

Challenges:
a. High interest rates: The Grameen Bank charges high interest rates on its loans. This can make it
difficult for borrowers to repay their loans, and it can also make it difficult for the bank to be
profitable.
b. Lack of access to credit: The Grameen Bank model is not available to everyone who needs it. This
is because the bank has limited resources, and it can only provide loans to a certain number of people.

c. Political instability: The Grameen Bank model is vulnerable to political instability. If the
government changes or if there is a civil war, the bank may be unable to operate.

Opportunities:
a. Technological advances: Technological advances are making it easier for the Grameen Bank to
reach more people and to provide them with loans. For example, the bank is now using mobile phones
to deliver loans and to collect payments.

b. Government support: Governments in many countries are now supporting microfinance programs.
This support can help the Grameen Bank to expand its operations and to reach more people.

c. Public awareness: Public awareness of microfinance is increasing. This is helping to create a demand
for microfinance services, and it is also helping to raise money for microfinance programs.

Here are some recent data on the Grameen Bank model:

 The Grameen Bank model has been replicated in over 100 countries around the world.
 As of 2022, the Grameen Bank has over 9 million borrowers, of which 96% are women.
 The bank has disbursed over $10 billion in loans since its inception in 1976.
 The repayment rate for Grameen Bank loans is over 98%.

The bank has helped lift millions of people out of poverty, and it is considered one of the most
successful poverty alleviation programs in the world.

The Grameen Bank model has gained international recognition and has been replicated in many
countries worldwide. It has had a significant impact on poverty reduction, women's empowerment,
and community development. The success of the Grameen Bank model has inspired the development
of other microfinance institutions and influenced the broader field of microcredit globally
Replication of Grameen Model in Nepal
During the period of 1992-1996, five regional development banks (Grameen Bikash Banks),
following the Grameen bank model of Bangladesh were set up to cater the financial needs of the
deprived sections of the society in rural areas especially women for undertaking income generating
activities. In the beginning, the rural development banks, one each in the eastern and for western
development regions, were established towards the end of 1992. By June 1996, three other banks,
one each in the other three development regions, were also set up. In aggregate, NRB and HMG hold
about 33% and 10% respectively.

The basic objective of these banks is to provide financial resources required for diverse types of
income generating activities by forming group of deprived women of rural areas and help reduce the
level of poverty among the rural households. Identification and motivation of targeted groups,
compulsory training about rules and regulation of bank and its lending procedure, easy loan at
doorstep without any physical collateral, 2+2+1 lending scheme to observe the performance of
preceding loan receiver and compulsory saving scheme are some of the sound features of Grameen
Banking. These features have partly stimulated the clients to achieve a high and more stable income
with proper employment generation and which in turn raises the repayment rate. The present
fragmentary studies have shown that repayment rate of Grameen banks is as high as 95% so that these
banks occupy a better position than previously launched programs.

The operation modalities of Grameen Bank are first to identify the poor women in the village. Then
motivate and organize women in group of five. Each woman is given compulsory training among the
group members for at least seven days to provide information on banks credit and their lending
procedures and made women aware of their farming and business. The training also makes women
to read and write even their own name. The Grameen Banks provide and collect loans at the door step
and loans are distributed to individual group members against group guarantee in the field of
agriculture, micro-enterprises, trade, and service sectors, any rural women from rural households with
less than 0.6 hector in Terai and 0.5 hector in hills are eligible to join the group recognition test then
the group member becomes eligible for the loan. The loans are extended following 2+2+1 model
means in the group; rest will be facilitated at last observing the performance of earlier member. There
may be a four-week gap between the first and second phase and within sixteen weeks all borrowers
get a loan. The bank goes to the borrowers themselves during the group meeting at the villages. The
purpose of loan is to provide an opportunity to the rural women for undertaking and promoting their
farming, small enterprises, and trade and service activities. The bank lends credit up to 5 thousand
rupees per borrower in the first phase and this amount gradually increases up to Rs.25 thousand in
the successive period. The banks regulate 20% interest rate per annum for all purposes. In this respect
it is severely higher than the loan provided by Banijaya Banks due to their high service delivery cost,
and it is not considerable. Again, rural people need banking services at the doorstep rather than high
interest rates. Although the interest rate of development bank is high, the program is highly
satisfactory because clients have been able to achieve a high and more stable income with massive
employment opportunities and which are the region of high repayment rate. Saving in a group is
compulsory, and each member must save Rs. 1 or 2 in the group fund where Rs. 1 daily during training
period and 5 percent of received credits are also deposited. The group fund is mobilized for
emergency purposes or to overcome the problem of households' credit.

By mid- January 2005, these banks have already formed 35,435 groups through the 4,961 centers of
1,003 VDCs of 43 districts and forwarded micro-credit without collaterals to 147,949 members for
income generating activities by mobilizing local skills. As of now, these banks have provided micro-
credits totaling Rs11.55 billion. Of this, Rs10.16 billion has been recovered with Rs1.39 billion
outstanding in credit. Total amount of saving deposited by these groups reached Rs471.60 million
including collective savings Rs.416.80 million and individual savings Rs.54.80 million by mid-
January 2005.

Recently, four NGOs have been transformed into private development banks under the development
bank act 1995 with a view to expanding their scope and scale of micro- finance operations. These are
Nirdhan Utthan Bank Ltd. NUBL (1998), Swabalamban Bikas Bank Ltd., SSBL (2001) DEPROSC
Development Bank Ltd., DDBL (2000) and Chimek Bikas Bank Ltd., CBBL (2001). However, the
last two banks do not follow the Grameen bank pattern and the former one was the first introduced in
Grameen banking system since early 1992 in the name of Nirdhan Program. Up to mid- January 2005,
these banks provided credit totaling of Rs.4.62 billion to 113,122 members of 24,547 groups through
the 4,658 centers of 881 VDCs. During the same period Rs.3.89 billion has been recovered while
total outstanding loan has been reached to 737.10 million.
 Meeting peers
regularly

Repaying
Joint liability
regularly

The Grameen
loan product

Meeting loan Repaying in

officer regularly small sums

There are four institutions working as replicas of GBBs.

a. Swabalamban Bikas Bank Ltd. (SB Bank): SB Bank is a Microfinance Development Bank, which
started its operation on January 14, 2002. the Bank`s registered office is situated in Janakpur,
Dhanusha, Nepal. Over 13 years ago, the center for self-help Development, an NGO, initiated the
Self-help Banking Program based on the Grameen Bank Model with some adaptations in September
1993. The institution's main objective is to provide the disadvantaged section of the rural poor with
easy access to credit, which will help them improve their socio-economic status and make full use of
their existing skills and resources.

b. Nirdhan Utthan Bank Ltd (NUBL): Nirdhan Utthan Bank limited, “the bank for upliftment of the
poor” is a microfinance bank established in November 1998. It was granted a license in April 1999
to undertake banking activities. It provides microfinance services such as loans, deposits, micro-
insurance, and remittance services. The lending methodologies are individual lending based on
Grameen Bank, Bangladesh model and group lending based on self- help Group model through a few
specified branch offices. Though legally established as a company in 1998, the operation of NUBL
is a continuation of microfinance services provided by an NGO called “NIRDHAN” which has been
providing microfinance services since March 1993.
 c. Chhimek Bikas Bank Ltd (CBB): CBB Ltd is a microfinance development bank providing
microfinance service to the poor, the marginalized and the deprived, with a main focus on women
living below the poverty line. It was registered with the company Registrar`s office in December
2001 and obtained a license in January 2002 from Nepal Rastra Bank.

d. Deprosc Development Bank Ltd (DD Bank): Deprosc Development Bank is a microfinance bank
working in the central and western region of Nepal. The bank has been promoted by DEPROSC
Nepal (an NGO active in microfinance business). The other promoters are Agriculture Development
Bank, Nepal Bank, NABIL Bank, Lumbini Finance and Leasing company CEAPRED (an NGO) and
former bankers having 15-20 years’ experience. This bank was registered in January 2001. Deprosc
Development Bank has been established to provide microfinance services, which are adaptable to
local situations, cost effective and financially viable and sustainable (NRB, 2008).

Features of Grameen Model in Nepal

• Targeted to poor: This model targets the poor
• Doorstep service: Bank goes to clients instead of clients to bank in this system.
• Collateral less: Loans are generally disbursed without collateral.
• Repeated and increased volume of loans
• Good repayment: Repayment rate above 95% in Grameen. It is because of the methodology and
strong discipline in the system.
• Focus on women
• It is fast growing in Nepal, Grameen has been found fastest for outreach growth. This is due to
methodology (easy access to loan, easy repayment schedule, doorstep service, etc.) and strong
financial discipline adopted by the system.
• Managed by banking professional
• Positive impact on marginalized groups

III. Co-operatives

A cooperative society is a voluntary association started with the aim of serving its members. The
philosophy of the formation of cooperative society is "all for each and each for all" to pool their
resources and carry on the business for their own welfare. Cooperative is a form of business where
individuals belonging to the common bond join hands with the objective of promoting economic
interest of its members in accordance with cooperative principles. A cooperative society is formed
with the following broad objectives:

• To render service to its members instead of making profits.

• To encourage a state of mutual help in the place of competition.
• It assures a state of self-help in the place of dependence

Cooperative Values are based on the values of self-help, self-responsibility, democracy, equality, and
solidarity. In the tradition of their founders, cooperative members believe in the ethical values of
honesty, openness, social responsibility and caring for others.

The history of cooperative societies in Nepal dates to 1956, when the government first started 13
cooperatives societies in Chitwan district. In 1963, the government established the Cooperative Bank,
which later was merged into the Agricultural Development Bank, Nepal in 1968. Later, in 1973 the
government handed over the management of these cooperatives to the Agricultural Development
Bank for ten years and later, the management of the cooperatives was again handed over to the
members themselves in 1992.

In 1991, the government of Nepal enacted the Cooperative Act 1992. Under this Act, a group of 25
people from a community can form a cooperative by registering it with the Department of
Cooperatives. The Savings and Credit Cooperatives (SCCs) do not come under the regulatory
framework of the Nepal Rastra Bank (NRB). However, some cooperatives licensed from NRB for
limited banking services have been providing services to non-members too. They come under its
regulation and supervision.

The Savings and Credit Cooperatives (SCCs) can target all community members in a given locality
irrespective of their social and economic status. Twenty-five people can get together to run a
cooperative in their respective locality/village. These cooperatives take savings deposits from their
members and whoever wants to put savings in the cooperative has extended membership. They also
provide loans to their members for a number of purposes. Loans provided to the members have a
 minimum term of three months to three years covering specific areas such as agriculture, housing,
micro enterprises, or some social purposes.
The SCCs are supposed to be self-regulated. These organizations have not been well regulated and
supervised by higher authorities; as a result, many of them do not have standard accounting and sound
management practices. They also lack good governance. In spite of all this, SCCs are considered the
most suitable financing model for the hills and mountains as they provide both savings and financial
services to the members who are the local people in a homely atmosphere without much bureaucratic
process.

Cooperative Principles
a. Voluntary and Open Membership: Cooperatives are voluntary organizations, open to all persons
able to use their services and willing to accept the responsibilities of membership, without gender,
and social, racial, political, or religious discrimination.

b. Democratic Control: Cooperatives are democratic organizations controlled by their members, who
actively participate in setting their policies and making decisions. Men and women serving as elected
representatives are accountable to the membership.

c. Economic Participation: Members contribute equitably to, and democratically control, the capital
of their cooperative. At least part of that capital is usually the common property of the cooperative.
Members usually receive limited compensation, if any, on capital subscribed as a condition of
membership.

d. Autonomy and Independence: Cooperatives are autonomous, self-help organizations controlled by

their members. If they enter into agreements with other organizations, including governments, or raise
capital from external sources, they do so on terms that ensure democratic control by their members
and maintain their cooperative autonomy.

e. Education, Training, and Information: Cooperatives provide education and training for their
members, elected representatives, managers, and employees so they can contribute effectively to the
development of their cooperatives. They inform the general public - particularly young people and
opinion leaders - about the nature and benefits of cooperation.
 f. Cooperation among Cooperatives: Cooperatives serve their members most effectively and
strengthen the cooperative movement by working together through local, national, regional, and
international structures.

g. Concern for Community: Cooperatives work for the sustainable development of their communities
through policies approved by their members.

IV. Small Farmer Cooperative Limited (SFCL) Model

The Agricultural Development Bank Nepal (ADBN) initiated the Small Farmer Development
Program (SFDP) as a pilot project in 1975. After finding the successful implementation of the
program in two pilot sites, the ADBN expanded the SFDP gradually to 422 sites covering a total of
652 VDCs in 75 districts, which catered to around 188,000 small farmer families.

Later, an attempt was made to convert the Small Farmer Development Program Sub-Project Offices
into Small farmer' Cooperatives. Institutional development for this conversion was initiated in 1988
under GTZ's Rural Finance Nepal Project (RUFIN). In 1993, four sub project offices of Dhading
district were first registered as Small Farmer Cooperative Limited (SFCL).

SFCL has a three tiers structure. At the village level, at the ward level and at the VDC level, all groups
and inter-groups are represented in the Executive Committee. For the operation of the SFCL, the
Executive Committee is formed of the members elected by the General Assembly. The Executive
Committee is responsible for hiring the Manager and other staff and for deciding on the rules and
regulations needed to ensure the smooth and effective operation of the organization.

The grassroots groups organize regular meetings to collect mandatory savings and loan repayments
and applications for loan demand. These loan applications are forwarded to their respective inter-
groups, which appraise them and forward with recommendations to the Executive Committee for
final decision. The SFCL is generally confined to one VDC area and it targets only the small farme1·s.
The loans are extended mainly with collateral security. They also make some loans without collateral
security. Sanakishan Bikash Bank Limited (SKBBL) provides them with wholesale loans while the
 Federation of SFCLs (Small Farmer Cooperative Limited) regularizes and supervises their financial
activities.
V. Financial Intermediary NGOs (FINGOs)

NGOs can be established under the 1978 Society Registration Act and 1991 Social Welfare Act. The
1998 Financial Intermediary Society Act allows NGOs to provide microcredit to their members, as
financial intermediary NGOs (FINGOs). Financial NGOs fall under the 2006 Banks and Financial
Institutions Act, as Class D institutions. Nepal Rastra Bank classifies licensed institutions into four
classes (A, B, C, and D) based on the minimum paid-up capital needed for a license. All microfinance
institutions fall under category D.

Class D institution can:

 Supply credit as prescribed.

 Supply microcredit with or without any movable or immovable property as collateral or security for
operating any microenterprise. Such credit can go only to an institution’s groups or members who
have saved for the period and the amount prescribed by Nepal Rastra Bank.

 Accept deposits with or without paying interest and refund such deposits, subject to the limit
prescribed by Nepal Rastra Bank.

 Perform such other functions as prescribed by Nepal Rastra Bank.

In addition, the 2006 Banks and Financial Institutions Directives allow Class D institutions to:
i. Provide loans to deprived and low-income individuals or groups of up to NRs 40,000 to
operate microenterprises, with no more than NRs 100,000 going to a single microenterprise.
In addition, such loans should account for up to 25 percent of the institution’s total loans and
advances.
ii. Mobilize savings up to 30 times their core capital funds. Deposits from nonmembers are not
allowed.
The Financial Intermediary Society Act authorizes the NGOs to perform micro financing services,
skill training and business development to low-income households, and act as agent of commercial
and other banks. FINGO target excluded and low-income people, especially women living in tough
economic conditions. Out of more than 15000 NGOs in Nepal only 47 NGOs are registered in NRB
for doing limited micro banking services to the poor till July 2006. NRB have not issued any license
to new FINGOs thereafter.

Specific features of credit under the provision of the Act and practices followed by the
institutions are:

i. Training and social mobilization of poor members in the group /center

ii. Saving as key part of credit Members have been involved in a variety of saving products.
iii. Group members are well informed about saving and credit operations
iv. Risks for default are covered. Loan recovery is above 98 per cent.

FINGOs work in 38 districts (25 hills and 13 Terai). Society for Local Volunteers for Development
Efforts (SOLVE) Nepal, Mahila Adarsha Sewa Kendra, Women Entrepreneurs Association of Nepal
(WEAN), Association of cottage and small industries etc. are working in hill districts.

Institutions such as the Centre for Self Help Development (CSD), Development Project Service
Centre (DEPROSC) work in both hill and Terai districts.
Jeevan Bikas Samaj, Srijana Community development center etc. work in Terai districts.
Small FINGOs provide need-based credit to small groups ranging from agricultural, industrial,
commercial, alternative energy credits, and social credits to rural households through women
members. These institutions provide credit plus input to their clients. Institutions provide social
security schemes, remittance, and skill enhancement programs.
FINGOs have been playing a significant role in reducing social and economic pove1ty in rural and
urban areas.
 FINGOs in Nepal face challenges of:
i. Serving rural and remote households living in hilly districts
ii. Restrictive regulations for MFI that contrast with the liberal environment provided to
commercial banks
iii. Unhealthy competition
iv. Resource constraints, such as shortage of credit funds
v. Development needs and lack of attention from the government and Nepal Rastra Bank
vi. Lack of efficient and trained staff security risks in the management of local branches
and lack of supervising and monitoring institutions

VI. Self Help Groups- SHG

Self-Help Groups (SHGs) is one of the programs initiated in collaborative effort of government and
non-government organizations (NGOs) aiming at evolving supplementary credit system with the
financial resources of the formal pool by combining flexibility, sensibility, and responsiveness of
informal credit system with the financial resources of the formal credit institutions. The formation of
Self-Help Groups is viewed as a poverty alleviation mechanism and an effective tool for rural
development. The Self-Help Groups have contributed a lot in the development of socio- economic
status of the rural people. In Nepal there are several forms of informal self-help groups such as
'Dhukuti', Mothers group, Tole samitee and many other groups with specific objectives.

SHG is a small autonomous non-political group of people living in the neighborhood and sharing
common concerns, who come together voluntarily to work jointly for their personal, social, and
economic development. A Self-Help Group is a small, economically homogeneous and affinity group
consisting of 10 to 20 persons for;
• Regular savings of small amount
• Contributing to common corpus
• Providing Collateral free loans on terms decided by the group
• Collective decision making
• Resolve conflicts through mutual discussions
• Meet emergency needs
• To eradicate poverty.
 According to Katz & Bender (1976) "Self-help groups are voluntary, small group structures for
mutual aid and the accomplishment of a special purpose. They are usually formed by peers who have
come together for mutual assistance in satisfying a common need, overcoming a common handicap
or life-disrupting problem, and bringing about desired social and personal change". The initiators and
members of such groups perceive that their needs are not, or cannot be, met by or through existing
social institutions. Self-help groups are a method of organizing the poor people and the marginalized
to come together to solve their individual problems. The SHG concept is used by the government,
NGOs, and others worldwide.

SHGs are small informal associations created for the purpose of enabling members to reap economic
benefit out of mutual help, solidarity and joint responsibility. The benefits include mobilization of
savings and credit facilities and pursuit of group enterprise activities. The group-based approach not
only enables the poor to accumulate capital by way of small savings but also helps them to have
access to formal credit facilities (Shylendra, 1998).

Limitations of SHGs:

(i) Lack of awareness and unenthusiastic behavior among some members.

(ii) Rigorous government regulations hinder innovative ideas of groups.

(iii) Despite improvements of thoughts and beliefs, gender sensitization has a long way to go, especially
in villages.

(iv) The final products of SHG members often do not find proper distribution channels, resulting in
inadequate sales which demoralize the spirit of members.

(v) Other hindering factors consist of caste problems, village politics, intra-group conflicts etc.
4. Social Banking

Social Banking describes the provision of banking and financial services that consequently pursue a
positive contribution to the potential of all human beings to develop, today and in the future. Example:
banking for poor, lead banking, intensive banking etc. The features of social banking are:

• Socially, culturally, ecologically, and ethically oriented

• Dialogue with a wider group of stakeholders,
• Emphasis on human rights and solidarity,
• Equal treatment of genders,
• Organizational structures based on participation,
• Ownership structures preventing dependency of dominant individual interest,
• Pro-active contributions to the public discussion of perceived problem areas,
• Rejection of the profit maximization principle and of speculative activities,
• Self-perception as an intermediary providing services to depositors and borrowers,
• Transparency in all business conduct,
• Triple Bottom Line approach for the simultaneous consideration of multiple success criteria.

Triple-line Bottom Approach

5. Commercial Banking
Commercial banking refers to the activities and services offered by banks to individuals, businesses,
and organizations. Commercial banks are financial institutions that provide a wide range of financial
products and services to meet the banking needs of their customers.

Commercial banks make money by lending money to businesses and other organizations at a higher
interest rate than they pay on deposits. This difference in interest rates is called the spread.
Commercial banks also make money by charging fees for their services, such as ATM fees and
overdraft fees.

Commercial banks play a significant role in the economy by providing businesses with the capital
they need to grow and operate. They also help to facilitate trade and commerce by providing payment
processing and other services.

There are two main types of commercial banks:

a. Retail banks: Retail banks are the most common type of commercial bank. They offer their services
to individuals and small businesses.

b. Investment banks: Investment banks provide financial services to large corporations and
governments. They help businesses raise capital by issuing stocks and bonds. They also advise
businesses on mergers and acquisitions.

Commercial banks are regulated by banking authorities in their respective countries to ensure
compliance with regulations, maintain stability, and protect the interests of depositors and customers.
The main regulatory body for commercial banks in Nepal is Nepal Rastra Bank (NRB). Commercial
banks are an important part of the economy. They provide businesses with the capital they need to
grow and operate. They also help to facilitate trade and commerce.
 Here are some key aspects of commercial banking:

a. Deposit services: Commercial banks accept deposits from individuals and businesses, such as
checking accounts, savings accounts, and term deposits. These deposits provide a source of funds for
the bank to lend to borrowers.

b. Lending and credit services: Commercial banks provide loans and credit facilities to individuals
and businesses. They offer several types of loans, including personal loans, home mortgages, business
loans, and lines of credit. Banks assess the creditworthiness of borrowers and charge interest on the
loans provided.

c. Payment services: Commercial banks facilitate payment transactions for their customers. They offer
services such as issuing debit and credit cards, processing electronic fund transfers, providing online
and mobile banking platforms, and issuing checks.

d. Investment services: Commercial banks may offer investment services, including investment
advice, brokerage services, and wealth management solutions. They assist customers in investing
their funds in stocks, bonds, mutual funds, and other financial instruments.

e. Foreign exchange services: Commercial banks provide foreign exchange services, allowing
customers to exchange one currency for another. They facilitate international transactions, such as
international wire transfers, currency conversions, and foreign exchange hedging.

f. Trade finance: Commercial banks support international trade by offering trade finance services.
They provide letters of credit, trade guarantees, export financing, import financing, and other services
to facilitate smooth international trade transactions.

g. Treasury services: Commercial banks manage the treasury operations for their customers, which
involve managing cash, liquidity, and investments. They offer cash management services, treasury
risk management, and assistance in managing financial transactions and investments.
h. Risk management: Commercial banks assess and manage several types of risks, including credit
risk, market risk, operational risk, and liquidity risk. They have risk management systems and
processes in place to ensure the stability and soundness of their operations.

i. Relationship management: Commercial banks focus on building relationships with their customers.
Relationship managers work closely with businesses and individuals to understand their financial
needs and provide personalized banking solutions.

How does SB differ from CB?

Social Banking Commercial Banking

Basic Function Provide financial access to the Provide banking services to trade,
weaker and marginalized segments industries, and commerce.
of society.
Emphasis Developmental needs of society. Maximization of shareholder’s
wealth.
Motive Bringing down the costs of providing Earning profit by accepting deposits
services and making banking at lower cost and lending at higher
affordable to the common people. rates.
Concentration Protection of eco-system and support Maintaining liquidity and
sustainable environmental practices profitability through diversification
through lending policies. of investment.
Risk Lesser risk. More risk due to speculative
activities.
Structure Organizational structure based on Organizational structure based on
participation. corporate practice.
 6. Financial Access
Access to finance can be broadly defined as access to financial products (e.g., deposits and loans) and
services (e.g., insurance and equity products) at a reasonable cost. It is the situation in which everyone
in the economy (rich or poor) gets financial benefits from financial institutions. In the current context,
mainstream commercial banks are providing services to the top, middle-level family, and upper layers
of low-income families. They actually don't want to serve or provide credit to the poorest because of
the risk of loan loss and higher transactions cost for dealing smaller loans. The MFIs, other NGOs
and SHG are helping a lot for financial access to the poorest that are overlooked by the mainstream
financial institutions.

Here financial access includes;

a. Access to transaction services: People without any bank account are referred to as 'unbanked'. This
distorts their access to broader economic opportunity and increases the risk of poverty.

b. Access to credit: A distinction has to be made between people who are refused any access to credit
by lenders, that is 'credit excluded' people, and those who can only access credit through loan sharks
at unaffordable rates. Lack of access to credit impacts access to the minimum national standard of
living and may stigmatize (to treat someone like they are bad) people.

c. Access to insurance services: It has not yet been defined what kind of insurance is considered
essential when talking about financial exclusion. People excluded cannot protect their savings in a
financial institution, or do not want to do it.

d. Access to savings services: It remains a problem for some people who either lack the necessary
documents to open a deposit account or who do not see the point in opening one.

Financial Access in Nepal

The NRB is effortful to increase access to finance and is pursuing this in four ways.

i. Directed Credit: The NRB introduced the Directed Credit Policy in 1974 for the first time. The
requirement of this policy was to invest a specified percent of total deposits in the underprivileged
 sector to increase the flow of credit to small farmers and businesses. The scheme was renamed as
"Priority Sector Credit" in 1976. The lending target was fixed at 12 percent of outstanding loans and
advances since 1990. NRB has directed that 12 percent of priority sector loan including 3 percent of
the total portfolio, be given to the hard-core poor under the "Deprived Sector Credit" program since
1991/92. The priority sector lending program was phased out since mid-July 2006, but deprived sector
lending requirement still continues.

ii. Services for Enhancing Access to Finance: In this regard, five Grameen Bikas (Rural
Development) Banks were established focusing on the philosophy of banking to the poor, with the
support of NRB in each of the five-development regions. This model was the replication of the
Grameen Banking model in Bangladesh. The distinctive features of these banks are collateral free
credit to the poor women on group guarantee basis. This program also provides loan to the woman
clients who are required to have mandatory saving and other social and educational programs. In
addition, the refinance rates and the lending procedures have been further eased to facilitate special
category loans targeting to women entrepreneurs and low-income groups.

iii. Enhancing Confidence in Microfinance Institutions: The NRB has initiated special and follow-up
inspections of microfinance institutions. However, thousands of cooperatives operate saving and
credit related activities, virtually beyond the supervisory jurisdiction of a competent authority. To
address this issue, the NRB has submitted a proposal to GoN for introducing a separate Microfinance
Authority Act. The enactment of this Act will initiate the establishment of a separate institution for
regulating and supervising all the microfinance service providers including Class D financial
Institutions in order to enhance public confidence in them.

iv. Rural Self-Reliance Fund: In 1991, just after the restoration of multi-party democracy, the GoN
established the Rural Self Reliance Fund (RSRF), with the objective of providing wholesale loans to
NGOs, Co-operatives, and other financial intermediaries for lending to the poor in order to improve
their standard of living through income generating activities. The RSRF provides loans through
NGOs or co-operatives that are actively engaged in local saving mobilization and community
development activities. It provides wholesale loans to cooperatives and NGOs at an interest rate of
eight percent.
7. Financial inclusion

Financial inclusion involves providing access to an adequate range of safe, convenient, and affordable
financial services to disadvantaged and other vulnerable groups, including low income, rural and
undocumented persons, who have been underserved or excluded from the formal financial sector.
Financial inclusion is the state in which all working age adults have effective access to credit, savings,
payments, and insurance from formal service providers. Effective access involves convenient and
responsible service delivery, at a cost affordable to the customer and sustainable for the provider,
with the result that financially excluded customers use formal financial services rather than existing
informal options. Financial inclusion / inclusive financing is the delivery of financial services (credit,
savings, payments, remittance, fund transfer, insurance, and all types of services of formal financial
institutions) at affordable costs to the sections of disadvantaged and low-income segment of society
(Financial exclusion where those services are not available or affordable). Financial inclusion is
measured in three dimensions:
i. Access to financial services;
ii. Usage of financial services; and
iii. The quality of the products and the service delivery.

Financial inclusion can be defined as:

• Access to a full suite of financial services

Including credit, savings, insurance, and payments

• Provided with quality

Convenient, affordable, suitable, provided with dignity and client protection

• And financial capability

Clients are informed and able to make good money-management decisions

• To everyone

Who can use financial services excluded and underserved people

• Through a diverse and competitive marketplace

A range of providers, a robust financial infrastructure, and a clear regulatory framework

Why Financial Inclusion?
Financial inclusion is a mechanism to improve people’s livelihoods, lower poverty, and advance
economic development. Financial inclusion facilitates efficient allocation of productive resources and
thus can potentially reduce the cost of capital. Access to appropriate financial services can
significantly improve the day-to-day management of finances. An inclusive financial system can help
in reducing the growth of informal sources of credit, which are often found to be exploitative.
Financial inclusion benefits the poor people who are excluded from the fundamental tools of
economic self-determination, including savings, credit, insurance, payments, money transfer and
financial education.
Financial Inclusion in Nepal
The Banks and Financial Institutions Act (BAFIA), which governs all activities of banks in the
country, is a central path for advancing financial inclusion. NRB has been made compulsory through
deprived sector lending directive, for class A, B and C class financial institutions to make available
low-cost funds to micro finance institutions (MFIs), thereby facilitating access of financial services
to the underserved areas. Financial access has been rising with the increase in branches of financial
institutions. As at mid-July 2016, the number of branches of commercial banks stood in 1869,
followed by 1,378 branches of MFIs, 852 branches of development banks and 175 branches of finance
companies. The population per branch of financial institution remained at 6,562 at mid-July 2016.5
However, despite the rise in number of BFIs and their branches, the financial institutions are still
primarily scattered around the urban or semi-urban areas where geographical access is fairly simple.
With respect to regional distribution, as at mid-July 2016, the major branches of BFIs are situated in
the Central Development Region (45.5 percent), followed by Western Development Region (24.0
percent) and Eastern Development Region (16.4 percent). Despite continuous efforts from the NRB
in increasing the outreach of financial services in remote areas, the progress has been quite dismal
with respect to the branch expansion in Mid-Western Development Region (9.2 percent) and Far
Western Development Region (4.9 percent). Branchless banking has been promoted taking into
consideration the payment needs of people who are excluded from access to the financial system. As
at mid-July 2016, branchless banking centers aggregated 812. Similarly, Mobile phone-based
payment systems have been encouraged to facilitate payments at merchandise outlets. The total
number of ATM terminals increased to 1,908 in mid-July 2016 from 1,721 in mid-July 2015. The
total number of debit cards and credit cards issued also increased to 4,657,125 and 52,014 respectively
in mid-July 2016 from 4,531,787 and 43,895 in mid-July 2015.
Financial Access vs. Financial Inclusion

A
I’m taking loan from bank B C
I do not need loan
I have no collateral. So, bank is
denying to grant loan.

Current
consumers of Voluntary exclusion from
financial services financial services: Involuntary exclusion from
Access to services but financial services:
• -No need No access to services due to:
• -No awareness • -High price
• -Non-availability of product
• -Incapability due to poor -
economic condition

Financial Access = A + B
Financial Inclusion = Bringing C under A
Basis Financial Access Financial Inclusion

Definition Availability and proximity of Usage and access to a full range

financial services of financial services

Focus Availability of financial Effective utilization of

services and infrastructure financial services

Key Elements Physical access to banks and Accessibility, usage, quality,

branches and empowerment

Goal Expand the reach of financial Ensure individuals and

services communities are financially
empowered

Importance Helps meet basic financial Promotes economic growth and

needs reduces poverty

Measures Number of bank branches and Account ownership rates, usage

ATMs frequency, financial literacy

Challenges Limited physical infrastructure Lack of awareness, gender, and

in underserved areas social disparities

Examples Opening new bank branches in Promoting digital financial

underserved areas solutions, tailored products
Unit 3: Micro Finance Institutions LH 5

Ownership and Legal Form of MFIs (Micro Finance Institutions), Objectives of MFIs, the
importance of institutions, Organizational structure, Governance, Types of financial
institutions, Offering microfinance services, Capital structure Management structure, growth,
and transformation.

Microfinance has evolved as an economic development approach intended to benefit low-income

people. The term refers to the provision of financial services to low-income clients, including the
self-employed. Microfinance is not simply banking; it is a development tool. Microfinance activities
usually involve:

• Small loans, typically for working capital

• Informal appraisal of borrowers and investments
• Collateral substitutes, such as group guarantees or compulsory savings
• Access to repeat and larger loans, based on repayment performance
• Streamlined loan disbursement and monitoring
• Secure savings products.

1. Ownership and Legal Form of MFIs

The legal status of an institution determines who has ownership and who has decision-making power.
Microfinance institutions come in a variety of institutional forms (project, non-profit organization,
cooperative, private company). The choice of form will determine organizational type, decision-
making procedures and thus the institution’s governance. Institutional statutes may be more or less
formal (ranging from bank to project status). An institution may be part of the public, private or
nonprofit sectors.

• Project form: The institution was not formalized at the time of creation. Its status is one of a
development projects, most often funded directly by donors.
• Non-profit organization (NGO) form: Non-profit organizations cannot mobilize savings. In
cases where savings services are offered, it is simply tolerated, usually because of the absence
of a legal framework for microfinance.

• Cooperative form: An institution owned by its members who are the direct beneficiaries of
the savings and credit services offered.

• Private company form: A company (commercial bank or Finance Company, for example
with limited or unlimited liability) with a variable capital structure, depending on the origin
and motivation of the shareholders:
I. Private capital: local (local banks, employees, clients, etc.) or international
(commercial banks, social investment funds, donor investment funds, private
commercial funds).
II. Public capital: local and/or national government.

• Public entity form: A public entity is state-owned or belongs to local governments and might
be a shareholder company with public shareholders – in some cases ruled by banking law, in
other cases ruled by a special law (e.g., development banks).

2. Objectives of MFIs
Selecting a target market depends on the objectives of the microfinance service provider and
the perceived demand for financial services. In any country there are unserved or underserved
enterprises and households, ranging from the ultra-poor, who may not be economically active,
to small growing enterprises that provide employment in their communities. This range or
continuum constitutes the demand side for microfinance services. Often the supply side does
not offer a corresponding continuum of services. MFIs need to supply services that fill the
gaps and integrate the unserved groups into the market.

The goal of MFIs as development organizations is to service the financial needs of unserved
or underserved markets as a means of meeting development objectives.
 These development objectives generally include one or more of the following:

a. To reduce poverty
b. To empower women or other disadvantaged population groups
c. To create employment
d. To help existing businesses grow or diversify their activities
e. To encourage the development of new businesses

In a World Bank study (1996) of lending for small and microenterprise projects, three
objectives were most frequently:

• To create employment and income opportunities through the creation and expansion of
microenterprises
• To increase the productivity and incomes of vulnerable groups, especially women and the
poor
• To reduce rural families’ dependency on insufficient crops through diversification of their
income generating activities.

Given the substantial number of conditional variables in each country context, every
organizational decision to enter or serve a target market will involve balancing the conditions
in that market. This decision-making process must keep in mind the two long-term goals
of microfinance:
a. Outreach, serving those who have been consistently underserved by financial
institutions (such as women, the poor, and indigenous and rural populations), and
b. Sustainability, generating enough revenue to cover of providing financial services.
Depending on which target market is selected, there are consequences for MFI’s
financial position, because costs will be affected.

In short, there are tradeoffs involved in the decisions about objectives and how to reach them.
MFIs need to determine where their unmet demand is for microfinance services and which
target group matches their objectives.
 3. Importance of MFIs

i. The promise of reaching the poor. Microfinance activities can support income generation for
enterprises operated by low-income households.

ii. The promise of financial sustainability. Microfinance activities can help to build financially
self-sufficient, subsidy-free, and locally managed institutions.

iii. The potential to build on traditional systems. A microfinance activity sometimes simulates
traditional systems (such as rotating savings and credit associations). They provide the same
services in similar ways, but with greater flexibility, at a more affordable price than
microenterprises and on a more sustainable basis. This can make microfinance services
attractive to many low-income clients.

iv. The contribution of microfinance to strengthening and expanding existing formal financial
systems. Microfinance activities can strengthen existing formal financial institutions, such as
savings and loan cooperatives, credit union networks, commercial banks, and even state-run
financial institutions, by expanding their markets for both savings and credit—and potentially,
their profitability.

v. The growing success rates. There is an increasing number of well-documented, innovative

success stories in settings as diverse as rural banking of Bangladesh. This is in stark contrast
to the records of state-run specialized financial institutions, which have received substantial
amounts of funding over the past few decades but have failed in terms of both financial
sustainability and outreach to the poor.

vi. The availability of better financial products as a result of experimentation and innovation.
The innovations that have shown the most promise are solving the problem of lack of
collateral by using group-based and character-based approaches; solving problems of
repayment discipline through high frequency of repayment collection, the use of social and
peer pressure, and the promise of higher repeat loans; solving problems of transaction costs
 by moving some of these costs down to the group level and by increasing outreach; designing
staff incentives to achieve greater outreach and high loan repayment; and providing savings
services that meet the needs of small savers.

4. Organizational structure/Ownership

Ownership is an important but often unclear issue for MFIs, particularly for those MFIs funded with
donor contribution. Owners of the MFI (Micro Finance Institutions) that elect (or at times compose)
the governing body of the institution and, through their agents on the board, hold management
accountable.

Neither formal financial institutions nor NGOs (Non-Governmental Organizations) have owners per
se. Formal MFIs have shareholders who own shares that give them a residual claim to the assets of
the MFI if there is anything remaining after it has discharged all its obligations. Shareholders have
the right to vote their shares to elect board members, who in turn control the company. Having
shareholders results in clear lines of accountability between the board members and the MFI.

NGOs do not generally have shareholders; rather, management usually elects the board members.
This can (but does not always) result in a conflict of interest if management selects board members
who will conform to the interests of senior management. NGO board members do not usually fulfill
the board’s fiduciary role by assuming responsibility for the institution’s financial resources,
especially those provided by donors.

As MFIs formalize their structures (that is, change from being an NGO into a formal financial
institution) and begin to access funding beyond the donor community, the “owners” or those that have
a financial stake in the institution can change. If the NGO remains as a separate entity, it often owns
a majority of the shares of the new institution. In spite of this majority ownership, it is important that
the relationship between the MFI and the NGO be kept at arm’s length and includes a transparent and
clear system of transfer pricing.
“Owners” of formalized MFIs can generally be divided into four categories:
• NGOs
• Private investors
• Public entities
• Specialized equity funds

All of these owners are concerned with receiving an adequate return on their investment. However,
NGOs and public entities may have other priorities as well. For example, they may be concerned with
a social return or positive impact in the lives of the clients.
Owners may be heavily involved in the operations of the MFI or may take on a more passive role.
Owners that play a more active role must have adequate skills and the ability to spend the time
required. Owners are often also called upon to access additional capital, particularly equity capital.
As owners they may wish to maintain their stake as MFI grows and takes on additional capital. This
implies that they also must have continued access to capital.

5. Ownership and Governance

As the MFI grows and management systems are developed, the need for governance arises to ensure
effective management of the MFI and, potentially, to attract people with much-needed skills (usually
from the private sector). Governance establishes a means of holding management accountable toward
stakeholders. Similarly, as the MFI grows the issue of ownership becomes apparent. This is
particularly important as the MFI begins to create a more formalized structure.

Governance refers to a system of checks and balances whereby a board of directors is established to
oversee the management of the MFI. Governance is sometimes conceived as a virtuous circle that
links the shareholders to the board, to the management, to the staff, to the customer, and to the
community at large. An institution’s governance structure helps mediate the interests of various
stakeholders and protects the long-term health of the institution. It establishes a means of holding
management accountable.
The board of directors is responsible for reviewing, confirming, and approving the plans and
performance of senior management and ensuring that the vision of the MFI is maintained.
Management is responsible for the daily operations of putting the vision into action.
An MFI must define the following to adopt good governance structure:
a. The role of board members both within the board and with regard to external alliances
b. The desired areas of expertise
c. The existence of committees to oversee specific areas of operation
d. Term limits of board seats
e. The process for replacing board members
f. The role of the executive director in selecting board members
g. The optimum number of board members
h. Mechanisms to evaluate the contribution of individual members

Governance gives shareholders, donors, governments, and regulators confidence that managers are
being appropriately supervised. Thus, board members should not receive any personal or material
gain other than the approved remuneration.

The basic responsibilities of the board are:

• Fiduciary: The board has the responsibility to safeguard the interests of all of the institution’s
stakeholders. It serves as a check and balance to ensure the MFI’s investors, staff, clients, and
other key stakeholders that the managers will operate in the best interest of the MFI.

• Strategic: The board participates in the MFI’s long-term strategy by critically considering the
principal risks to which the organization is exposed, and approving plans presented by the
management. The board does not generate corporate strategy but instead reviews management’s
business plans in light of the institution’s mission and approves them accordingly.

• Supervisory: The board delegates the authority for operations to the management through the
executive director or chief executive officer. The board supervises management in the execution
of the approved strategic plan and evaluates the performance of management in the context of the
goals and time frame outlined in the plan.
 • Management development: The board supervises the selection, evaluation, and compensation of
the senior management team. This includes succession planning for the executive.

6. Types of financial institutions offering microfinance services

i. Formal institutions are defined as those that are subject not only to general laws and regulations
but also to specific banking regulations and supervision.

• Public development banks

• Private development banks
• Savings banks and postal savings banks
• Commercial banks
• Nonbank financial intermediaries.

ii. Semiformal institutions are those that are formal in the sense of being registered entities subject
to all relevant general laws, including commercial law, but informal insofar as they are, with a
few exceptions, not under bank regulation and supervision.
• Credit unions
• Multipurpose Cooperatives
• NGOs
• (Some) Self-help groups.

iii. Informal providers (generally not referred to as institutions) are those to which neither special
bank law nor general commercial law applies, and whose operations are also so informal that
disputes arising from contact with them often cannot be settled by recourse to the legal system.
• (Pure) moneylenders
• Traders, landlords, and the like (as moneylenders)
• (Most) self-help groups
• Rotating savings and credit associations (work groups, multipurpose self-help groups)
• Families and friends.
 7. Capital structure of MFIs

Fundamentally, there are two main separate categories of financing instruments that an MFI can
choose:
i. Equity financing
ii. Debt/liabilities financing

i. Equity Financing:

Equity financing refers to the act of raising money to finance business activities by issuing stocks
(common or preferred stocks) to the current owners or potential investors. This form of financing
enables firms to receive more investment funds from the current owners and potential investors with
or without borrowings for their startups or when they need to raise additional equity to offset existing
debts. There are two typical types of investors: social investors and commercial investors. First, social
investors, called microfinance focused funders, are individuals or institutions that invest with social
objectives as a high priority. Second, commercial investors, called private-equity funders, are profit-
driven investors from the private sector who are likely to tend to focus more on financial returns
(dividends) from their investments.
 ii. Debt financing:

Liabilities financing/debt financing refers to the borrowed money which a firm must pay back to
lenders with interest after a specific agreed period of time. MFIs tend to rely on debt financing to
fund their businesses if they are well established and have steady sales, solid collateral, and profitable
growth. Due to lack of sufficient funds (equity), MFIs use borrowed money as an extra source of
finance to expand their businesses.

a. Deposits

Deposits refer to the sum of savings deposited in financial institutions. They are categorized
according to the type of client (individual vs. institution) and various products. In microfinance, there
is an additional category which includes disclosures of voluntary deposits vs. compulsory deposits.

8. Institutional growth and transformation (Upgrading)

When the existing structure of an organization is unable to manage the growth, there is a need for
transformation (alternation in the ownership and structure of the organization). For MFIs that are
structured as formal financial institutions, that is, development or commercial banks, the issues of
growth and transformation are not as significant. Generally, growth within a formal institution can be
accommodated within the existing structure. Transformation is rarely an issue. If MFIs are structured
as semi-formal financial institutions, the issues of growth and transformation are significant.
Generally, growth within a semi-formal institution can be accommodated by using any one of
the following three options:

i. Maintaining the existing structure and managing growth within that structure;
ii. Forming an apex institution to support the work of existing MFIs; and
iii. Transforming to a new: formalized financial institution.

i. Expansion within an Existing Structure

Depending on the objectives of the MFI and the contextual factors in the country in which it works,
an NGO or cooperative may be the most appropriate institutional structure, providing the MFI can
continue to grow and meet the demands of the target market. Existing structures may be most
appropriate, because formalizing their institutions can require substantial capital and reserve
requirements. As formal financial intermediaries, they may become subject to usury laws or other
regulations that limit the MFI’s ability to operate.

ii. Creating an Apex Institution

Some MFIs, particularly those partnering with international NGOs, may choose to create an apex
institution as a means of managing growth and accessing additional funding. An apex institution is a
legally registered wholesale institution that provides financial, management, and other services to
retail MFIs. These apex institutions are similar to apex institutions for financial cooperatives. Rather
than being member based, the apex institution is set up and owned by an external organization. Apex
institutions do not provide services directly to micro-entrepreneurs; rather, they provide services that
enable retail MFIs (primary institutions) to pool and access resources.
An apex institution can (i) provide a mechanism for more efficient allocation of resources by
increasing the pool of borrowers and savers beyond the primary unit, (ii) offer innovative sources of
funds, such as guarantee funds or access to a line of credit from external sources and (iii) serve as a
source of technical assistance for improving operations, including the development of management
information systems and training courses.

iii. Creating a Formal Financial Intermediary

Recently the field of microfinance has focused on the transformation of financial NGOs into formal
financial institutions. This approach involves the transfer of the NGO’s or cooperative’s operations
to a newly created financial intermediary where the original institution is either phased out or
continues to exist alongside the new intermediary. In most cases, the original MFI’s assets, staff,
methodology, and systems are transferred to the new institution and adapted to meet the more rigorous
requirements of a financial intermediary. Various means may be established to determine a transfer
price for the assets and operations of the NGO or cooperative to the new entity. It is imperative,
however, that the transfer price mechanism be transparent.

The rationale for developing a formal financial institution is compelling: the potential to access both
savings and commercial funding may help solve an MFI’s funding constraints and increase its ability
to provide additional financial services to the target market. However, creating a formal financial
institution also implies additional costs and restrictions as the MFI becomes regulated and supervised.
Capital requirements may be much higher than anticipated, and unless the MFI has reached financial
self-sufficiency, it will be difficult (and costly) to attract equity investors and commercial debt. The
MFI must develop the institutional capacity to manage a number of different products and services,
mobilize resources, and enhance management information systems to adhere to regulatory reporting
requirements and manage additional products. While transformation may seem like an ideal path,
MFI should consider the substantial changes that are required when transforming to a formal financial
institution.
Unit 4: Product of Micro Finance LH 8

Saving product- Concept of saving, saving mobilization, Types of saving, compulsory saving,
voluntary saving, non-financial services, Micro insurance, Pricing of saving product. Credit
product: micro credit, individual credit, Character, and cash-flow based lending, Micro
enterprises loan, Working capital loan, agricultural loan, Loan against group guarantee,
interest rate and services charges on micro credit

1. Concept of Saving:
Saving is a foundational pillar in an inclusive financial system. Savings contribute to financial
inclusion at the client, microfinance institutions and industry levels. Savings services strengthen the
finances of low- income households, savings deposits strengthen the funding base or microfinance
and are the basis for a competitive, efficient, and sound microfinance industry. Savings are broadly
defined as a means to secure future consumption at any time either in cash or in kind. “Saving” can
be referred as “cash deposited by clients in order to consume or invest it in a later date.” Saving is the
action of keeping part of current income to use it later. Savings defines the amount kept aside in the
current period (income minus consumption in a given period).

From an institutional perspective, if deposit services are appropriately priced, mobilizing micro and
small savings can help MFIs (Micro Finance Institutions) reach financial self-sufficiency. In fact,
introducing savings facilities may considerably improve MFI’s client outreach, while increasing
demand and controlling costs in its operations. Through deposit activities, an MFI (Micro Finance
Institutions) can lower their capital costs and build a sustainable base for expansion.

By offering savings services, MFIs gain several important advantages. These include:

• An attractive source of funds is from deposits, as their financial costs are normally lower than
funds from the interbank market.
• Lower liquidity risk from a small number of withdrawals from tiny amounts on deposit. The
financial institution is less exposed than it would be if larger withdrawals were made from larger
savings accounts.
 • A more stable funding source than donor funds or discounted lines from central banks.
Small depositors, in general, do not intervene in the bank’s day-to-day business as do most
governments and donors that provide funding.

Importance of Savings to MFIs:

i. Deepening & expanding outreach:

• Large numbers of customers choose to use savings services instead of credit, but limited
access.
• Savings help the poor to better organize their financial lives and deal with emergencies.
• Accumulation of assets from savings helps improve quality of life.
• Savings are equally, if not more important, than credit in development.
• Low usage of savings services is not an indication of low demand.
• Access to savings is the key to financial inclusion.

ii. Sustainability & growth

The main Funding source for sustainable growth is savings, it is

• It is less costly than loans which many MFIs rely on.
• Stable source of funding
• Improves public image & confidence.

Making savings attractive to customers:

• Security – from fraud, collapse of MFI is paramount even in the face of inflation.
• Low transaction costs – proximity & convenience
• Appropriately designed products – frequent deposits of small variable amounts, quick
access contractual deposits
• Interest rates – when transaction costs are low, savings take place even with negative real
returns.
• Connectivity – ability to transact at different branches or parts of the country.
• Payment facilities– facilities to pay bills, fees, or transfer money.
• Recent innovations with potentials: mobile banking – especially when connected to
savings accounts and bill payments, agency banking – allowing banks to appoint agents
 that can make certain transactions on behalf of banks or MFIs and a combination of the
two has immense potential.

Micro savings

A branch of microfinance, consisting of a small deposit account offered to lower-income families or

individuals as an incentive to store funds for future use. Micro savings accounts work similar to a
normal savings account, however, are designed around smaller amounts of money. The minimum
balance requirements are often waived or extremely low, allowing users to save tiny amounts of
money and not be charged for the service.

Not all of us have the ability to save large amounts of money every month, but saving for emergencies,
future expenses, and large purchases are important goals. That is where micro saving tools are helpful.
Frequently, there is a waiver available regarding the lowest balance requirements or the balance
requirement is pretty low. This permits the customers to save a limited amount of money and no fee
is charged for offering this service.

Micro savings programs are commonly provided in developing nations as a means to motivate saving
for educational activities and other types of investments in the future. Investors who are putting
money into these micro savings plans are better organized to deal with any type of unexpected costs
that are normally detrimental (harmful) for individuals with a small income.

2. Saving Mobilization:
Savings mobilization has long been a controversial issue in microfinance. In recent years there has
been increasing awareness among policymakers and practitioners that there is a vast number of
informal savings schemes and MFIs around the world (in particular, credit union organizations) have
been successful in mobilizing savings. These developments attest to the fact that low-income clients
can and do save. The World Bank’s “Worldwide Inventory of Microfinance Institutions” found that
many of the largest, most sustainable institutions in microfinance rely heavily on savings
mobilization. Often neglected in microfinance, deposits provide a highly valued service to the world’s
poor who seldom have reliable places to store their money or the possibility to earn a return on
savings” (Paxton 1996).

The survey also found that the ability to effectively mobilize deposits depends greatly on the
macroeconomic and legal environment. “Statistical analysis of the surveyed institutions reveals a
positive correlation between the number of deposits mobilized and the average growth in per capita
GNP of the country from 1980 to 1993. Likewise, higher deposit ratios are negatively correlated with
high levels of inflation. Finally, the amounts of deposits are positively correlated with prominent
levels of population density” (Paxton 1996). Furthermore, institutions operating with donor funds
generally were found to have a high rate of loan portfolio growth, while deposit-based programs grew
more slowly (probably due to a lack of funds). Also, institutions that mobilized deposits were found
to have higher average loan sizes and were more likely to work in urban areas than institutions
providing only credit. This latter finding relates to the fact that most institutions that collect savings
must be regulated to do so. Larger urban institutions tend to be regulated more often than smaller
MFIs, and they often reach a clientele at a higher income level.

3. Types of Savings Products for Micro entrepreneurs:

Deposit instruments must be designed appropriately to meet local demand. It is crucial for an MFI to
conduct market research prior to introducing savings products and to offer a good mix of products
with various levels of liquidity that respond to the characteristics and financial needs of various
market segments. When Bank Rakyat Indonesia decided to offer voluntary saving products it
conducted an extensive study of local demand for financial services and systematically identified
potential savers. The bank also looked closely at existing savings services in the informal sector and
designed its products to overcome limitations and to replicate the strengths of existing services. There
are three broad deposit groups based on the degree of liquidity: highly liquid current accounts,
semi liquid savings accounts, and fixed-term deposits.

i. Liquid Accounts:
Highly liquid deposits provide the greatest flexibility and liquidity and the lowest returns. Current
accounts or demand deposits are deposits that allow funds to be deposited and withdrawn at any time.
Frequently no interest is paid. Highly liquid accounts.arc difficult to manage, because they require
substantial bookkeeping and are not as stable a source of funding as term deposits. Only a limited
portion of demand deposits can be used to provide loans (based on reserve requirements), because
the MFI must be able to service withdrawal requests at all times.

ii. Semi liquid Accounts:

Semi-liquid accounts provide some liquidity and some returns. Some savings accounts are semi
liquid, which means that the borrower can usually withdraw funds a limited number of times per
month and deposit funds at any time. Unlike current accounts, savings accounts generally pay a
nominal rate of interest, which is sometimes based on the minimum balance in the account over a
given period (monthly, yearly). They begin to act like term deposits if interest is paid only when a
minimum balance is held in the account. This encourages the client to hold a certain amount of money
in the account, which makes management by MFI easier.

iii. Fixed-Term Deposits:

Term deposits are savings accounts that are locked in for a specified amount of time. They provide
the lowest liquidity and the highest returns. Term deposits are generally a stable source of funding
for the MFI and pay a higher rate of return to the saver. Generally, the interest rate is based on the
length of the term of the deposit and the expected movement in market rates. Term deposits range
from a one-month term to several years.
The choice of products to offer must be based on the needs of the clients in the area served by the
MFI. Many first-time savers will choose a highly liquid account. As they become more experienced
with managing their savings, they will likely open more than one deposit account, using a semi liquid
or fixed-term deposit account for longer-term savings.

4. Compulsory Saving:
Compulsory savings differ substantially from voluntary savings. Compulsory savings (or
compensating balances) represent funds that must be contributed by borrowers as a condition of
receiving a loan, sometimes as a percentage of the loan, sometimes as a nominal amount. For the
most part, compulsory savings can be considered part of a loan product rather than an actual savings
product since they are so closely tied to receiving and repaying loans. (Of course, for the borrower
compulsory savings represent an asset while the loan represents a liability; thus, the borrower may
not view compulsory savings as part of the loan product.)
Compulsory savings are useful to:
• Demonstrate the value of savings practices to borrowers
• Serve as an additional guaranteed mechanism to ensure
the repayment of loans
• Demonstrate the ability of clients to manage cash flow
and make periodic contributions (important for loan repayment)
• Help to build up the asset base of clients.

However, compulsory savings are often perceived (rightly) by clients as a “fee” they must pay to
participate and gain access to credit. Generally, compulsory savings cannot be withdrawn by
members while they have a loan outstanding. In this way, savings act as a form of collateral. Clients
are thus not able to use their savings until their loan is repaid. In some cases, compulsory savings
cannot be withdrawn until the borrower actually withdraws his or her membership from the MFI.
This sometimes results in the borrowing by clients of loan amounts that are in fact less than their
accumulated savings. However, many MFIs are now beginning to realize the unfairness of this
practice and are allowing their clients and members to withdraw their compulsory savings if they do
not have a loan outstanding or if a certain amount of savings is still held by the MFI.

5. Voluntary Saving:
As the name suggests, voluntary savings are not an obligatory part of accessing credit services.
Voluntary savings services are provided to both borrowers and nonborrowers who can deposit or
withdraw according to their needs. (Although sometimes savers must be members of the MFI, at other
times savings are available to the general public.) The interest rates paid range from relatively low to
slightly higher than those offered by formal financial institutions. The provision of savings services
offers advantages such as consumption smoothing for the clients and a stable source of funds for the
MFI.
The requirement of compulsory savings and the mobilization of voluntary savings reflect two very
different philosophies (CGAP 1997). The former assumes that the poor must be taught to save and
that they need to learn financial discipline. The latter assumes that the working poor already save and
that what is required are institutions and services appropriate to their needs. Microfinance clients may
not feel comfortable putting voluntary savings in compulsory savings accounts or even in other
accounts with the same MFI. Because they often cannot withdraw the compulsory savings until their
loan is repaid (or until after a number of years), they fear that they may also not have easy access to
their voluntary savings. Consequently, MFIs should always clearly separate compulsory and
voluntary savings services.

There are three conditions that must exist for an MFI to consider mobilizing voluntary savings
(CGAP 1997):
• An enabling environment, including appropriate legal and regulatory frameworks, a
reasonable level of political stability, and suitable demographic conditions
• Adequate and effective supervisory capabilities to protect depositors
• Consistently good management of the MFI’s funds. The MFI should be financially solvent
with a high rate of loan recovery.

6. Non-financial Services:
Social services, or nonfinancial services that focus on improving the well-being of
microentrepreneurs. They include health, nutrition, education, and literacy training. Social services
are likely to require ongoing subsidies, which are often provided by the state or through donors
supporting NGOs (Non-Governmental Organizations).

The degree to which an MFI provides each of these services depends on whether it takes a
“minimalist” or “integrated” approach.

Microfinance Institutions—Minimalist or Integrated?

MFIs by definition provide financial services. However, an MFI may also offer other services as a
means of improving the ability of its clients to utilize financial services. There is much debate in the
field of microfinance as to whether MFIs should be minimalist—that is, offering only financial
intermediation—or integrated—offering both financial intermediation and other services. Most MFIs
offer social intermediation to some extent. The decision to offer nonfinancial services determines
whether an MFI is minimalist or integrated.
MFIs using the minimalist approach normally offer only financial intermediation, but they may
occasionally offer limited social intermediation services. Minimalists base their approach on the
premise that there is a single “missing piece” for enterprise growth, usually considered to be the lack
of affordable, accessible short-term credit, which the MFI can offer. While other “missing pieces”
may exist, the MFI recognizes its comparative advantage in providing only financial intermediation.
Other organizations are assumed to provide other services demanded by the target clients. This
approach offers cost advantages for MFI and allows it to maintain a clear focus, since it develops and
provides only one service to clients.

The integrated approach takes a more holistic view of the client. It provides a combination or range
of financial and social intermediation, enterprise development, and social services. While it may not
provide all four, the MFI takes advantage of its proximity to clients and based on its objectives,
provides those services that it feels are most needed or that it has a comparative advantage in
providing.

An MFI chooses a minimalist or more integrated approach depending on its objectives and the
circum- stances (demand and supply) in which it is operating. If an MFI chooses to take an integrated
approach, it should be aware of the following potential issues:

• Providing financial and nonfinancial services are two distinct activities, which may at times
lead an institution to pursue conflicting objectives.
• It is often difficult for clients to differentiate “social services,” which are usually free, from
“financial services,” which must be paid for, when they are receiving both from the same
organization.
• MFIs offering many services may have difficulties identifying and controlling the costs per
service.
• Nonfinancial services are rarely financially sustainable.
Here are some common non-financial services offered by MFIs:

i. Business Development Services (BDS): BDS encompasses a range of services aimed at

enhancing the capacity and skills of microfinance clients to manage and grow their businesses.
This may include training in business planning, financial management, marketing, product
development, and entrepreneurship.

ii. Financial Education and Literacy: MFIs provide financial education and literacy programs
to improve clients' understanding of basic financial concepts, budgeting, savings, debt
management, and responsible borrowing. These programs empower clients to make informed
financial decisions and improve their financial well-being.

iii. Market Linkages and Networking: MFIs may facilitate linkages between
microentrepreneurs and potential buyers, suppliers, or distribution networks. By connecting
clients to larger markets and networks, they help expand business opportunities and increase
income potential.

iv. Technical Assistance and Training: Some MFIs offer technical assistance and specialized
training to clients in specific sectors, such as agriculture, handicrafts, or small-scale
manufacturing. This includes support in improving production techniques, adopting
sustainable practices, accessing appropriate technology, and complying with quality standards.

v. Social and Health Services: Recognizing the link between social well-being and economic
development, MFIs may collaborate with other organizations to provide access to social
services. This may include healthcare services, education and vocational training, housing
support, or support for women's empowerment initiatives.

vi. Community Development Initiatives: MFIs often engage in community development

projects to address broader social and environmental challenges. This may involve investing
in infrastructure development, supporting local schools or healthcare centers, promoting
environmental sustainability, or facilitating community savings groups.
By offering non-financial services alongside their financial products, MFIs aim to support holistic
development, empower clients, and promote sustainable livelihoods. These services help build the
capacity, resilience, and social capital of microfinance clients, enabling them to overcome barriers
and thrive in their entrepreneurial pursuits.

7. Definitions of micro insurance:

Micro insurance is insurance with low premiums and low coverage. It gives the micro entrepreneurs
the chance to focus more on their core business which drastically reduces the risk affecting their
property, health or working possibilities. It is a financial arrangement that protects low-income people
against specific perils in exchange for regular premium payments proportionate to the likelihood and
cost of the risk involved. It can be delivered through a variety of different channels, including small
community- based schemes, credit unions or other types of microfinance institutions, but also by
enormous multinational insurance companies, etc.

The common features that micro insurance holds are;

• Transactions are low-cost (and reflect members 'willingness to pay)
• Clients are low-net-worth (but not necessarily uniformly poor);
• The essential role of the network of micro insurance units is to enhance risk management of
the members of the entire pool of micro insurance units over and above what each can do when
operating as a stand-alone entity.

Micro insurance scheme:

A micro insurance scheme is a scheme that uses, among others, an insurance mechanism whose
beneficiaries are (at least in part; people excluded from formal social protection schemes, particularly,
informal economy workers and their families. The scheme differs from others created to provide legal
social protection to formal economy workers. Membership is not compulsory (but can be automatic),
and members pay, at least in part, the necessary contributions in order to cover benefits.
Micro insurance schemes may cover various risks (health, life, etc.); the most frequent micro
insurance products are:
• Life micro insurance (and retirement savings plans)
• Health micro insurance (hospitalization, primary health care, maternity, etc.)
• Disability micro insurance
• Property micro insurance-assets, livestock, housing
• Crop micro insurance

8. Pricing of Savings (Deposits):

The interest rate paid on deposits is based on the prevailing deposit rates of related products in similar
institutions, the rate o1 inflation, and market supply and demand. Risk factors such as liquidity risk
and interest rate risk must also be considered based on the time period of deposits. Finally, the costs
of providing voluntary savings also influence deposit pricing policies.

People have different motivations for saving money. In the broadest sense, these motivations
can be defined as;

• Transaction based - people need to have money to facilitate transactions

• Precautionary - people need to retain money to meet unforeseen events or to plan for an
uncertain future and
• Speculative - people invest money for high returns.
The motives should also be considered while pricing deposits. The following table shows details;

Motivation Type of account Accessibility Basis of fees Typical interest

paid
Transaction Current account, Instant Transaction Graduated
ordinary savings based fees interest rates
account based on account
balances.
Precautionary Long term Instant with fees Interest spread Higher interest
savings accounts, or with notice than ordinary
contractual period savings account
savings accounts.
Speculative Fixed deposits for Limited or zero Interest spread Higher interest
larger amounts until maturity rates, often based
on market return

In longer term accounts there are often no explicit fees and charges. Instead, fees are implicit, they
are based on offering a lower return to the customer in interest paid than the institution can earn
through investing in the deposits.
Graduated interest rates are a common way for institutions to offer higher interest rates for larger
deposits.
Ledger fees versus transaction-based fee has the added advantage that it rewards the efficiency of the
institution, in that, the more transactions it is able to process in a given infrastructure the more profit
it is likely to make. Gradually Action Research Partners have been responding to this perception of
the market and have moved to charging for transactions.

9. Credit:
Credit is borrowed funds with specified terms for repayment. When there are insufficient accumulated
savings to finance a business and when the return on borrowed funds exceeds the interest rate charged
on the loan, it makes sense to borrow rather than postpone the business activity until sufficient savings
can be accumulated, assuming the capacity to service the debt exists (Waterfield and Duval 1996).

Loans are generally made for productive purposes— that is, to generate revenue within a business.
Some MFIs also make loans for consumption, housing, or special occasions. While many MFIs insist
that only productive loans be made, any loan that increases the liquidity of the household frees up
enterprise revenue, which can be put back into the business.

Most MFIs strive to reach sustainability (which may or may not include financial sustainability) by
ensuring that the services offered meet the demands of clients, that operations are as efficient as
possible and costs are minimized, that interest rates and fees are sufficient to cover costs, and that
clients are motivated to repay loans. MFIs can be sustainable providing they have enough funds to
continue operating in the long term. These funds can be obtained solely through operational revenue
or through a combination of grants and operating revenue. As micro-finance develops, clear
principles are being established that lead to financially viable lending.

10. Microcredit:
Microcredit is the extension of small loans (micro loans) to impoverished borrowers who typically
lack collateral, steady employment, and a verifiable credit history. It is designed not only to support
entrepreneurship and alleviate poverty, but also in many cases to empower women and uplift entire
communities by extension. In many communities, women lack the highly stable employment histories
that traditional lenders tend to require. Many are illiterate, and therefore unable to complete
paperwork required to get conventional loans.
Microcredit is part of microfinance, which provides a wider range of financial services, especially
savings accounts, to the poor. Modern microcredit is generally considered to have originated with the
Grameen Bank founded in Bangladesh in 1983. Many traditional banks subsequently introduced
microcredit despite initial misgivings (fillings of doubt). The United Nations declared 2005 the
International Year of Microcredit As of 2012, microcredit is widely used in developing countries and
is presented as having "enormous potential as a tool for poverty alleviation."
11. Individual loan:
The individual loan is designed for clients that have specified needs beyond the group lending model.
A loan is given to an: individual outside of the group lending process. Amounts are typically high.
Individual lending requires greater up-front analysis of clients and their cash flows, sometimes
physical collateral, and frequent and close contact with clients during the term of the loan. Loan
approvals and amounts are based on an applicant's eligibility and debt capacity, which in turn are
dependent upon a number of factors, including personal and business characteristics, for example,
age, gender, or reputation, sources and amount of income, cash flow, and available collateral.
Historically many providers also considered the purpose of the loan as part of the loan approval
decision, but this is less and less common as providers begin to understand client cash flows, their
needs, and the fac1 that money is fungible within households and microenterprises.

Cash flow analysis is used primarily for individual loans and focuses on the overall cost structure of
the household or microenterprise, including all revenues flowing in and expenses flowing out,
anticipated cash flows during the term of the loan. and the absorptive debt capacity of the borrower.
A credit rating is obtained from a credit bureau and provides information on a borrower's history of
repayments and delinquencies (immoral behavior) from all providers participating in the credit
bureau.

12. Character and cash-flow based lending:

i. Character-Based lending:
Some MFIs lend people a good reputation in the community. Prior to making a loan the credit officer
visits the community, asks people about the character of the borrower, and decides about the loan.
The history of the borrower is very helpful to know the character of the borrower. As we know poor
people normally have no assets to keep collateral, they need to be provided loan on the basis of their
character.
What kind of borrower will you be for the bank?
• The best clue to your character is your personal credit history.
• We always check to see how well you have managed your personal debt in the past.
• What if you do not have a personal credit history? If so, Personal references, business
experience and work history can sometimes substitute, but a strong personal credit history
 proves that you have the willingness and the discipline to repay past debts and future
obligations.

ii. Cash flow-based lending:

It allows individuals or companies to borrow money based on the projected future cash flows of a
company. A financial institution grants a loan that is backed by the recipient's personal or business
cash flows. This means that a company borrows money from expected revenues they anticipate they
will receive in the future. Credit ratings are far more important in this form of lending. In addition to
historical cash flows. For example, an enterprise that is attempting to meet its payroll obligations
might use cash-flow finance to pay its employees now and pay back the loan and any interest on the
profits and revenues generated by the employees on a future date.

These loans do not require any type of physical collateral like property or assets. Instead, these lenders
examine expected future company incomes, its credit rating, and its enterprise value. This emphasizes
more entrepreneurship skills, in contrast to asset-based lending. The advantage to this method is that
a company can obtain financing much faster, as an appraisal of collateral is not required.

13. Microenterprise Loans:

This loan is provided to micro enterprises to established or expand a small business as a path to
economic security, Microenterprise loans are normally repaid over up to five years, with the
periodical repayment, amount and terms are determined based on the financial projections of the
business. Pre- and post-loan technical assistance is provided as part of this loan program.

14. Working capital loan:

It is the loan for the current expenditure that occurs in the normal course of the business. It refers to
investment in current or short-term assets to be used within one year. Examples are wood purchased
for carpentry, food or goods purchased for market selling or feed purchase for poultry farm. This loan
is provided for the period of one year or less. The MFIs normally provide this loan matching the
business cycle of the borrowers. This loan carries less risk to the lender as the maturity of the loan is
noticeably short. This loan is also provided in the agriculture sector as well. This loan is provided by
matching the cash flow of the borrowers so that tha1 they can easily pay the loan on maturity.
15. Agricultural loan:
Rural finance refers to financial services provided in rural areas for agricultural as well as
nonagricultural purposes. Agricultural loan, primarily a subset of rural finance, is dedicated to
financing agriculture-related activities such as inputs, production, storage, processing, and marketing
of goods. In addition to funding for working capital, agricultural finance also funds investment and
infrastructure, such as irrigation systems, storage facilities, and machinery. Agricultural loans are
provided in various forms (cash and in-kind) to agro enterprises and farmers operating small, medium,
and large farms. The period of this loan is normally less than one year, as the farmers harvest the
crops, they make the payment of the loan.

16. Loan against group guarantee:

Low-income clients often have minimal assets to pledge for loans; property, land, machinery, and
other capital assets are often not available. Because of this, collateral substitutes and alternative
collateral are used to reduce the risk to the lender.

Group guarantee
Many providers facilitate the formation of groups whose members jointly guarantee each other's
loans. Guarantees are either implicit guarantees, with other group members unable to access a loan if
all members are not current in their loan payments, or actual guarantees, with group members liable
if other group members default on their loans.

Some providers require group members to contribute to a group guarantee fund, which is used if one
or more borrowers fail to repay. Use of the group guarantee fund is sometimes at the discretion of the
group itself and sometimes decided by the provider. If it is used at the group's discretion, the group
will often lend money from the guarantee fund to the group member who is unable to pay. The
member who "borrows" from the group fund is then responsible for paying the fund back. If use of
the group guarantee fund is managed by the provider, the fund is seized to the extent of the defaulted
loan, with other group members making up any shortfall.
Group Lending
Group-based approaches lend either to the group itself as one loan, to individuals who are members
of a group, or to groups who then lend individually to the members. Group lending reduces transaction
costs and risks to providers and often facilitates greater access to financial services for those who are
difficult and expensive to reach, including remote, rural populations, those with low debt capacity,
and those who have no collateral or credit history. The group mechanism effectively shifts the bulk
of the responsibility for screening, monitoring, and enforcement from the provider to the borrowers,
and thus some of the costs. Some of the most well-known group lending methodologies include the
following:

• Grameen: Five-person subgroups, six of which make up a center of 30 individual borrowers;

the subgroups guarantee each other's loans, and the center provides a secondary guarantee.
• Solidarity groups: Three to 10 people per group, each guaranteeing each other's individual
loans.
• Village banks: 15 to 50 people who form a "village bank" that makes individual loans to the
members of the village bank. In some cases, pooled member savings may be loaned to
members within the group; such loans are referred to as "internal account" loans.

Disadvantages of the group approach include higher transaction costs for clients due to time
productive activities or household responsibilities), a relatively limited product offering, a lack of
privacy, and of course the risk a fellow group member will default. Furthermore, group members
sometimes feel pressure to borrow even if they do not need a loan or are unsure of their ability to
repay. This may also happen in Savings Groups or Self-Help Groups even though loans are made by
the group to individuals.

17. Calculating Interest Payments:

The amount that a borrower pays to a lending institution in interest is determined not only by the
stated interest rate but also by the method used to calculate interest. Two general techniques are
widely used: the declining balance method and the 'flat” method. The declining balance method
imposes lower costs on the borrower than does the flat method. Equivalently, the declining balance
method generates lower yield on an MFI's portfolio than does the flat method.
 i. Declining Balance Method
When the declining balance method is used, interest is computed based on the balances that remain
in the borrower's hands. As successive installments of principal are repaid, these balances decline. In
this case, interest is not charged on the amount of the loan principal that the borrower has already
repaid. In the early periods when the outstanding balance is high, the contribution of interest to the
PMT is relatively high and the contribution of principal repayment to the PMT is relatively low. As
the principal balance declines, interest payments to the PMT decline too.

ii. Flat Method

When the fiat method is employed, interest is computed based on the original face amount of the loan
rather than on the declining balances. Computing interest using the flat method instead of the
declining balance method has the effect of raising the payment made each period, and, therefore,
increasing the "effective" interest rate to the borrower: This means that the loan is costlier to the
borrower and, equivalently, that the loan generates more income for the lending institution.

The Effective Interest Rate

The effective interest rate is the rate that a client is "really" paying, based on the amount of loan
proceeds actually in the client's hands during each period of the life of the loan. In includes all direct
financial costs of loan in one interest rate. In most cases it is different than the stated interest rate due
to interest payment time and other charges in addition to interest charge. It is an important concept
for determining whether the conditions of a loan make it less expensive for the borrower than other
loans. The effective interest rate is calculated as;

Effective interest rate = Total Interest paid + Total of other charges X 100

Average loan used during the period

Where

Average Loan amount = Sum of loan balances of each period X 100

No. of Periods

Total interest paid = Sum of interest paid in all the period

Setting Interest Rates
How should an MFI decide what prices to charge its clients? To achieve financial sustainability,
program income must cover all programmatic and financial costs. For most MFIs without other assets
that provide income, this means that interest income from loans must cover all costs. The Consultative
Group to Assist the Poorest (CGAP) has designed a straightforward method to allow MFIs to
determine what effective interest rate they need to charge in order to achieve financial viability. The
interest rate required for financial sustainability (R) is determined by five elements, each expressed
as a percentage of the average outstanding loan portfolio:

1. Administrative expense rate (AE):

It includes rent and utilities, salaries, travel and transportation, office supplies, etc. It is calculated by
dividing total annual administrative expenses by average outstanding loan portfolio;
2. Targeted capitalization rate (K):
It is the net real profit that the MFI decides to target, divided by the average loan portfolio.
3. The cost of loan loss rate (LL):
It is calculated by dividing annual loss due to uncollectible loans by average outstanding loan
portfolio.
4. The market cost of funds rate (CF):
It is the cost of funds paid while collecting funds from depositors or borrowing from mainstream
financial institutions.
5. Investment income rate (II):
It is the income expected from an MFI's financial assets other than the loan portfolio, divided by the
average loan portfolio.

Interest rate (R) = AE + K + LL + CF - II

1 - LL
Nominal vs. Real Interest Rates
The interest rate charged to borrowers is usually called the nominal interest rate. It is the rate indicated
in the loan contract. This is different from the real interest rate because it includes inflation. When
we talk about interest rates, we normally talk about nominal interest rates. It does not measure the
real growth in purchasing power of money.
The real interest rate is the rate which actually increases the purchasing power of money. It is the rate
realized from investment after adjusting for inflation. If the nominal interest rate is higher than the
level of inflation, then the real interest rate is positive. For borrowers, a positive interest rate means
that they have actually paid something for the benefit of using the money that they have borrowed.
In order for the loan fund to maintain its value, it is essential for an MFI to charge a nominal rate of
interest that is greater than the rate of inflation.

Real Interest Rate= Nominal Interest Rate - Rate of Inflation

Unit 5: Directed or Deprived Sector lending LH 6

Meaning and concept, Directed lending- importance, Pros and cons views, Priority sector
lending vs. deprived sector lending, NRB (Nepal Rastra Bank) policies for DSL, Penalty in case
of default in DSL, Direct lending Vs Indirect lending. Roles of DSL for increasing productivity.

1. Directed lending Program/ Directed Credit Programs:

Directed credit programs (DCPs) have always been used as a convenient policy tool to direct the flow
of financial resources to a specific sector of the population for a specific purpose. In most cases, the
targeted sectors are those perceived by policymakers to be in need of financial resources to conduct
a specific activity considered essential for development (e.g., production loan, working capital loan,
processing loan, etc.). DCPs are thus used as a policy tool. They are relatively easy to implement and
provide government high visibility, unlike infrastructures which take a long time to build and
implement. Thus, DCPs are deemed essential in alleviating the plight of the perceived disadvantaged
sector of the economy. In view of their easy implementation and their immediate effect on the target
beneficiaries, they are usually preferred by policymakers especially when immediate results are
considered a priority in the design of policies.

DCPs are defined as credit programs directed toward a specific sector, with funding coming from
sources external to the implementing organization. In most cases, DCP funds are either budgetary
allocation, grants, or loan proceeds from bilateral or multilateral donor organizations.

It may be useful to provide the following definitions:

• Fund source (FS) – the source of credit funds. It includes budgetary allocations, special funds,
grants, loan proceeds, or internally generated funds.
• Executing organization (EO) – the agency which was given the funds for the credit program.
• Fund administrator/manager (FA) – the agency that administers and manages the funds earmarked
for the credit program.
• Lending conduit (LC) – the institution through which funds are channeled to the end-user.
 Under the direct model, credit resources are lent directly to the end-user by the executing agency,
which also acts as the fund administrator.

Directed sector lending programs in microfinance and rural banking can have several advantages and
disadvantages. Let us explore the pros and cons of such programs:

2. Pros of Directed Sector Lending:

i. Financial Inclusion: Directed sector lending programs can promote financial inclusion by
directing credit to microfinance institutions and rural banks that serve underserved or
marginalized populations. This helps expand access to financial services in remote or
economically disadvantaged areas, empowering individuals and fostering economic
development.

ii. Poverty Alleviation: By targeting microfinance and rural banking sectors, directed sector lending
programs can contribute to poverty alleviation. These programs enable the provision of credit to
small-scale entrepreneurs, farmers, and rural households, helping them invest in income-
generating activities, increase productivity, and improve their living standards.

iii. Local Economic Development: Directed sector lending can support local economic
development in rural areas. By providing credit to microenterprises, agricultural activities, or rural
infrastructure projects, these programs stimulate economic growth, create employment
opportunities, and enhance the overall economic viability of rural communities.

iv. Sector-Specific Expertise: Directed sector lending programs encourage microfinance

institutions and rural banks to specialize and develop expertise in serving specific sectors, such
as agriculture, livestock, or small-scale industries. This can lead to more tailored financial
products, improved risk assessment, and better support for the unique needs and challenges of
these sectors.

v. Policy Alignment: Directed sector lending programs can align with government policies and
developmental goals. By directing credit towards sectors prioritized by the government, such as
 agriculture or rural development, these programs contribute to the implementation of national
strategies and promote sustainable and inclusive growth.

3. Cons of Directed Sector Lending:

i. Market Distortions: Directed sector lending programs can distort market forces and hinder the
efficient allocation of credit. When credit allocation is directed by government policies rather
than market dynamics, it may lead to misallocation of resources, inefficiencies, and potential
market distortions.

ii. Reduced Autonomy: Microfinance institutions and rural banks participating in directed sector
lending programs may have limited autonomy in determining their lending priorities. This can
restrict their ability to respond flexibly to changing market conditions or emerging needs,
potentially hindering their overall effectiveness and competitiveness.

iii. Credit Quality Risks: Directed sector lending can pose credit quality risks if loans are extended
to borrowers who do not meet standard creditworthiness criteria. This may lead to higher default
rates and credit risk, especially if lending decisions are influenced by political considerations
rather than sound risk assessment practices.

iv. Sustainability Concerns: Directed sector lending programs may face challenges in achieving
long-term sustainability. If the directed lending is not accompanied by adequate capacity-
building measures, technical assistance, or monitoring, it may result in unsustainable lending
practices or over indebtedness among targeted borrowers.

v. Administrative Burden: Implementing and monitoring directed sector lending programs

requires regulatory oversight and administrative efforts. This can place an additional burden on
regulatory authorities, microfinance institutions, and rural banks in terms of compliance,
reporting, and coordination, potentially impacting operational efficiency.

It is essential for governments, regulatory authorities, and financial institutions to carefully design
and implement directed sector lending programs in microfinance and rural banking, considering their
potential pros and cons. Regular monitoring, evaluation, and policy adjustments are vital to maximize
the positive impacts while minimizing potential drawbacks.

4. Priority sector lending program (PSCP):

Priority Sector refers to those sectors of the economy which may not get timely and adequate credit
in the absence of this special attention. Financing to the ‘small sector’ and priority sector is a
mandatory credit requirement of the NRB. The commercial banks were required to invest a certain
percentage of their credit portfolios into this sector. At the beginning there were two programs
launched by NRB: Priority Sector Credit Program (PSCP) and Deprived Sector Credit
Program (DSCP).

In the year 1981, this program was further amended as 'Intensive Banking Program' (IBP). IBP
incorporated the provision of group lending at joint liability. It was the first collateral free loan
system. The priority sector includes financing in agriculture, cottage industries, services sector, and
hydro power. As per the requirements of the country, this sector has undergone many amendments
from time to time. Originally, the banks were required to invest 5 percent of the total deposit in 1974,
increased to 7 percent of the total deposits in 1976, with the introduction of a new concept of financing
in priority sector, known as IBP, the NRB had also changed the deposit-based into credit-based.
Henceforth, the banks were required to invest 8 percent of the total credit outstanding which later
increased to 10 percent in 1985 and 12 percent in 1991. It was 9% in 2003.

The priority sector financing has been regarded as one of the best targets and objective-oriented
development finance programs in Nepal. Although such financing has its own downside and has
experienced some criticisms, quite a number of rural people benefited from it. Investment in priority
sectors lending gradually declined from 9% in 2003 to 6%, 4%, 2% and 0% in 2004, 2005, 2006 and
2007, respectively. The policy was ruled out completely from 2007.
5. Deprived Sector Credit Program (DSCP):

The deprived sector credit policy is directed credit policy of Nepal Rastra Bank, which is designed to
meet micro credit demand of poorer and weaker section of the country. This policy was introduced
for commercial banks in 1990. Under this policy provision, commercial banks were liable to lend up
to 3 percent of their total loan outstanding to deprived people. Later, the policy was extended to
development banks and finance companies also. The deprived sector includes the low-income people
especially socially deprived women, endogenous lower caste, blind & hearing impaired. disabled,
craftsman, artisan, small & marginal farmer, and landless people. From the very beginning, these
people are excluded from the formal banking services. The lending to those people who are deprived
of lending from formal financial sector comes under deprived sector credit.

The main objective of deprived sector credit is to uplift the socio-economic status of these people.
This was a mandatory program started at that time and still in practice with some amendments. If the
banks fail to achieve the target, they are penalized for the shortfall. The penalties are charged as per
the NRB Act, and such penalties are deposited into NRB's profit and loss account.

According to the directives of NRB directives 2073: "A class licensed institutions are required to lend
at least 5 percent of their total outstanding loan and advances, B class licensed institutions shall
require extending 4.5 percent of their total credit and C class licensed institutions are required to lend
4 percent in deprived sector lending. Moreover, A class commercial Banks should lend at least 2
percent directly to the deprived sectors and remain through indirect lending with the help of D class
financial institutions.

6. Rationale of Deprived Sector Credit:

Nepal is one of the poorest countries in the world. As estimated in 2014 about 28 percent of people
are living below the poverty line. It was 42 percent in l996. It is understood that lack of access to
productive resources is the root cause of poverty. Banks and financial institutions are the main sources
of financial resources. Financial institutions act as financial intermediaries and mobilize financial
resources in the economy. The access to financial resources activated indigenous skill and increased
the productivity of the poor people. Despite the various measures, most of the banks and financial
institutions are concentrated in urban and semi urban areas dealing with big borrowers and rural &
poor people are forced to depend on the informal financial market.
More than 75 percent of the people of this country live and work in rural areas. Thus, rural people
have not benefited on an equal footing from the recent financial development. We cannot ignore our
reality where greater role of social responsibility of commercial banks is expected. To address these
problems. NRB introduced the directed credit policy.

The introduction of deprived sector credit policy envisaged to help to flourish the micro financing
activities in the country. It is believed that micro credit is a powerful tool of poverty alleviation
through increasing economic activities thereby increasing income, employment, and livelihood.
However, ongoing micro credit programs could cover only 35 percent of total rural credit demand.
Therefore, deprived sector credit policy could be instrumental to support the overall micro credit
demand of rural poor. It is estimated that 2.4 million households require the micro finance services
in Nepal. The available data revealed that only 35 percent of total micro finance clients have been
enrolled in the ongoing programs and the large mass is still deprived of formal credit.

7. Impact of Deprived Sector Credit Policy:

The fundamental micro finance activities undertaken in the country revealed that the deprived sector
credit policy has created favorable impact on increasing access to finance, expansion of micro finance
activities and improving socio economic status of the deprived people. The impact of the policy can
be evaluated based on following indicators;

i. Increased in access to finance:

The rapidly expanding banks and financial institutions, particularly micro credit development banks
have contributed to an increase in access to finance for the rural poor. It has helped to increase the
number of borrowers, and many are enjoying credit facilities. The policy has been playing a very
positive role in the establishment of MFIs. The number of MFIs with private sector participation is
expanding significantly.

The policy provision has assured fund for lending to the micro finance institutions. As a result,
numbers of MFIs have been established. It creates a competitive environment in micro financing. The
 growing competition compelled these institutions to be more efficient. Consequently, the rural poor
people will benefit ultimately.

ii. Increase in Micro Finance Activities:

The mandatory deprived sector lending policy is one of the main and continuous sources of funds for
MFIs. This has helped to collect the funds for MFIs and such collected funds are being utilized in
lending to deprive families and the group. Now the MFIs slowly have started to mobilize saving as
well. This has helped to increase the MF activities.

iii. Improvement in Socio-economic Status:

Micro credit programs help to assemble poor people in-group, give an opportunity to discuss and
share information about their business and create awareness against poverty. Micro credit financing
procedure has developed the attitude of financial discipline among the poor. As a result, the flow of
micro credit, outstanding repayment rate and increase in group savings has been achieved by MFIs.
This indicates that the policy provision has enhanced the socio-economic status of the deprived
people.

iv. Increase in Economic Activities:

Once the poor people get credit for income generating activities it energizes them and becomes more
productive. It will help to enhance economic activities thereby increasing income, self-employment,
and livelihood of the poor people.

8. NRB Policies for deprive sectors lending:

The following Directives have been issued, having exercised the powers conferred by Section 79 of
the Nepal Rastra Bank Act, 2002, with regard to the deprived sector lending to be extended by the
institutions of Class “A”, “B” and “C” licensed by this Bank: -

1. The "A" class licensed institutions are required to lend at least 5 percent of their total outstanding
loan and advances "B" class licensed institutions shall require extending 4.5 percent of their total
credit and class "C" licensed institutions are required to lend 4 percent in deprived sector lending.
 Moreover, A class commercial Banks should lend at least 2 percent directly to the deprived sectors
and remain through indirect lending.

For the purpose of these Directives, "deprived " means low income and especially socially backward
women, tribal people, Dalit, blind, hearing impaired and physically incapacitated persons,
marginalized and small farmers, craft-men, labor, and landless squatters’ family. All micro-credits to
be extended for the operation of self-employment oriented micro-enterprises for the upliftment of
economic and social status of deprived sector up to the limit specified by this Bank is termed as
"deprived sector lending".

2. The following loans and advances directly extended by the licensed class "A", "B" and "C" shall be
included under the deprived sector lending: -
a. Micro credit extended up to Rs. 1,00,000 per group/individual against group/personal guarantee to
the deprived or low-income individual for operating micro business;
b. Extension of loan not exceeding Rs. 1,00,000 per family for the purpose of Micro Hydropower
Project up to 50 kilowatts, Solar-Home-System, solar cooker, solar dryer, solar pump, biogas,
improved water mills, improved cooking stoves and wind energy according to renewable energy
technology;
c. Micro industrial credit up to Rs. 3,00,000 for each business extended to deprived or low-income
individual to operate the micro industries against acceptable collateral/to group members against
group guarantee.
d. Loans up to 150,000 per person extended to the individuals who are going for foreign employment.
e. Foreign employment loan extended by any "A" class licensed bank in coordination with a bank
prescribed by Government of Nepal to workers going for foreign employment under the Youth Self-
employment and Employment Training Program of the Government of Nepal. ·
f. The loan not exceeding Rs.3,00,000 extended by bank or financial institutions to per
individual/family eligible to receive deprive sector lending for sheep farming to produce wool
necessary for carpet or for maintaining handloom to weave carpet against acceptable collateral
security shall be calculated as the deprive sector lending.
g. Loan up to Rs 4,00,000 provided to the women to run micro industry.
h. Amount lent to Grameen sectors through consumer committee or cooperatives for the sake of
purchasing agricultural equipment and other machinery like thresher, tractor etc.
i. Loan up to Rs.2,00,000 to the deprived family members to get technical education at secondary and
higher secondary level.
j. Loan up to Rs 3,00,000 delivered in group guarantee to the farmers to create cold storage house to
protect agriculture products.
k. Loan to purchase the one Rikshya in the ownership of the same Rikshya driver.

3. The following loans extended indirectly by "A", "B" and "C" class licensed institutions shall be
calculated as the deprived sector lending;
a. Wholesale loan extended against the institutional capability and institutional guarantee to the "D"
class licensed institutions and bodies established for performing micro credit related works under the
prevailing statutes relating to financial intermediation activities.
b. With a view to improving the level of income and to enhance employment for those living below
the poverty line, deprived or people with low income, wholesale loans may be extended to the Co-
operative Societies established and in operation in rural areas.
c. Extension of wholesale loans to small farmers cooperatives and "D" class micro finance
development bank.
d. Loans not exceeding Rs. 150,000 extended to the workers going for foreign employment by the
licensed financial institutions by borrowing funds from "A", “B'” and "C" class licensed institutions.
Such a loan shall be calculated only as deprived sector lending of the "A", “B” and "C" class licensed
institutions.

Moreover, bank and financial institutions are required to obtain progress report in every six months
regarding the utilization of the extended credit towards deprived sector from the institutions which
were provided with wholesale credit with the intention of including the same under the deprived
sector lending. If such wholesale credit is, during the inspection of this Bank, found to be misused,
the amount to the extent of misuse shall not be considered for as deprived sector lending.

4. The promoter shares capital investment made by the licensed "A", "B" and "C" class banks and
financial institutions in the class "D" financial institutions shall also be calculated as indirect the
deprived sector lending.
5. Cent percent of the amount received by micro finance development banks from the licensed
institutions under the deprived sector lending shall have to be compulsorily extended to the
deprived sector. If no such investment is made, the wholesale loans to be extended to the licensed
institutions to the micro finance development banks shall not be calculated as the deprived sector
lending.

6. The loans extended to the deprived sector shall be calculated based on the total outstanding loans
before six months (including bills purchases and discounted, except the portion of the deprived sector)
in every quarter
i.e., at the end of the months of Ashwin, Paush, Chaitra and Ashadh.

1. Regarding Inclusion of Low-Cost Housing Loans in Deprived Sector Lending:

The loans extended fulfilling the following conditions for the purchase of land and house construction
to the persons eligible for inclusion under the deprived sector shall be eligible for inclusion under the
deprived sector lending: -
a. The loan not exceeding Rs.4,00,000 provided against secured collateral on a group or individual
basis.
b. The credit policy of the concerned bank and financial institution has to contain the specific policy
as to the extension of loan to deprived sector for the purpose of purchase of land and house
construction.
c. All necessary requirements according to the laws in force for the time being and the Directives of
this Bank have to be observed.
d. Deprived sector shall mean people with low income, particularly socially backward women, tribal
people, and Dalit, blind, having the hearing capacity impaired and physically disabled, marginalized,
and small farmers, craft-men, labor, and landless squatters as defined in Point No. 1 above.,
8. The quarterly statement relating to deprived sector lending shall be prepared in the format referred
to in NRB Form No. 9.5 and be sent to the concerned supervision Department of this Bank within 15
days of the completion of the quarter.
9. The concerned licensed institution shall have to state clearly in its Credit Policy the policy and
procedural provisions relating to the loans to be extended to the deprived sector.
10. Notwithstanding anything contained in other Directives, no loan loss provision of 20 percent shall
be required for the loans to be extended to the deprived sector directly or indirectly against the
group/personal/institutional guarantee.
11. ln case the licensed institution of classes "A", "B" and "C" do not extend the deprived sector
lending to be extended according to the Directives relating thereto or extend lesser amount of loans,
the amount not extended or less extended shall be fined to the concerned licensed institution at the
rate of highest percentage of interest it charges on loans during that calculation time pursuant to
Section 81 of the Nepal Rastra Bank Act, 2002.

9. Penalty in case of default in DSL:

In case the licensed institution of classes "A", "B" and "C" do not extend the deprived sector lending
to be extended according to the Directives, the part of the loan amount not extended or less extended
shall be fined to the concerned licensed institution at the rate of highest percentage of interest it
charges on loans during that calculation time pursuant to Section 81 of the Nepal Rastra Bank Act,
2002.
The MFIs should invest the entire wholesale loan taken from the commercial banks and other
wholesale lending institutions at subsidized rate to the deprived sectors. If they use such a fund for
other purposes or deposit the fund in 10 interest bearing accounts worth with the hope of earning
profit, they will be penalized. They shall be fined interest on such less invested amount.

10. Direct lending provision:

The dictionary meaning of direct lending “A situation in which a person or organization lends money
directly to another person or organization without involving anyone else in the arrangements.” Direct
lending involves the transfer of funds from the ultimate lender to the ultimate borrower, most often
through a third party. According to the new monetary policy of 2016-2017 NRB has directed the
commercial banks to lend two percent of their total loan portfolio to the deprived sector from their
own capacity. They were maintaining the deprived sector lending criteria set by the Central Bank
through providing funds to Micro Finance Institutions (MFIs). The recently launched Monetary
Policy 2016-17 has provisioned two per cent direct lending to the deprived sector through the own
capacity of the commercial banks, out of the five per cent of the total loan portfolio to the deprived
sector.

MFIs - class D financial institutions - are specialized institutions for deprived sector lending. As per
the current provision, Commercial Banks have to lend Rs 28 billion (at the current lending level of
the Class A banks) directly to the deprived sector. However, the monetary policy has allowed
commercial banks to count loans up to Rs one million issued in the agriculture sector as deprived
sector loans. This provision may help commercial banks to meet the target of two per cent lending in
the deprived sector.

Commercial banks had been lending through microfinance institutions (MFIs) - class 'D' financial
institutions to maintain deprived sector lending target of five per cent set by Nepal Rastra Bank (NRB)
until last fiscal. As per the recent provision of the monetary policy, commercial banks have to lend
around Rs 28 billion directly (based on the recent lending level) to the deprived sector. On average,
one commercial bank has to lend around Rs one billion to the deprived sector.

The central bank has also listed the sectors, people and types of loans which can be counted as
deprived sector lending. Micro credit extended to women, Dalits, disabled, marginalized, small
farmers and landless family, and aspiring migrant workers, can be counted as loans to deprived sector,
according to NRB.

The MFIs are currently mobilizing funds from the commercial banks totaling around Rs 75 billion -
nearly 5 percent of the total lending by the commercial banks to the deprived sector. As the new NRB
provision has put the limit on direct lending to the deprived sector to 2 percent of their total lending,
the commercial banks are likely to pull out that amount from the microfinance institutions. The new
provision, the microfinance operators fear, will decrease their business volume by a third. “Around
Rs. 25 billion will be pulled out from our system.”

The central bank, however, defended its move saying that the monetary policy made such a provision
to curb the high interest rates charged by the MFIs to their borrowers. "At present, micro-finance
institutions are charging extremely high interest rates," said Shiba Raj Shrestha, deputy governor of
the NRB. "Once, the commercial banks start lending directly the interest rates will come down."

11. Indirect Lending:

Indirect lending is lending by the original lender to a financial intermediary who pools the funds of
many lenders in order to re-lend at a markup over the cost of the funds. The ultimate borrowers are
normally unknown to the original lenders. A lender faces less risk in indirect lending because as a
specialist in the field, the intermediary normally has a well-established credit standing. Of course,
lower risk usually means less gain for the lender. The microfinance investment funds, and
microfinance investment vehicles lend the donors and other investors’ money to the microfinance
institutions.

Indirect lending generally offers lower costs to the ultimate borrower for small or short-term loans.
Most borrowers lack sufficient credit standing to borrow directly. Borrowers who do have that option
may find it cheaper, especially for large sums. In fact, it may not even be possible to borrow large
sums indirectly through intermediaries. The capacity of the direct financial markets is much larger
than that of even the largest intermediaries.
 12. Direct lending Vs Indirect lending:

Here is a comparison table illustrating the differences between direct lending and indirect lending in
microfinance and rural banking, along with examples:

Direct Lending Indirect Lending

Definition Lending directly from the Lending through intermediaries

lender to the borrower or financial institutions

Borrower Interaction Direct interaction between Lender does not directly

lender and borrower interact with the borrower

Risk Assessment Lender assesses borrower’s Lender relies on intermediary’s

creditworthiness risk assessment

Control Lender has direct control over Lender has limited control over
loan terms loan terms

Examples i. Traditional bank loans i. Mortgage-backed

securities

ii. Peer-to-peer lending ii. Mutual funds investing

platforms in corporate bonds

iii. Direct lending by iii. Insurance companies

development banks to investing in
projects government bonds

Examples of Direct Lending in Microfinance and Rural Banking:

i. Direct loans provided by microfinance institutions to individual entrepreneurs or small businesses

in rural areas. The microfinance institution conducts an assessment of the borrower's
creditworthiness, provides the loan directly, and establishes a repayment plan.
 ii. Loans provided by rural banks directly to farmers or agricultural cooperatives. The rural bank
assesses the creditworthiness of the borrowers, disburses loans for agricultural purposes, and
directly interacts with the borrowers throughout the lending process.

iii. Direct lending by a government-sponsored microfinance program to rural entrepreneurs or

women-owned businesses. The government program directly provides loans to targeted
beneficiaries in rural areas, helping them start or expand their businesses.

Examples of Indirect Lending in Microfinance and Rural Banking:

i. Wholesale lending by a microfinance network to local microfinance institutions, which then lends
to individual borrowers in rural areas. The microfinance network provides funds and support to
local microfinance institutions, which handle the loan disbursement and repayment collection
from individual borrowers.

ii. Funding provided by a development bank to a microfinance intermediary, which then disburses
loans to rural borrowers such as farmers or women's self-help groups. The development bank
provides financial resources to the microfinance intermediary, which in turn lends to targeted
borrowers in rural areas.

iii. Investment by a private equity fund in a microfinance institution that serves rural clients. The
private equity fund invests in a microfinance institution that operates in rural areas, indirectly
supporting the lending activities of the microfinance institution to rural borrowers.

In direct lending in microfinance and rural banking, the lender has direct control over loan terms,
borrower interactions, and risk assessment. In indirect lending, the lender relies on intermediaries or
financial institutions to facilitate lending, risk assessment, and borrower interactions.
 13. Roles of DSL for increasing productivity:

Directed sector lending in microfinance and rural banking can play a crucial role in increasing
productivity by providing targeted financial support to specific sectors and underserved populations.
Here are the roles of directed sector lending in microfinance and rural banking for increasing
productivity:

i. Access to Capital: Directed sector lending ensures that microenterprises, small businesses, and
farmers in specific sectors have access to capital. By providing targeted loans, it helps them invest
in productivity-enhancing activities such as purchasing modern equipment, expanding operations,
or adopting modern technologies. This access to capital can significantly contribute to increased
productivity levels.

ii. Sector-Specific Support: Directed sector lending programs can provide tailored financial
products and services to specific sectors, such as agriculture, agribusiness, or rural industries.
This targeted support can address sector-specific challenges, promote innovation, and facilitate
the adoption of best practices, leading to improved productivity levels within those sectors.

iii. Skill Development and Training: Directed sector lending programs can be combined with skill
development and training initiatives. By providing financial resources for training programs or
capacity-building activities, these programs help enhance the skills and knowledge of
microentrepreneurs, farmers, and rural workers. Improved skills can boost productivity and
competitiveness in the targeted sectors.

iv. Technology Adoption: Directed sector lending can facilitate the adoption of technology in
microfinance and rural banking. By providing financial support for digital infrastructure,
information systems, or fintech solutions, directed lending programs can enable microfinance
institutions and rural banks to offer efficient and technology-driven financial services. This, in
turn, improves access to finance and financial management tools for borrowers, leading to
increased productivity.
 v. Value Chain Development: Directed sector lending can support the development of value chains
in specific sectors. By providing financial resources to different actors along the value chain, such
as producers, processors, and distributors, it strengthens the entire ecosystem and fosters
collaboration and efficiency. This integrated approach can result in increased productivity and
competitiveness within the value chain.

vi. Investment in Infrastructure: Directed sector lending programs can support investments in rural
infrastructure, such as irrigation systems, roads, storage facilities, or energy supply. These
infrastructure investments can remove bottlenecks, reduce production costs, and enable better
market access for rural producers, ultimately improving productivity levels.

vii. Financial Inclusion: Directed sector lending in microfinance and rural banking promotes
financial inclusion by extending credit to underserved populations. By providing access to
financial services for individuals who have limited or no access to traditional banking, it
empowers them to engage in productive economic activities, create livelihoods, and contribute to
overall productivity growth.

By channeling resources to specific sectors and underserved populations, directed sector lending
programs in microfinance and rural banking can unlock their potential, address market failures, and
facilitate productivity improvements. These programs act as catalysts for economic growth, job
creation, and sustainable development in targeted sectors and rural areas.
Unit 6: Measuring the Performance of MFIs LH 8

Analyzing financial statements, financial performance ratios, efficiency, and productivity;

liquidity and capital adequacy; asset and liability management, Loan loss and provisioning,
Benchmarking, Rating MFIs, Social Performance Measurement, and Impact performance
evaluation of microfinance institutions in the framework of WOCCU model, CGAP model, and
SEEP model

1. Analyzing financial statements:

It is the process of reviewing and analyzing a company's financial statements to make better economic
decisions. Financial statement analysis is the use of analytical or financial tools to examine and
compare financial statements in order to make business decisions. In other words, financial statement
analysis is a way for investors and creditors to examine financial statements and see if the business
is healthy enough to invest in or loan to.
These statements include the income statement, balance sheet, statement of cash flows, and a
statement of changes in equity. Financial statement analysis is a method or process involving specific
techniques for evaluating risks, performance, financial health, and future prospects of an organization.
It is used by a variety of stakeholders, such as credit and equity investors, the government, the public,
and decision-makers within the organization. These stakeholders have different interests and apply a
variety of different techniques to meet their needs. For example, equity investors are interested in the
long-term earnings power of the organization and perhaps the sustainability and growth of dividend
payments. Creditors want to ensure the interest and principal is paid on the organization’s debt
securities (e.g., bonds) when due.

2. Profitability/ Sustainability/ Financial performance ratios:

Profitability measures, such as return on equity and return on assets, tend to summarize performance
in all areas of the company. If portfolio quality is poor or efficiency is low, this will be reflected in
profitability. Because they are an aggregate of so many factors, profitability indicators can be difficult
to interpret. All performance indicators tend to be of limited use (in fact, they can be outright
misleading) if looked at in isolation and this is particularly the case for profitability indicators. To
understand how an institution achieves its profits (or losses), the analysis also has to consider other
indicators that illuminate the operational performance of the institution, such as operational efficiency
and portfolio quality. The profitability analysis is further complicated by the fact that a significant
number of microfinance institutions still receive grants and subsidized loans.

It shows the financial returns to the use of the capital and assets employed. The profit level also shows
MFI's self-sufficiency in relation to covering costs and building its equity. It answers the question:
Will our MFI have the financial resources to continue serving members and clients tomorrow as well
as today?

i. Operating Self -Sufficiency (OSS):

Operational Self-Sufficiency measures the degree to which internally generated operational revenue
covers all operating expenses. The ratio excludes non-operating revenues and donations. It does
include Financial Expenses and the Provision for Loan Losses together with other operating expenses.
This ratio measures the degree to which the institution is able to function independent of grant
support. A ratio of 100% is the MFI's break-even point and indicates that the MFI's income is equal
to operating expenses. Young, immature MFIs may take several years to break-even. This ratio should
show a gradual increasing trend, and not fluctuate too greatly.

Operating Self-Sufficiency = Financial revenue/ financial expenses + loan loss provision + Op.
Exp.
.
ii. Return on Assets (ROA):
Return on assets is an overall measure of profitability that reflects both the profit margin and the
efficiency of the institution. Simply put, it measures how well the institution uses all its assets. Return
on assets is a fairly straightforward measure. The ratio does not evaluate the source of the asset base
- whether through debt or equity, but simply the return of the portfolio and other revenue generated
from investments and operations. The return on assets should be positive. There is a positive
relationship between Return on Assets and the Portfolio to Assets ratio. MFIs that maintain most of
their assets in the loan portfolio tend to break even sooner and generate higher returns on their assets;
provided the loan portfolio performs well and other costs are also controlled.

ROA= Net Operating Income -Taxes/ average assets

 iii. Return on Equity:
A Return on Equity is probably one of the most important profitability indicators for commercial
banks and MFIs, particularly in comparison with other institutions. The return is measured only in
relation to what the MFI has built from operating surpluses, or what it has generated through
donations or other contributed sources. This ratio is particularly relevant for a private for-profit entity
with real flesh-and-blood owners. For them. ROE is a measure of paramount importance since it
measures the return on their investment in the institution. Increasing equity also strengthens MFI’s
capital structure and its ability to leverage debt financing. As markets mature and competition
increases, Return on Equity may level off and maintain a positive position without increasing
dramatically or at all.
ROE= Net Operating Income - Taxes/ average Equity

3. Efficiency and productivity:

Efficiency and productivity indicators are performance measures that show how well the institution
is streamlining its operations. Productivity indicators reflect the amount of output per unit of input,
while efficiency indicators also consider the cost of the inputs and/or the price of outputs. Since these
indicators are not easily manipulated by management decisions, they are more readily comparable
across institutions than, say, profitability indicators such as return on equity and assets. On the other
hand, productivity and efficiency measures are fewer comprehensive indicators of performance than
those of profitability.

Microfinance institutions have much lower rates of efficiency than commercial banks because on a
Rs per Rs basis microcredit is highly labor intensive: a thousand - Rs loan requires about as much
administrative effort as a loan a hundred times larger. In an MFI, administrative costs may be Rs 150,
Rs 200. or even Rs 300 for each Rs 1000 in the loan portfolio, so the efficiency ratio is 15%, 20% or
30%, whereas in commercial bank efficiency ratios of 1.5%. 2% or 3% are common. Economies of
scale have much less impact on efficiency in MFIs than is usually believed because of the high
variable costs of microcredit technology.

Efficiency and productivity ratios measure the costs of an MFI in relation to the outputs. It shows
how proficient the organization and management are in operating its financial activities, particularly
its use of assets and human resources. It answers the question: Does MFI serve as many clients as
possible with its resources, for the lowest possible cost? It is important to note that the efficiency
ratios must be used carefully. They are highly dependent on the loan methodology used, the number
of products and services offered, staffing structures, the physical context (rural or urban) and the
maturity of the MFI. Efficiency ratios should also be examined in conjunction with Portfolio Quality
ratios since a quality portfolio should not be sacrificed for high efficiency.

i. Operating Expense Ratio:

The Operating Expense Ratio measures the MFI operating expenses (not including the Cost of Funds
or the Provision for Loan Losses) as compared to the average loan portfolio. There are numerous
efficiency indicators used in the financial services industry, using a variety of other denominators,
including Average Performing Assets and Average Total Assets. The advantage of using the Average
Gross Loan Portfolio is that the Yield and the Cost of Funds ratios are all based on the same
denominator. Once MFIs select the ratio and the denominator that they wish to use, they should be
consistent in using it.

Operating expenses ratio= Operating Expenses/ Average Gross Portfolio

ii. Cost per Active Client:

This ratio measures the operating expenses (not including cost of funds or provision) that the MFI
requires to serve a single active client. It is then also the amount of revenue that the MFI needs to
generate from every single client in order to break even. The ratio will also be affected by the
methodology and the technologies used by the MFI. The largest operating expense in most MFIs is
its labor costs. By examining the trends in the ratio's numerator and denominator, and the ratio itself,
one can determine whether a reduced Cost per Client is the result of reduced labor costs or the more
efficient use of labor. Many MFIs compare their Cost per Active Client with other national or
international MFIs. When doing so, it is useful to consider that different countries have different
national incomes, and that straight forward comparisons may not be that meaningful.

Cost per Active Client= Operating Expenses/ Average Number of Active Clients (excluding
Consumer and Pawn Loans)
Note: Operating expenses = All expenses related to the operation of the institution (including all the
administrative and salary expenses, depreciation, and board fees) by the average number of active
borrowers. Interest and provision expenses, as well as extraordinary expenses, are not included.

iii. Cost per borrower:

This ratio provides a meaningful measure of efficiency by showing the average cost of maintaining
an active borrower. Since the size of the loans is not part of the denominator, institutions with larger
loans do not automatically appear more efficient, as is the case with the operating expense ratio. The
cost per borrower ratio is in this sense a "fairer" indicator than the operating expense ratio.
This ratio complements the operating expense ratio in much the same way that the write-off ratio
complements portfolio at risk. It is tempting to simply conclude that high operating expenses are a
sign of inefficiency, just as it is tempting to believe that low portfolio at risk is necessarily the same
as excellent portfolio quality. Both would be wrong. Companies may have high operating expenses
because their average loan sizes are extremely small.
Indeed, the Operating Expense Ratio and the Cost per Borrower move in opposite directions. This is
most pronounced when average loans are very small. In those cases, the Operating Expense Ratio
invariably rises fast, whereas the Cost per Borrower drops equally quickly.

Cost per borrower= Operating Expenses/ Average Number of Active Borrowers (excluding
Consumer and Pawn Loans)

iv. Active Clients per Staff Member/ Personal productivity:

This ratio reflects the total number of active clients - savers and borrowers - that are served per MFI
staff member. The number of active borrowers is defined as individually identifiable borrowers who
have at least one current outstanding loan with the institution. Thus, a solidarity loan with four
members is considered as four borrowers.

Multiple loans to the same borrower are considered as one borrower. Borrowers are used in the
numerator instead of loans since the number of people served determines workload more than the
number of loans does. Two simultaneous loans to the same borrower do not require twice the effort
of one loan. Pawn loans and consumer loans are typically excluded from this calculation, as they
require far less screening and analysis efforts.

Total staff is defined as the total number of people that work full time in an MFI. It includes contract
staff such as consultants, as long as they work full-time. If there are a significant number of part-time
employees, then their number is adjusted to full-time equivalents. Two people working half-time then
become equivalent to one full-time employee.

This ratio captures the productivity of the institution's staff - the higher the ratio the more productive
the institution. The ratio does not differentiate between credit or service staff and administrative staff.
Low staff productivity does not usually mean that staff works less, but that they are tied up in
excessive paperwork and procedures. There are many factors affecting both service and
administrative productivity, not to mention paperwork, technology, remote service locations, etc.
What is important to remember is to regularly monitor this ratio, particularly in relation to the MFI's
business plan.

Active Clients per Staff Member= Number of Active Borrowers and savers/ Total Staff

v. Borrowers per Loan Officer/ Loan officer productivity:

This ratio reflects the productivity of loan staff in serving their client caseload. The higher the
caseload per officer, the more clients will be served, and the greater the efficiency gained. The ratio
is useful when the MFI sets growth targets; it is easy to calculate and to measure on a regular basis.
However, the ratio does have some limitations. Since it is also highly reflective of the methodology
used - the loan products (groups vs. individual lending) or the geographical context (low density
populations as in some rural areas vs. an urban client base).
As a result, comparisons between MFIs become less helpful or meaningful. A final factor to consider
is that there is an optimal caseload that Loan Officers can carry before their portfolio quality begins
to drop. Sacrificing quantity for quality is not the objective of managing for greater efficiencies. There
are also operational issues that cause the ratios to plateau at optimal levels. Streamlining the
methodology or introducing technological changes may be the only way in which to break the plateau.

Borrowers per Loan Officer= Number of Active Borrowers /Number of Loan Officers
 vi. Client Turnover:
This ratio is intended to give MFI managers some indication of clients who leave the program during
a particular period of time. It does not tell management why clients may leave. The ratio is not precise
or perfect - it does not provide information about clients who leave for a while and then return at a
later date. It does not provide information about clients who may use a remittance service occasionally
after no longer using lending services. The ratio is considered important because managers need some
level of client satisfaction with MFI's products and services. The general thinking is that the cost of
retaining clients is relatively lower than the cost of recruiting and initiating new clients to the MFI.
Therefore, the lower the turnover, the higher the perceived level of satisfaction of clients.

Client Turnover = No. of active clients at beg.+ New clients join during the year - No of active
clients at the end
Average No. of active clients

vii. Average Outstanding Loan Size:

For many, this ratio is some indication of MFI's ability to reach as many lower-income and poor
clients as possible. This is important to many donors and investors, but also to MFI's vision of
reaching its targeted clientele. MFI managers who need to monitor this ratio regularly should do so
in light of the Gross National Income per capita (provided in external Macro-Economic Data) and the
Cost per Client. The average income level of clients in the area served may also be less than the
official Gross National Income per capita. From a financial perspective, this ratio can be used to
project and plan portfolio growth as loan size is one of the drivers of profitability.

Average outstanding loan size= Gross loan portfolio/ No of loans outstanding

viii. Average Loan Disbursed:

This ratio gives MFI managers some idea about MFI's demand for loans, client profitability and the
capacity to increase income. Increased loan sizes generally increase financial revenue for MFI. The
challenge is for managers to understand why loan sizes increase. Are clients' businesses growing and
able to absorb higher amounts of debt? Are clients diversifying the loan proceeds to other activities?
Are repeat loan size increases automatically expected - both clients and Loan Officers? This ratio
should be monitored in conjunction with portfolio quality ratios, to ensure that the client still has the
capacity to repay the loan, in spite of increased amounts of debt.

Average Loan Disbursed = Value of loan disbursed/ No of loan disbursed

Tips for Managing for Efficiency and Productivity:

• Develop and fine-tune your products and services for your clients, and for the locations in
which you work.
• Take advantage of any technology that will decrease your operating and transaction costs -
for your institution and for your clients.
Implement effective incentive systems for strong staff performance - your financial services team and
your support and administrative staff. Staff working together toward common goals will think "win /
win" rather than compete against one another.
Continually monitor portfolio quality to ensure that efficiency is not compromised by increasing
delinquency.
Probe the ratios carefully, ensuring that the trends in the numerator and the denominator alone are
understood and analyzed as well. This will strengthen understanding and management for efficiency
in operations.
Do not jump to conclusions when analyzing and comparing efficiency ratios with other MFIs,
particularly from other countries.
Term Formula Explanation
Sustainability and Profitability
Operational Financial Revenue/ Measures how well an MFI can cover its costs through
Self- (Financial Expense + Impairment operating revenues.
Sufficiency Losses on Loans + Operating
Expense) -
Return on Net Operating Income - Taxes/ Measures how well the MFI use its assets to generate returns.
Assets Average Assets This ratio is net of taxes and excludes non-operating items
(ROA) and donations.
Return on Net Operating Income - Taxes/ Calculates the rate of return on the Average Equity for the period.
Equity Average Equity Because the numerator does not include non-operating items or
(ROE) donations and is net of taxes, the ratio is frequently
used as a proxy for commercial viability.
Asset/Liability Management
Yield Indicates the MFI's ability to generate cash from interest, fees,
Cash Received from Interest, Fees,
and Commissions on Loan and commissions on the Gross Loan Portfolio. No revenues
Portfolio/ that have been accrued but not paid in cash are
Average Gross Loan Portfolio included.
Portfolio to Gross Loan Portfolio/ Measures the MFI's allocation of assets to its lending activity.
Assets Assets Indicates management's ability to allocate resources to the
MFI's pnmary and most profitable activity-making
microloans.
Cost of Financial Expenses on Calculates a blended interest rate for all the MFI's funding
Funds Funding Liabilities/ (Average liabilities.
Ratio Deposits+ Average Borrowings)
Debt to Liabilities/ Equity Measures the overall leverage of an institution and how much
Equity cushion it has to absorb losses after all liabilities are paid.
Efficiency and Productivity
Operating Operating Expense/ Highlights personnel and administrative expenses relative
Expense Average G ross Loan Portfolio to the loan portfolio the most commonly used efficiency
,
Ratio indicator.
Cost per Operating Expense/ Provides a meaningful measure of efficiency for an MFI,
Active Client Average Number of Active allowing it to determine the average cost of maintaining an active
Clients client.
Borrowers Number of Active Borrowers/ Measures the average caseload of (average number of
per Number of Loan Officers borrowers managed by) each loan officer.
Loan Officer
Active Number of Active Clients/ The overall productivity of the MFI's personnel in tenns of
Clients Total Number of Personnel managing clients, including borrowers, voluntary savers, and
per Staff other clients. --·
Member
Average Gross Loan Portfolio/ Measures the average outstanding loan balance per borrower.
Outstanding Number of Loans Outstanding This ratio is a profitability driver and a measure of how much of
Loan Size each loan is available to clients.
Average Value of Loans Disbursed/ Measures the average value of each loan disburseq. This ratio
Loan Number of Loans Disbursed is frequently used to project disbursements.
Disbursed
 4. Leverage and Capital Adequacy:
Leverage refers to the extent to which an MFI borrows money relative to its amount of equity. In
other words, it answers the question of how many additional Rs, or other currency can be mobilized
from commercial sources for every Rs or other currency worth or funds owned by the MFI. Leverage
states the relationship of funding assets with debt versus equity. Capital adequacy refers to the amount
of capital an MFI has relative to its assets. Capital adequacy relates to leverage in terms of the
adequacy of the MFI's funding structure.

The term "capital" includes the equity of an MFI and a portion of its liabilities, including subordinated
debt.
Invested capital, including member shares, notes payable, and investments by outsiders.
Institutional capital, including retained earnings and reserves (that is, a required amount of capital
that a financial institution must set aside as regulated by the superintendent of banks or the
government)
Debt capital, including subordinated debt and loans from the central bank.

Capital serves a variety of purposes: as a source of security, stability, flexibility, and as a buffer
against risk and losses. As the possibility of losses increases, the need for capital increases. This is
particularly relevant for MFIs, because the borrowers or members often lack occupational and
geographical diversity to help spread risk. Capital must be sufficient to cover expected and
unexpected losses. In addition, capital is required to fund losses when new services are introduced,
until those services generate adequate income, or when an MFI is expanding. Expansion of the
number of branches or the area covered by each branch requires substantial capital investment. The
planned growth of an MFI requires capital to increase in proportion to its asset growth.

Leverage:
The term leverage measures to what extent the debt has been used in the capital structure of the
company. An MFI's leverage is measured by calculating its debt-to-equity ratio. The debt-to-equity
ratio states how much debt an MFI has relative to its equity.

It is important for all organizations to maintain a proper balance between debt and equity to ensure
that the equity or viability of the organization is not at risk. If an MFI has a large amount of equity
and very little debt, it is likely limiting its income-generating potential by not making use of external
sources of debt (that is, a line of credit or a loan that can be borrowed for, say, 10 percent and on lent
to clients at 25 percent). Therefore, it may be better for the MFI to increase its liabilities, if possible,
to increase its income-generating assets. An organization must ensure that it does not take on too
much debt relative to its ability to repay that debt. They must make a tradeoff between risk and return.
The degree of leverage greatly affects the return on equity ratio of an MFI. An MFI that is more
highly leveraged than another will have a higher return on equity, all other things being equal. It
includes; debt equity ratio and debt assets ratio.

Capital Adequacy Standards:

Capital adequacy means that there is a sufficient level of capital required to absorb potential losses
while providing financial sustainability. The purpose of establishing and measuring capital adequacy
for an MFI is to ensure the solvency of the organization based on the reasons mentioned above. For
the most part, MFIs are highly capitalized due to donor funding and their inability to access
commercial debt. However, this is changing, and if MFI are to reach substantial numbers of low-
income clients, they will have to increase and expand their' sources of funding while ensuring prudent
management. Capital adequacy standards help to ensure the viability of MFIs as they increase their
degree of leverage.
International standards of capital adequacy have been put forth through the Basel Agreement Capital
adequacy standards require MFIs to have both a minimum nominal amount of capital and an adequate
amount of capital to cover the risk of losses. Capital adequacy is based on risk-weighted assets (as
set out under the Basel Accord, which identifies different risk levels for different asset types. There
are five standard risk weights ranging from 0 to 100 percent risk. Capital adequacy is usually
measured by the following ratio of capital to risk-weighted assets:

Capital adequacy ratio= Total capital/ Risk weighted assets.

Basic knowledge:

Financial Revenue from Loan Portfolio:

Revenue from interest, fees, commissions, and other fees earned on the loan portfolio. This includes
not only interest paid in cash but also interest accrued but not yet paid.
Interest on Loan Portfolio:
Interest earned on the loan po1ifolio. If the MFI is earning interest on loans to employees or board
members, this interest should be disclosed. If this interest is significant, the MFI should create two
subaccounts for (13) - one for interest from clients and the other for interest from related parties.

Fees and Commissions on Loan Portfolio:

Penalties, commissions, and other fees earned on the loan portfolio. This may also include revenue
under Islamic finance methods. If the MFI is earning fees and commissions on loans to employees or
board members, these should be disclosed. If these fees and commissions are significant, the MFI
should create two subaccounts for (I3)-one for fees and commissions from clients and the other for
fees and commissions from related parties.

Balance sheet
Gross Loan Portfolio:
All outstanding principals are due within or at 12 months for all outstanding client loans. This includes
current, delinquent, and renegotiated loans, but not loans that have been written off. All delinquent
loans should be considered short-term and included here. It does not include interest receivable. If
the MFI makes loans to employees, board members, or others associated with the institution, it should
disclose this and, if the amount is significant, create subaccounts to separate loans to clients and loans
to related parties.

Impairment Loss Allowance:

Previously known as the loan loss allowance, the portion of the Gross Loan Portfolio that has been
expensed (provisioned for) in anticipation of losses due to default. This item represents the
cumulative value of the impairment losses on loans less the cumulative value of loans written off.
Express this item as a contra asset account and state it as a negative number.

Net Loan Portfolio:

The Gross Loan Portfolio less the impairment Loss Allowance.
Number of Loans Disbursed:
The number of all loans disbursed during the period. For MFIs using a group lending methodology,
the number of loans should refer to the number of individuals receiving loans as part of a group or as
part of a group loan. If one person receives more than one loan in the period, count each loan.

Number of Loans Outstanding:

The number of loans in the Gross Loan Portfolio. For MFIs using a group lending methodology, the
number of loans should refer to the number of individuals receiving loans as part of a group or as part
of a group loan.

Number of Active Clients:

The number of active borrowers, depositors, and other clients who are currently accessing any of
MFI's financial services; i.e., they have a loan, deposit, and/or insurance account that is active as of
the report date. Individuals who access multiple services with an MFI should be counted as a single
client. Individuals who are not currently receiving services are not included. Neither borrowers whose
loans have been written off nor depositors who have not had a deposit, withdrawal, or interest earned
in the past 12 months are considered to be active.

Number of New Clients during period:

The number of clients who did not have an active account at the beginning of the period but do have
an active account at the end of the period. '

Number of Active Borrowers:

The number of individuals who currently have an outstanding loan balance with MFI or are primarily
responsible for repaying any portion of the Gross Loan Portfolio. Individuals who have multiple loans
with an MFI should be counted as a single borrower.

Income statement:
The Income statement is a flow statement that represents activity over a given period, such as a day,
month, quarter, or year. The Income Statement may also be referred to as a profit and loss statement
because it illustrates the overall net profit or loss for that period (nonprofit MFIs may also use the
terms “net surplus” or “deficit”). The Income Statement summarizes all the revenue and expense
transactions for a defined period, usually the financial year to date. The Income Statement may have
two columns of data showing present and past period performance to facilitate comparison.

The presentation of the Income Statement is normally divided between revenue accounts and expense
accounts. It also usually includes some division of operating accounts and non-operating accounts.
Operating accounts include all revenue and expenses that are related to the MFIs core business of
making loans, accepting deposits, borrowing funds, and providing other financial services. Non-
operating accounts include all revenue and expenses that result from activities outside the MFIs core
financial business, such as training or the sale of merchandise. Although many MFIs have ongoing
support from donors, donations and grant funds from donors are considered to be non
operating revenue.

All donations for loan capital and operating expenses are included in the Income Statement.
Revenue refers to money received (or to be received if accrual accounting is used) by an organization
for goods sold and services rendered during an accounting period. Revenue for an MFI includes
interest earned on loans to clients, fees earned on loans to clients, interest earned on deposits with a
bank, and so on.
Expenses represent the costs incurred for goods and services used in the process of earning revenue.
Direct expenses for an MFI include financial costs, operating expenses, and provision for loan
impairment.
By recording the net profit/loss earned, the Income Statement measures the financial performance
from which indicators on efficiency and profitability can be extracted.

BALANCE SHEET:
The Balance Sheet is a stock statement. In other words, it captures the financial position or financial
structure of an MFI at a moment in time. A Balance Sheet is usually produced monthly or quarterly
(at a minimum, annually), although MFIs with an adequate management information system can
usually produce a Balance Sheet on a daily or weekly basis. The Balance Sheet summarizes the ending
balance of all assets, liability, and equity accounts.

Recording donations, grants, and in-kind contributions is important for MFIs.

Assets represent what the organization has, or what is owned by the organization or owed to it by
others. Assets are those items in which an organization has invested its funds for the purpose of
generating future receipts of cash.
Liabilities represent what is owed by the organization to others. For example, a loan that has been
granted to the organization or obligations that the organization has to provide goods and services in
the future.
Equity represents the capital or net worth of the organization. Equity includes capital contributions
of any investors or donors, retained earnings, and the current year surplus.
Depends on transfer of data from the Income Statement, Namely, Net Surplus (deficit) current year;
the amount of income (or loss) generated in the current year; recording Donated Equity/current year
from cash donations on the Income Statement.
It is useful to compare Balance Sheets from previous periods in order to determine if the organization
is growing and how well it is managing its financial resources, for trend analysis, and for analyzing
the relative distribution of assets, liabilities, and equity.

CASH FLOW STATEMENT:

As its name states, the Cash Flow Statement is a flow statement that represents the inflows and
outflows of cash during a specified period. Of the three main financial statements, the Cash Flow (or
sources and uses of funds) is the statement MFIs are least likely to create. A monthly Cash Flow
Statement is a valuable liquidity management tool, as without sufficient cash, MFIs cannot disburse
loans, pay employees, and settle debts.
The Cash Flow Statement summarizes each transaction or event that causes cash to increase (the
sources of cash) or decrease (the uses of cash). Increases in cash, however, are not sources; rather,
the sources of cash are the events that cause the cash increase. Similarly, decreases in cash are not
uses; the events causing cash to decrease are the uses. For example, the increase in the Gross Loan
Portfolio is not the use of cash; rather, the use is the disbursement of loans to clients.

PORTFOLIO REPORT AND ACTIVITY REPORT:

A portfolio report and activity report link the loan portfolio information of the three previously
discussed statements- Income Statement, Balance Sheet, and Cash Flow Statement. The purpose of
the portfolio report is to represent in detail MFI's micro lending activity, present the quality of the
loan portfolio, and provide detail on how the MFI has provisioned against potential losses. Unlike
other statements, the design of this report varies from MFI to MFI. The content, however, should be
consistent and must include the following:

Portfolio activity information

Movement in the Impairment Loss Allowance

The closely linked Movement in Impairment Loss Allowance and the Portfolio Aging Schedule are
related to MFI’s assessment of the default risk associated with its loan portfolio.

Impairment Loss Allowance is a contra asset account that reduces the value of the Gross Loan
Portfolio. The value of that allowance is determined by first creating a Portfolio Aging Schedule.

All MFIs should have a policy for calculating and creating an impairment Loss Allowance and writing
off loans. The generally accepted method for MFIs to assess default risk is based on the timeliness of
principal payments on loans. The assumption is that the longer a loan remains past due, the more at
risk the outstanding balance of the loan will become. This remaining outstanding balance is referred
to as the portfolio at risk. Understanding the difference between arrears and portfolio-at-risk is
important.

Arrears measure the sum of all past due payments, whereas portfolio-at-risk is the total value of loans
outstanding that have one or more past due payments - a much larger amount. The word delinquency
may refer to either, which leads to confusion. MFIs create a Portfolio Aging Schedule by segregating
their loans into groups based on their "age," or how many days have passed since the first payment
was missed.

Each of these categories is multiplied by a loss allowance (or provisioning) rate, which represents the
perceived chance of the loan not being repaid. The portfolio-at-risk for each age is then multiplied by
the appropriate loss allowance rate. The sum of these calculations is the amount the MFI should set
aside in the Impairment Loss Allowance.

If the existing Impairment Loss Allowance is less than what is required, the MFI will need to increase
it, usually monthly or quarterly, by Provision for Loan Impairment.
MFIs should also have a policy on writing off loans. Both the Gross Loan Po1ifolio and the
Impairment Loss Allowance are reduced by the outstanding balance of the loan for the amount of the
write-off, which reduces the MFI's total assets. This action is the financial representation of the
management's belief that the loan is unlikely to be repaid. Of course, the MFI should continue to seek
to recover these loans until all legal and other efforts have failed. If the write-off exceeds the value
of the Impairment Loss Allowance, the MFI must first increase the Impairment Loss Allowance by
increasing Impairment Losses on Loans before reducing the Gross Loan Portfolio and the Impairment
Loss Allowance.

5. Asset/ Liability Management:

These ratios illustrate the ability of the MFI to manage its financial obligations when they become
due, while maximizing the utilization of assets for profitable purposes. The overall objective is to
maximize idle resources as profitably as possible, while paying their expenses, debts, and obligations
on time without borrowing funds.

i. Yield on Portfolio:
The Yield on Portfolio measures how much the MFI receives from its portfolio in the form of cash
from interest, fees, and commissions. Portfolio yield measures how much the MFI actually received
in cash interest payments from its clients during the period. A comparison between the portfolio yield
and the average effective lending rate gives an indication of the institution's efficiency in collecting
from its clients. It also provides insight into portfolio quality since most MFIs use cash accounting
and portfolio yield does not include the accrued income that delinquent loans should have generated
but did not.

Generally speaking, portfolio yield is the initial indicator of an institution's ability to generate revenue
with which to cover its financial and operating expenses. MFIs tend to disguise their interest rates,
but portfolio yield is an easy way to calculate the actual rate obtained by an institution. Portfolio yield
shows how much, on average, the MFI really receives in interest payments on its loans. Generally,
the MFI's yield does not fluctuate very much, unless there is a change in interest rates, the method of
calculating interest or in fees. If it varies significantly from the effective interest rate (often called a
"yield gap") then it may be a sign of delinquency.

Yield = Cash Received from Interest, Fees, and Commissions on Loan Portfolio
Average Gross Loan Portfolio

ii. Portfolio to Assets:

The Portfolio to Assets ratio is a simple ratio that looks at how much of the MFI's asset base is
invested in a high performing loan portfolio. An MFI's primary business is to provide loans and other
financial services to micro-entrepreneurs. This is also the MFI's most profitable activity. It is
recommended that this ratio be monitored monthly. Fluctuations may be due to seasonal activity or
rigid operational patterns (e.g., "batch" lending). The ratio can also signal excess liquidity or demand
for additional funding. MFIs that rely on savings to fund lending activities or are regulated by local
banking guidelines need to pay special attention to this ratio.

Portfolio to Assets = Gross Loan Portfolio

Assets

iii. Cost of Funds Ratio:

The Cost of Funds Ratio is calculated by dividing interest and fee expenses on funding liabilities by
period average funding liabilities. The denominator contains all funding liabilities of the institution,
including deposits, commercial funds, subsidized funds, and quasi-capital. It does not include other
liabilities, such as accounts payable or a mortgage loan an MFI may have obtained to finance its
offices.
As its name indicates, this ratio measures the average cost of the company's borrowed funds. In
comparing MFIs, the cost of funds ratio shows whether they have gained access to low-cost funding
sources such as savings. MFIs that can mobilize savings tend to have relatively low cost of funds.
However, this advantage is offset to some extent by the higher administrative cost of mobilizing
savings.

In many cases, the funding liabilities of MFIs include subsidized funds. Such subsidies will drive the
cost of funds down, when in fact the real cost of commercial borrowing for the institution is far higher.
As subsidized MFIs grow, and as they increasingly resort to commercial borrowing to sustain their
growth, rapidly rising cost of funds can lead to severe pressure on margins, which management must
counteract by cutting other costs or raising lending rates.

The significance of this ratio is in its comparison to the Yield on Portfolio ratio, which is fundamental
to interest rate management. The remaining margin between the yield and the cost of funds is what
the MFI has available for operational costs and the provision for loan losses.

Cost of Funds = Financial Expense on Funding Liabilities

(Average Deposits+ Average Borrowings)

iv. Debt to Equity:

The Debt-to-Equity ratio (also referred to as the Leverage ratio) is a common measure of an MFI's
capital strength or adequacy at a particular point in time. Equity is important because it is an indication
of internal strength and the capacity to absorb some stress and losses before creditors are at risk.
Equity is also important because it is the base on which to leverage and attract debt funding - and
therefore it is used frequently by investors and lenders.

Debt/Equity = Liabilities
Equity

Note: An increasing debt/equity ratio indicates the MFI's capacity to attract debt funding based on its
capital strength of its own equity. Too low a ratio might indicate that the MFI is not maximizing its
equity base. Too high a factor may be risky for investors and may spell cash flow challenges during
challenging times.

v. Liquid Ratio:
The Liquid Ratio is one measurement of the adequacy of cash to pay short-term liabilities to lenders,
depositors, and other creditors. This is important for both banks and MFIs. These institutions need to
ensure that they pay their salaries, bills, and expenses on time. Failure to repay loans on time may
limit access to funding in the future. The lack of funds to provide timely, repeat loans may seriously
erode client confidence. The inability to repay client deposits on time will also threaten client trust
and confidence and could jeopardize MFI significantly. Liquidity ratios vary, depending on banking
requirements and risk tolerance. Central banks may require certain liquid ratios to be maintained,
particularly in their role in maintaining public trust in the banking sector. A problem in one institution
can be hazardous for everyone.

Liquid Ratio = Cash + Trade Investments

(Demand Deposits + short-term Time Deposits + Short-term Borrowings +
Interest Payable on Funding Liabilities + Accounts Payable and other Short-
term Liabilities)

Tips for Managing for Asset/Liability Management:

• Interest rate management: The interest rate set by the MFI must generate enough revenue to
cover the cost of funds, operational costs, and the provision for loan losses. The margin between
the yield on portfolio and the cost of funds is the amount available for other operational
expenses. Rates that are intentionally subsidized or unintentionally too low do does not sustain
services in the long term for clients.
• Asset management: Assets should be invested and put to their most productive means in order
to produce the most revenue possible.
• Leverage: Finding the right balance between debt and equity funding is not always
straightforward. Borrowing funds for growth and expansion may be recommended, provided
that more revenue is generated than the cost and use of borrowing.
• Liquidity Management: The MFI needs to manage its liquidity to ensure that it has sufficient
funds on hand to meet any short-term obligations, including operational expenses, interest, and
principal payable.
• Foreign Currency Management: Some MFIs borrow funds in foreign currency because local
currency borrowings are unavailable. If the MFI also has assets in foreign currency, some of the
risk of exchange rate fluctuations, particularly losses, can be minimized. However, the risk can
be significant in places where the local currency fluctuates highly.
Accounting Adjustments:
Among the adjustments that are often needed before the financial performance of an MFI can be
analyzed are accounting entries that adjust an MFI’s financial statements so that they adhere to proper
accounting standards. These adjustments include accounting for loan losses, accounting for
depreciation of fixed assets, and accounting for accrued interest and accrued interest expense.

Accounting for Loan Losses:

Accounting for loan losses is an essential element of MFI financial management and one of the most
poorly managed. To accurately reflect the financial performance of an MFI, it is necessary to
determine how much of the portfolio is generating revenue and how much is likely to be
unrecoverable. This is done by examining the quality of the loan portfolio, creating a loan loss reserve,
and periodically writing off loans. Many MFIs do not like to make loan loss reserves because they
are anxious to report their expenses as low as possible and do not want to admit (to donors or others)
that some of the loans they have made are not performing. Further, many MFIs choose to maintain
bad loans on the books because they feel that if they were to write off a loan, all efforts to collect it
would stop. Initially, MFIs may avoid accounting for loans losses, but as MFIs mature and their
exponential growth slows down, the problem becomes more significant. Carrying loans on the books
that have little or no chance of being repaid overstates the assets on the balance sheet and results in a
lower-than-expected yield on assets (this is reflected in lower revenue than expected based on the
effective yield calculation). Furthermore, accurately accounting for loan losses on a periodic basis
saves the MFI from taking a large loss (and a consequent increase in expenses) all at one time for
loans that were made over a period of years (Stearns 1991). Loan losses should be recorded close to
the period in which the loan was made.
In order to accurately account for loan losses, the first step is to determine the quality of the loan
portfolio. This is done by referring to the “portfolio report.”

The Portfolio Report:

One of the most important monitoring tools of an MFI is its portfolio report, which provides
information on the quality of the loan portfolio and the size of the lending activities. Since the loan
portfolio is most often MFI’s largest asset and, therefore, its main revenue-generating asset, ensuring
accurate and timely reporting of the portfolio is crucial to the financial management of an MFI.

Loan Loss Reserve:

A loan loss reserve is an account that represents the amount of outstanding principal that is not
expected to be recovered by an MFI. It is the amount “reserved” to cover losses of the loan portfolio.
The loan loss reserve is recorded as a negative (or contra) asset on the balance sheet. The loan loss
reserve reduces the net portfolio outstanding. (Some MFIs record the loan loss reserve as a liability.
The net effect is the same.)

The amount of the loan loss reserve should be based on historical information regarding loan defaults
and the amount of time loans have been delinquent. Past performance of delinquent loans is the most
important indicator for predicting future performance.

To determine an adequate loan loss reserve, an aging analysis should be performed periodically
(monthly or quarterly). Aging analysis refers simply to the classification of delinquent loans in the
periods of time that they have been in arrears. In the aging analysis, the entire outstanding balance of
the loan that is in arrears (portfolio at risk) is considered. Once an aging analysis has been completed,
the loan loss reserve is established based on the likelihood of loan recovery for each aging category.
(The loan loss reserve as a percentage of loans outstanding may be regulated in some countries, which
would be applicable if the MFI is regulated as a formal financial institution.)

6. Loan Loss Provision:

The loan loss provision is the amount expensed in a period to increase the loan loss reserve to an
adequate level to cover expected defaults of the loan portfolio. It is based on the difference between
the required loan loss reserve and the current outstanding loan loss reserve.

To make the adjustment, the first time a loan loss reserve is created, a loan loss provision is recorded
on the income statement as an expense (debit) in an amount equal to the required loan loss reserve.
The loan loss reserve is then recorded on the balance sheet as a negative asset (credit). This reduces
the net outstanding loan port- folio. Subsequent loan loss provisions are recorded on the income
statement in the amount necessary to increase the loan loss reserve to its required level. Once debited
on the income statement, the amount is added (credited) to the existing loan loss reserve on the
balance sheet. Note that the loan loss provision is a noncash expense and does not affect the cash flow
of an MFI.

7. Benchmarking:
Benchmarking is the process of comparing your business' processes and performance metrics to
industry 'bests' and best practices from other companies. Metrics often measure quality, time, and
cost. In the process of best practice benchmarking, management identifies the best firms in their
industry, or in another industry where similar processes exist, and compares the results and processes
of those studied (the 'targets') to their own results and processes. The value of benchmarking depends
on the availability and quality of comparative data. Fortunately, a fairly large body of quality
comparative data is now available for benchmarking through the Micro Banking Bulletin, rating
agencies, and international and local network organizations. This Framework is intended to further
the availability of data by promoting standard definitions and formats so that data can be easily shared
across institutions and continents. Comparisons across institutions or peer groups require caution.
Local conditions, institutional characteristics, and management choices affect institutional
performance. Further, unless the number of institutions in the peer group is sufficient, averages and
median calculations may be misleading.

The micro finance industry needs established standards or benchmarks to allow auditors to compare
the performance of one MFI with that of another. Auditors should also complete a trend analysis on
the portfolio quality. This analysis will demonstrate that even though loans of MFIs are often
unsecured, they can be safe.

8. Rating MFIs:
The prevalence and importance of ratings in microfinance have grown exponentially since they were
first introduced in the mid-1990s. Used primarily by funders, including both donors and investors,
ratings are evaluations of institutions’ operational, financial, and more recently, social performance
based on standardized methodologies.

Microfinance institutional ratings provide an opinion on long-term institutional sustainability and

creditworthiness through a comprehensive assessment of risks, performance, market position,
governance, and responsible finance practices. They measure the probability that a provider will
continue to operate and remain a “going concern,” even in the case of an external shock. They have
a strong focus on governance, on the quality of the microfinance operations and systems, and on
alignment of decisions with stated social goals and client protection, which are considered core assets
for long-run sustainability.

A credit rating is the product of conventional rating agencies (Standard & Poor’s, Fitch, and Moody’s
are the best-known rating agencies) and has a narrower focus than general performance ratings. Credit
ratings focus specifically on whether a provider is able to meet its credit obligations, assessing the
default risk during a given period of time. The methodology applied to a microfinance credit rating
is the same as that applied to any financial institution—its purpose is primarily to make an opinion
regarding the institution’s default risk at a given time. Although many market players take interest in
credit ratings as objective third-party assessments of provider’s creditworthiness, they are also used
by investors and supervisory authorities as part of the compulsory requirements to comply with
regulations.

A social rating is an independent assessment of an organization’s social performance using a

standardized rating scale (SEEP 2006;). A social rating typically assesses both social risk (the risk of
not achieving social mission) as well as social performance (the likelihood of contributing social
value). The social rating evaluates practices, measures a set of indicators and scores them against
benchmark levels and generally accepted standards. A social rating assesses how the processes and
performance of a provider have contributed toward specific desired goals, with an analysis of overall
outreach and quality of services provided. A social rating cannot in itself determine whether a
provider has achieved a particular social impact. What a social rating contributes to, however, is
whether the processes undertaken by a provider have moved the institution closer to achieving its
particular social mandate.

Mainstream rating agencies tend to rate debt and the probability of default on a continuous basis,
upgrading and downgrading ratings accordingly. In contrast, the timing of updates for microfinance
ratings is more fragmented, because ratings tend to be valid for an extended period of time. Repeat
ratings demonstrate maturity in the market, as financial service providers have the resources and
expertise at their disposal to commission another rating. The frequency of repeat ratings also
demonstrates that ratings are seen as a tool to improve governance or motivate change within the
organization to continue to reach organizational mandates, both financial and social. Typically, the
rated provider itself pays for the rating, as is standard practice in mainstream ratings. Funding has
been given to providers to obtain their first ratings on a cost-sharing basis by multilateral agencies
and DFIs; however, this funding is being phased out. Ratings for MIVs and microfinance funds are
also available.
 9. Social Performance Measurement and Impact performance evaluation of microfinance
institutions in the framework of WOCCU model, CGAP model, and SEEP model:

i. WOCCU model:
PERLAS OR PEARLS IS A SYSTEM OF 39 FINANCIAL RATIOS that the World Council of
Credit Unions (WOCCU) uses worldwide to monitor the performance of credit unions. It was
originally designed and implemented with Guatemalan credit unions in the late 1980s.

The WOCCU now uses it to create a universal financial language that each credit union can speak
and understand, to generate comparative credit union rankings, and to provide the framework for a
supervisory unit at the second tier. Each ratio has a standard target or goal that each credit union
should strive to achieve.

A brief description of the PEARLS system and some of the key ratios is provided.

P—Protection (5 ratios). Refers to adequate protection of assets. Protection is measured by

comparing the adequacy of the provisions for loan losses against the amount of delinquent loans.
Protection was deemed adequate if a credit union had sufficient provisions to cover 100 percent of
all loan’s delinquent for more than 12 months and 35 percent of all loan’s delinquent for 1–12 months.

E—Effective financial structure (8 ratios). Determines growth potential, earnings capacity, and
overall financial strength. Ratios measure assets, liabilities, and capital, and their associated targets
constitute an ideal structure for credit unions.

Net loans/total assets (Goal 60%–80%)

Liquid investments/total assets (Goal maximum 20%)
Fixed assets/total assets (Goal maximum 5%)
Savings and deposits/total assets (Target 70%–80%)
External borrowing/total assets (Goal 0%)
Reserves and retained earnings/ total assets (Minimum 8%)
A—Asset quality (3 ratios). Ratios measure the impact of assets that do not generate income.

Portfolio at risk > 30 days/ total loans (Goal is < 5%; maximum 10%)
Nonearning assets/ total assets (Maximum 7%)

R—Rates of return and costs (12 ratios). Disaggregates the essential components of net earnings
(by investment) to help management calculate investment yields and evaluate operating expenses.
The results more clearly indicate whether the credit union is earning and paying market rate on its
assets, liabilities, and capital.

Operating expenses/ average assets (Goal < 10%)

Net income/ average assets (Sufficient to maintain capital ratio of > 8%)
Return to members on shares (Goal > inflation rate)

L—Liquidity (4 ratios). Reveal if the credit union is administering its cash to meet deposit
withdrawal requests and liquidity reserve requirements, while minimizing the amount of idle funds.

Liquidity reserve/ withdrawable savings (Goal 10% minimum)

S—Signs of growth (7 ratios). Measures both financial and membership growth. By comparing asset
growth to other key areas, it is possible to detect changes in the balance sheet structure that could
have a positive or negative impact on earnings. Growth of institutional capital is the best indicator of
profitability and success, particularly if it is proportionately greater than the growth in assets.

ii. CGAP (Consultative Group to Assist the Poorest) model:

IN ITS PUBLICATION MANAGEMENT INFORMATION SYSTEMS for Microfinance

Institutions CGAP put forth a list of indicators oriented toward the needs of managers of MFIs. The
indicators are divided into six broad groups. Fifteen of the indicators are considered by the group as
key for both managers of MFIs and such external users as donors, investors, and regulators. Key
indicators are presented in capital letters.
Portfolio quality indicators
Portfolio at risk, two or more payments
LOAN LOSS RESERVE RATIO
LOAN WRITE-OFF RATIO
LOAN RESCHEDULING RATIO

Profitability indicators
ADJUSTED RETURN ON ASSETS
Adjusted return on equity
Return on assets
Return on equity
Financial sustainability

Financial solvency indicators

Equity multiplier
Quick ratio
Gap ratio
Net interest margin
Currency gap ratio
Currency gap risk
Real effective interest rate

Growth indicators
ANNUAL GROWTH IN PORTFOLIO
ANNUAL GROWTH IN BORROWERS
Annual growth in savings
Annual growth in depositors

Productivity indictors
ACTIVE BORROWERS PER LOAN OFFICER
Active borrower groups per loan officer
NET LOAN PORTFOLIO PER LOAN OFFICER
Active clients per branch
Net loan portfolio per branch
Savings per branch
YIELD GAP
Yield on performing assets
YIELD ON PORTFOLIO
Loan officers as a percentage of staff
OPERATING COST RATIO
Average cost of debt
Average group size
Head officer overhead share

Outreach indicators
NUMBER OF ACTIVE CLIENTS
Percentage of female clients
Number of active savers
Value of all savings accounts
Median savings account balance
Number of active borrowers
VALUE OF NET OUTSTANDING LOAN PORTFOLIO
DROPOUT RATE
Median size of first loans
MEDIAN OUTSTANDING LOAN BALANCE
Percentage of loans to targeted group

iii. SEEP model:

The Small Enterprise Education and Promotion (SEEP) Network connects microenterprise
practitioners from around the world in efforts to develop practical guidance that supports their
common vision of creating a sustainable income in every household. The SEEP Network has an
advocacy planning model that seeks to develop the capacity of advocacy within microfinance.
The following are the most common forms of advocacy it promotes:
• Engagement is a gradual process of relationship building. It is not focused on a particular policy
goal, but rather on the development of greater familiarity, trust, and mutual under- standing.
Associations can engage stakeholders through invitations to association-sponsored events,
educational opportunities, and formal and informal meetings.

• Facilitation and consultation are based on working with policy makers and affected stakeholders to
create opportunities for action. Facilitation involves creating opportunities for direct contact with
decision makers to promote dialogue and build awareness through conferences, workshops, field
trips, and meetings. Facilitation may also involve creating strategies for policy creation more directly.
Consultation with a diverse base of members and a broad range of stakeholders is required to increase
the contribution of individuals and organizations, while engendering greater overall participation in
policy-related discussions.

• One of the most significant contributions advocates can make to policy reform is through the
dissemination of high-quality research and information. Association members have a direct
understanding of the concerns of affected populations. By promoting credible and well-documented
information on the sector, associations can build legitimacy as a representative voice. Examples
include industry assessments, benchmarking reports, market studies, and focused policy
investigations.

In its most direct form, advocacy is about promoting concrete solutions to problems. Advocates can
promote the reform of existing laws and the creation of new ones, oppose legislative initiatives
considered damaging to the sector, and promote changes to the implementation of existing policies
and regulation. By lobbying decision makers as well as stakeholders who can influence them,
advocates can directly affect policy outcomes.
Unit 7: Matter of MFIs LH 10

Viability, Efficiency, Sustainability, Self-reliance, Outreach Cooperation, coordination, and co-

financing with various donors’ agencies. The role of governments in microfinance; national
microfinance policies, Subsidizing, The Role of Subsidies and Donors, Measuring subsidy
dependence, Traditional microfinance donors and instruments, socially responsible investors
Vs commercial investors: Equity vs. debt financing options, Microfinance investment funds vs
Microfinance investment vehicles, Culture of labor division, Opportunities, and challenges of
MFIs in Nepal.

1. Viability:
The term viability refers to the ability of microfinance institutions existence and develop as an
independent unit. It measures whether the MF can work and function without subsidies from funds
and donations. The excessive cost of administering loans has raised the question of microfinance
viability. The following points can make the institutions viable; positive real interest rates on loans;
high timely repayment rates; a high degree of self-financing from internal resources; appropriate
microfinance products and services; and vigorous striving for a profit-margin.

However, the viability of microfinance is not a big matter in Nepal as many of them are running with
the more than average profit. Now, many microfinance institutions are establishing with the motive
of earning profit. It is necessary to monitor them at regular intervals, so they do not charge more than
the required return to the poorest. NRB (Nepal Rastra Bank) has taken initiatives and encourage the
MFIs to invest in deprive sectors.

2. Efficiency:
Efficiency is the ability to avoid waste, energy, effort, money, and time in doing something or in
producing a desired result. In a more general sense, it is the ability to do things well, successfully,
and without waste. Efficiency management involves both maximizing revenue and minimizing costs
relative to the volume of business produced and managed. Productivity management includes
ensuring that staff are accountable for their activities, given the right incentives for productive and
efficient performance. and provided with timely and useful management information, Efficiency
management focuses on managing and reducing costs where possible. Outreach is negatively related
to MFI (Micro Finance Institutions) efficiency, MFIs that have lower average loan balances, which
is a measure of outreach depth, are less efficient because it increased processing cost per borrower.
This raises costs and decreases the profit.

3. Sustainability:
Microfinance has received a lot of attention as an important poverty alleviation tool. Sustainability
refers to the long-term existence of institutions. "The financial sustainability of MFIs is important as
the poor benefit most if they have access to financial services over time rather than receive just one
future loan but denied future loans because the MFI has disappeared." There are two levels of
sustainability that can be measured; operational self-sustainability and financial self-sustainability.
Operational self-sustainability means that operating income is sufficient to cover operating costs.
Financial self-sustainability means that the MFI also can cover the costs of funds and other forms of
subsidies received when valued at market rates. Therefore, to be sustainable, the MFIs must be
financially sustainable.

''In order to be able to make a significant and long-term contribution to reducing worldwide poverty,
MFIs need to be successful in extending loans to poor borrowers, while at the same time being able
to at least cover the costs of their lending activities, i.e., they may need to focus on being financial
sustainable in the long run."

4. Self-reliance:
Self-reliance is an important aspect for Micro Finance Institutions (MFIs) to ensure their long-term
sustainability and effectiveness in serving their target clientele. Self-reliance refers to the ability of
an MFI to generate sufficient financial resources to cover its operating costs and maintain its
financial viability without relying heavily on external funding or subsidies.

Achieving self-reliance is a gradual process that requires careful planning, continuous monitoring,
and adaptability to changing market conditions. MFIs must strike a balance between financial
sustainability and social impact to ensure they remain resilient and effective in serving the needs of
their clients while reducing their dependency on external funding.
 5. Outreach Cooperation:
Outreach is commonly understood as the number of clients served. The concept of outreach is
multidimensional and can be divided in four:

i. No. of person served:

The number of people now served who previously were denied access to formal financial services.
These persons will usually be the poor because they cannot provide the collateral required for
accessing formal loans, they are perceived as being too risky to serve, and impose high transaction
costs on financial institutions because of small size of their financial activities and transactions.

ii. The number of women served:

Women often face greater problems than men in accessing financial services. Women have been
excluded from formal financial services for a variety of reasons. Foremost is a cultural bias against
women. At the household level, most financial decisions are made by male heads of household,
although this cultural norm is shifting gradually.

iii. Depth:
The depth of outreach is important because the poorest of the poor face the greatest access problems.
So, to evaluate how well the MFIs reach the extremely poor some measure of depth of outreach is
needed. The depth of outreach is proxied by average loan size.

iv. The variety of financial services:

The poor demand varieties of services and their welfare will be improved if efficient and secure
savings, insurance, remittance transfer and other services are provided in addition to the loans that
are the predominant concern of policy makers.

6. coordination and co- financing with various donors’ agencies:

Coordination and co-financing with various donors' agencies play a significant role in supporting the
operations and growth of Micro Finance Institutions (MFIs). These partnerships help MFIs access
funding, technical expertise, and other resources necessary to expand their outreach and enhance their
effectiveness. Here are some key aspects related to coordination and co-financing with donors'
agencies:

i. Funding opportunities: Donors' agencies provide financial resources through grants, loans,
or equity investments to support MFIs' activities. These funds can be used for lending to
micro-entrepreneurs, capacity building, product development, technology adoption, and
social impact initiatives. Coordinating with multiple donors' agencies allows MFIs to tap into
diverse funding opportunities, reducing their dependence on a single funding source and
increasing their financial resilience.

ii. Technical assistance: Donors' agencies often offer technical assistance and advisory services
to MFIs. This can include training programs, mentoring, and knowledge-sharing initiatives to
strengthen the capacity of MFIs in areas such as financial management, governance, risk
assessment, and social performance management. Coordinated efforts with multiple donors'
agencies enable MFIs to benefit from a broader range of expertise and best practices,
enhancing their operational efficiency and sustainability.

iii. Market access and partnerships: Donors' agencies may facilitate partnerships between
MFIs and other stakeholders, such as banks, investors, NGOs, or government entities. These
collaborations can provide MFIs with access to new markets, networks, and expertise. For
example, donors' agencies may help MFIs establish relationships with local banks for co-
financing arrangements or support linkages with value chain actors to enable MFIs' clients to
access markets and expand their businesses. Coordinated efforts with donors' agencies help
MFIs leverage such partnerships for the benefit of their clients and overall sustainability.

iv. Advocacy and policy influence: Donors' agencies often have strong relationships with
governments and policymakers. Through coordinated efforts, MFIs can engage with donors'
agencies to advocate for an enabling regulatory and policy environment for microfinance.
This can involve promoting appropriate regulations, advocating for supportive government
policies, and participating in discussions and forums that shape the microfinance sector.
 Coordinated advocacy efforts amplify the voice of MFIs and increase the likelihood of policy
changes that foster a conducive environment for their operations.

v. Monitoring and evaluation: Donors' agencies typically require MFIs to report on their
activities, impact, and financial performance. Coordinating with multiple donors' agencies
may result in harmonized reporting frameworks and indicators, streamlining the reporting
process for MFIs. Additionally, coordinated monitoring and evaluation efforts can provide
valuable insights into the effectiveness of MFIs' interventions, helping them make data-driven
decisions and continuously improve their operations.

vi. Knowledge sharing and learning: Donors' agencies often facilitate knowledge sharing
platforms, conferences, and learning exchanges among MFIs and other stakeholders. These
opportunities enable MFIs to share experiences, learn from each other's best practices, and
stay updated on emerging trends and innovations in the microfinance sector. Coordinated
knowledge sharing efforts help build a stronger community of practice, fostering
collaboration and innovation among MFIs.

Coordinating and co-financing with various donors' agencies require effective communication,
transparency, and alignment of goals and objectives. MFIs should develop strong relationships with
donors' agencies, engage in regular dialogue, and proactively seek opportunities for collaboration and
resource mobilization. By leveraging the support and resources provided by donors' agencies, MFIs
can strengthen their operations, expand their outreach, and contribute to poverty reduction and
financial inclusion in their target communities.

7. The Role of governments in microfinance:

Governments play a crucial role in supporting and regulating the microfinance sector. They
can contribute to the growth and sustainability of Micro Finance Institutions (MFIs) and
promote financial inclusion.

Governments have a vital role in creating an enabling environment for microfinance to thrive.
By establishing sound regulations, providing financial support, facilitating capacity building,
 and advocating for the sector, governments can contribute to the growth, sustainability, and
positive impact of MFIs in promoting financial inclusion and poverty reduction.

School of Thoughts
Scrutiny and synthesis of available literature reveals that there are at least three different schools of
thought on the role of the state in developing the microfinance sector.

i. Laissez-faire School:
This school of thought emphasizes that the state should maintain macroeconomic stability and entrust
the private and non-- government sector with the responsibility to enhance access to financial services
and sustainable microfinance development. This school of thought underlines that the more the state
will involve in the microfinance sector, the less it will contribute to sustainable development.
According to this view, the state's main contribution to microfinance sector would be to stay out of
the way by closing the state owned commercial, development and microfinance banks and avoiding
directives.

ii. Interventionist School:

This school holds the notion that involvement of the state to enhance access to financial services and
microfinance development is a must due to market failure. Most of the poor are out of the frontier of
formal finance owing to the failure of the financial market. The state has a major role to play in
expanding frontier including provision of services by different types of government-owned
organizations owing to realities that traditional commercial banks are not interested in microfinance
market for various reasons including high transaction cost and credit risk and private risk capital is
unlikely to flow in those areas because of difficulties to achieve essential triangles of microfinance
(outreach, sustainability and impact) is these areas. While experts in this camp admit the possibilities
of “state failure,” they believe in the potential positive contributions of the state on expanding frontier
of financial services.

iii. Moderate Interventionist School:

This school of thought combines fundamentals of laissez-faire school and interventionist school. The
belief of this school of thought emphasizes that the state should not only maintain macroeconomic
stability but also provide an enabling policy environment and essential financial infrastructure.
However, this school does not support direct interventions by the state in providing financial services.

To sum-up, three school of thoughts emphasize that state has definite role to play for developing
microfinance sector, however, exact type and magnitude of roles varies depending on the
complexities involved in financial development and level of maturity of the microfinance industry.
Further, it implies that the role of state varies depending on context and realities on microfinance
markets and other country-specific conditions.

State can have distinct roles for developing the microfinance sector. Because all roles are not equally
effective and some roles may harm financial inclusion by discouraging private-sector delivery of
services, state need to be well informed of risks and benefits of specific interventions and tailor their
use to specific barriers that impede permanent financial services for the poor.
In consideration of the above school of thoughts Nepal government can play the following roles
to increase the efficiency of micro finance sectors.

i. Protector Role:
State should play a protective role for developing microfinance sector. The legal and regulatory
environment is the main tool for the state to demonstrate its protective role. Regulation becomes a
necessity with microfinance sector development to protect savers, allow MFIs to mobilize external
resources and offer them an official recognition against their informal and sometimes unfair
competitors. Regulation must strengthen microfinance movement and should not impede its
development with rigid rules. Regulation should encourage innovation providing flexibility for
institutional forms.
The proper functioning of the protector role of the state is most essential because it builds trust and
addresses imbalances between customers and financial institutions. Regulatory authorities have an
important mission of developing appropriate prudential regulations or adapting existing banking
regulations to protect solvency of large institutions that collect deposits from poor people, to protect
their savings and build confidence on clients. However, regulatory ambitions must be balanced with
available capacity to supervise, especially when determining which organizations should face
prudential supervision.
It can help to:
 • reduce unfair practices
• helps in gradual movement of MFIs towards success
• savers fund becomes secured
• borrowers are not compelled to pay more
• encourage for new products
• built trust and addresses imbalances between customers and financial institutions

ii. Provider Role:

In certain circumstances, the state should be engaged as a financial service provider to the poor and
disadvantaged groups. Given that the performance of state-owned financial institutions and programs
varies, there are cases where state has engaged as a direct Provider of financial services, especially
subsidized credit, as one of the least efficient policy interventions for sustainable access. Such a role
combines both financial and policy objectives. Although state owned microfinance services providers
typically are expected to at least break even, they often do not because of policy objective challenges.
Such institutions tend to perform better on outreach than profitability. They require massive periodic
recapitalizations, demanding extensive public funding that could have served other policy purposes
such as health or education or created incentives and support for private institutions to deliver pro-
poor finance. Those institutions with stronger outreach often performed better financially. Having the
state act as provider of financial services also may create unfair competition by offering subsidized
credit and erode payment culture if collections are more relaxed. The state backed institutions can
play a more positive role in providing payment or savings services than subsidized credit.
Where an extensive network of financial institutions already exists, the role of the state could be to
efficiently transform and restructure public institutions to strengthen the structure of the financial
system.

The state should provide:

• Subsidized fund to the weaker MFIs and co-operatives
• Direct financial services if required.
• Enough regularity requirement and policy
• When no rural banking network exists, the state should create a minimum banking structure
by developing public branches or incentive for commercial banks, where the private sector
fails to adequately address demand of specific poorer segments of the population.
 iii. Promotional Role:
The state could play a role in implementing innovations such as microfinance services to agriculture
or insurance services. Further, a balance of power must be created between state, local authorities,
and financial institutions through external control to avoid political intrusion while ensuring a
dynamic adoption of innovation and sound financial practices.
Global best practices indicate that MFIs require subsidies for start-up investment and network
building and for other innovations such as micro-insurance schemes. Further, addressing extreme
poverty requires complementary services such as infrastructure, education, health, etc. that can be
offered through NGOs or state services, but independently from financial services.
Hence, the promotional role of the state can be both direct and indirect. The indirect promotion tools
include policies and investments that benefit microfinance industry while not focusing exclusively
on promoting fair competition, strengthening payment system etc. State also may promote
microfinance sector more directly by developing a national microfinance strategy, establishing local
wholesale facilities that provide MFIs with financial and technical assistance or by supporting so-
called deprived sector lending in the selected un-served remote areas.

8. Microfinance Policy:
The history of microfinance in Nepal is over three decades old. However, there was not any stated
policy of the government on microfinance prior to the announcement of the microfinance policy by
the Ministry of Finance of the Government of Nepal in 2008 (2065 BS).

The demand for microfinance services by the poor and the destitute is ever increasing in the country.
Considering the tremendous achievements made by the countries such as Bangladesh and India, and
other developing countries in the reduction of poverty through massive flow of financial services
down to the poorest segment of the rural and the semi urban communities. the government of Nepal,
on the advice of the Nepal Rastra Bank promulgated “National Microfinance Policy, 2008” ·. It was
introduced as a new mechanism to boost the microfinance industry. It aims to improve the smooth
flow of funds to the poorest segment of the rural populace by creating national funds for microfinance.
It also has envisaged establishing a regulatory and supervisory body for regulating and supervising
the MFIs in the country so that they discharge their services effectively and efficiently. The highlights
of the policy are as follows:

1. Enhance the supply of microfinance services to the rural and urban poor to suit their geographical,
social, and economic situation.
2. Improve the smooth flow of microfinance services with or without collateral (group guarantee) to
the poor and the destitute by establishing a standard procedure for identifying the target groups.
3. The government will provide necessary help to microfinance institutions for social mobilization,
capacity development, organizational development, restructuring, and will encourage wholesale
micro credit providers both from the public and the private sectors.
4. The government will also integrate microfinance with various poverty alleviating programs and
projects and will implement these in a coordinated manner.
5. The government will coordinate its activities with the institutions responsible for micro-enterprise
development and will assist the targeted poor for their enterprise development.
6. The government will establish relations with microfinance service providing institutions (MFIs)
such as Community Organizations (COs), and Savings and Credit Groups (SCGs), by making a legal
provision to easily recognize these MFIs.
7. The government will also motivate destitute classes to mobilize their savings to improve their
access to microfinance services.
8. The government will make the necessary institutional and legal arrangements and create a separate
institution under the direct control of NRB to make the microfinance service providers (MFIs) self-
regulatory for timely operation, monitoring, supervision, and evaluation such that they can provide
microfinance services to the poor in a sustained manner.
9. To mobilize resources for the long-term easy access of the poor to microfinance services, a
“National Microfinance Development Fund” will be established. Assistance for microfinance from
foreign and national donors will be mobilized through this fund.
10. Conduct a survey to find out the exact members of existing cooperatives and microfinance
institutions, extension of services and access to services.
11. Organize training to improve the capacity of people engaged in the microfinance sector.
12. Adopt a policy of relaxation in permitting savings deposits to MFIs based on the services they
provided and their share capital status,
13. Adopt a flexible tax policy on the income of MFIs and tax on interest earnings of the poor.
Most of the initiatives and actions envisaged under the policy are yet to be observed. NRB, the central
bank, has been working on a draft to bring out a microfinance act and create a regulatory body.

9. Subsidizing:

A subsidy is a form of financial aid or support extended to an economic sector (or institution, business,
or individual) with the aim of promoting economic and social policy. Although commonly extended
by the government, the term subsidy can relate to any type of support - for example from NGOs or
as implicit subsidies. Subsidies come in various forms including direct (cash grants, interest-free
loans) and indirect (tax breaks, insurance, low-interest loans, accelerated depreciation. rent rebates).
The subsidy is typically given to remove some burden, and it is often considered in the public's overall
interest.

The institutions serving the poor are getting subsidies from various national and international donors.
The MFIs which are in infancy stage or immature require the subsidy. The institutions which reach
ultra-poor families of rural areas may also require different forms of subsidies because they must
incur comparatively higher administrative costs. Nepal government also provide subsidy to the MFIs
in the form of soft loan.
Subsidizing is the act of supporting the vulnerable section or the financial institutions financially.

Subsidizing is a practice in which Micro Finance Institutions (MFIs) receive financial support,
typically in the form of grants or subsidized loans, from governments, donors, or other entities.
Subsidies are often provided to MFIs to help them overcome challenges and promote their social
mission of serving low-income and marginalized populations.

It is important to note that subsidies alone may not be sufficient to address all the challenges faced
by MFIs or promote sustainable financial inclusion. Complementary measures, such as capacity
building, access to technical assistance, supportive regulatory frameworks, and partnerships with
other stakeholders, are also crucial to enhance the effectiveness and impact of MFIs in the long run.

Subsidizing can be a valuable tool for governments and donors to support the development and
outreach of MFIs, enabling them to extend financial services to underserved populations and
promote inclusive economic growth.

10. The role of Subsidies and Donors:

Subsidies and donors play a significant role in supporting the operations and impact of Micro
Finance Institutions (MFIs). Here are some key aspects related to subsidies and donors as a matter
of microfinance institutions:

i. Financial support: Subsidies and donors provide crucial financial resources to MFIs, which
can be in the form of grants, concessional loans, equity investments, or guarantees. These
funds enable MFIs to strengthen their financial base, expand their outreach, and offer
affordable financial services to low-income and marginalized populations. Subsidies and
donor funding often bridge the gap between the cost of providing services to underserved
populations and the revenue generated from those services.

ii. Enhancing financial inclusion: Subsidies and donor support facilitate the mission of MFIs
to promote financial inclusion. By providing financial resources to MFIs, subsidies and donors
help bridge the gap between the formal financial system and marginalized individuals or
communities who have limited access to financial services. This support allows MFIs to
extend their services to remote areas, rural populations, women, and other underserved
segments of society.

iii. Capacity building and technical assistance: In addition to financial support, subsidies and
donors often offer capacity building programs and technical assistance to MFIs. These
initiatives can include training in areas such as financial management, risk assessment,
governance, product development, and social performance management. Capacity building
and technical assistance help MFIs strengthen their operational and managerial capabilities,
leading to improved performance and sustainable growth.
iv. Social impact initiatives: Subsidies and donors often prioritize supporting MFIs with a
strong social mission. They may direct funding towards specific social objectives, such as
poverty alleviation, women's empowerment, environmental sustainability, or
entrepreneurship promotion. This support enables MFIs to design and implement innovative
financial products, services, and programs that address the specific needs of their target
populations and contribute to broader social and economic development goals.

v. Market credibility and partnerships: Subsidies and donor support enhance the credibility
and reputation of MFIs. The involvement of reputable donors and the endorsement of
subsidies can boost confidence among stakeholders, including clients, investors, regulators,
and other financial institutions. This credibility can open doors for partnerships and
collaborations with banks, non-governmental organizations (NGOs), government agencies,
and other stakeholders. Partnerships with donors and other organizations provide
opportunities for knowledge sharing, access to technical expertise, and potential co-financing
arrangements.

vi. Monitoring and impact assessment: Subsidies and donors often require MFIs to report on
their activities, impact, and financial performance. Regular monitoring and reporting enable
donors to assess the effectiveness of their support and ensure that funds are used for their
intended purposes. Impact assessments help MFIs measure and communicate their social
outcomes, providing valuable feedback to donors and informing the development of future
initiatives.

vii. Transition to self-sustainability: While subsidies and donor support are essential for the
growth and impact of MFIs, the goal is often to transition towards self-sustainability.
Subsidies and donors can play a role in helping MFIs develop the necessary capacities,
systems, and partnerships to generate sufficient income and reduce dependency on external
support. This includes supporting efforts to diversify funding sources, improve operational
efficiency, develop sustainable business models, and access commercial capital markets.
 It is important for MFIs to manage their relationship with subsidies and donors effectively. This
includes ensuring transparency, accountability, and alignment with the MFI's social mission.
MFIs should also strive to build financial resilience and seek long-term sustainability beyond the
reliance on subsidies and donor support.

Subsidies and donors are crucial partners for MFIs, providing financial resources, capacity
building, and technical assistance to help them reach underserved populations, achieve their social
objectives, and contribute to inclusive economic development.

11. Measuring subsidy dependence:

It is the index used to measure the financial viability of an MFI. The SDI (Subsidy Dependence Index)
measures the degree to which an MFI relies on subsidies for its continued operations. It was developed
by Jacob Yaron (1992) to calculate the extent to which an MFI requires subsidy to earn a return equal
to the opportunity cost of capital. The subsidy dependence index's objective is to provide a
comprehensive method of assessing and measuring the financial costs involved in operating an MFI
and quantifying its subsidy dependence. Calculating the subsidy dependence index involves
aggregating all the subsidies received by an MFI. The total amount of the subsidy is then measured
against the MFI's on-lending interest rate multiplied by its average annual loan portfolio. The Subsidy
Dependence Index (SDI) measures how much an MFI would have to increase its lending interest rate
to cover all its costs including adjustments. Particularly, the SDI matches the subsidy granted by
society, (the numerator in the SDI measure) to the value of fees and interest payments paid by clients
(the denominator).

The SDI is normally computed in two stages. In the first stage the total annual subsidy received by
the MFI is divided by the average annual LP. For a given MFI, this provides the annual subsidy per
annual dollar of LP.

In the second stage the total annual subsidy received by the MFI is divided by the interest and fee
income earned on the MFI’s LP. The second stage gives the complete SDI measure and places the
total amount of subsidies received by the MFI in the context of its activities.
An SDI above zero means that the MFI still needs subsidy to operate- (i.e., it has not achieved
financial sustainability. A two-stage calculation produces first the amount of annual subsidy and then
the index.

SDI = S
LP x I
Where:

SDI = Index of subsidy dependence of MFI;

S = Annual subsidy received by the MFI
LP= Average annual outstanding loan portfolio of the MFI
I= Weighted average interest yield earned on the MFI's loan portfolio.

If it is assumed that an increase in the lending interest rate is the only change that may compensate
for loss of subsidy, then the SDI provides a sensitivity measure of the MFI's self-sufficiency to the
annual yield it charges on its loans. Particularly under this assumption, the SDI indicates the
percentage increase in the annual yield on the MFI's LP needed for full subsidy independence.

However, if the only factor that influences the self-sustainability of the MFI is its lending rate is
unrealistic. Indeed, the SDI measure is an accurate measure of self-sustainability as it is influenced
not only by the yield obtained on the MFI's LP but also on interest rate spreads it faces, its loan
collection rate and the administration cost it incurs in carrying out its activities. In other words,
improving any of these factors, for example saving on costs or reducing loan losses also reduces the
SDI value and indicates improvement towards subsidy independence. Furthermore, using the SDI
facilitates comparisons of MFIs that provide similar products to similar clientele. Comparisons may
be carried out within a single country or across countries to assess the subsidy dependence of the
MFIs concerned. It can also be used to track the subsidy dependence of a given MFI over time to
assess whether it has truly progressed toward self-sufficiency.

A subsidy dependence index of zero means that an MFI has achieved financial self-sufficiency as
described above. A subsidy dependence index of 100 percent indicates that a doubling of the average
on-lending interest rate is required if subsidies are to be eliminated. Similarly, a subsidy dependence
index of 200 percent indicates that a threefold increase in the on-lending interest rate is required to
compensate for the subsidy elimination. A negative subsidy dependence index indicates that an MFI
not only fully achieved self-sustainability, but that its annual profits, minus its capital (equity) charged
at the approximate market interest rate, exceeded the total annual value of subsidies if subsidies were
received by the MFI. A negative subsidy dependence index also implies that the MFI could have
lowered its average on-lending interest rate while simultaneously eliminating any subsidies received
in the same year.

Four factors are critical for reducing or eliminating subsidy dependence:

• Adequate on-lending rates
• High rates of loan collection
• Savings mobilization, and
• Control of administrative costs
(Active savings mobilization helps to ensure a continuous source of funds for an MFI. An increase
over time in the ratio of the total value of voluntary savings to the loan portfolio will indicate the
extent to which an MFI has been successful in replacing concessional funds from donors (or the state)
with savings from Similarly, self-sufficiency ratios will also improve).

12. Traditional microfinance donors and instruments:

Traditional microfinance donors are organizations, institutions, or governments that provide financial
support to Micro Finance Institutions (MFIs) and microfinance programs. These donors contribute to
the development and expansion of microfinance services, aiming to promote financial inclusion and
poverty reduction.
Here are some examples of traditional microfinance donors and the instruments they commonly use:

i. Multilateral Development Banks (MDBs): MDBs, such as the World Bank, International
Finance Corporation (IFC), and Asian Development Bank (ADB), play a significant role in
financing and supporting microfinance initiatives. They provide funding through loans,
grants, and guarantees to MFIs, financial intermediaries, and microfinance investment
vehicles (MIVs). MDBs also offer technical assistance and policy advice to strengthen the
microfinance sector.
 ii. Bilateral Development Agencies: Bilateral development agencies, such as the United States
Agency for International Development (USAID), Department for International Development
(DFID), and Kreditanstalt für Wiederaufbau (KfW), are governmental organizations that
provide financial support to microfinance programs. They offer grants, loans, and technical
assistance to MFIs, microfinance networks, and government agencies involved in promoting
microfinance.

iii. Development Finance Institutions (DFIs): DFIs, such as the Overseas Private Investment
Corporation (OPIC) and CDC Group, are specialized financial institutions that provide long-
term financing, equity investments, and technical assistance to microfinance entities. DFIs
aim to mobilize private capital and promote sustainable development in emerging markets,
including through microfinance investments.

iv. Non-Governmental Organizations (NGOs): Many NGOs are actively involved in

microfinance and contribute to financial inclusion efforts. They provide grants, loans, capacity
building, and technical assistance to MFIs and community-based organizations engaged in
microfinance activities. NGOs often focus on reaching underserved populations, such as rural
communities, women, and vulnerable groups.

v. Public-Private Partnerships (PPPs): Public-Private Partnerships involve collaboration

between governments, private sector entities, and donors to support microfinance initiatives.
These partnerships leverage the strengths and resources of each stakeholder to achieve shared
development goals. PPPs can provide financial resources, technical expertise, policy support,
and market linkages to MFIs.

The instruments used by traditional microfinance donors can include:

- Grants: Non-repayable funds provided to MFIs or microfinance programs to support specific

activities, capacity building, or social impact initiatives.
- Loans: Financial resources provided to MFIs or financial intermediaries at concessional interest
rates or with favorable repayment terms.

- Equity Investments: Direct investments in the capital of MFIs, providing them with long-term
funding and sharing in their financial performance.

- Guarantees: Financial instruments that provide a credit enhancement, reducing the risk for lenders
and enabling MFIs to access commercial funding at more favorable terms.

- Technical Assistance: Non-financial support in the form of training, capacity building, institutional
strengthening, and advisory services to help MFIs improve their operational and managerial
capabilities.

- Policy Advocacy: Donors may engage in policy dialogue and advocacy efforts to support an
enabling environment for microfinance and promote favorable regulatory frameworks.

These traditional microfinance donors and their instruments play a vital role in mobilizing resources,
providing financial support, and fostering the growth and sustainability of microfinance institutions
and programs.

13. Socially responsible investors:

Investors engaged in social justice, environmental sustainability and alternative energy/clean
technology efforts are called socially responsible investors. They encourage corporate practices that
promote environmental stewardship, consumer protection, human rights, and diversity. They simply
avoid businesses involved in alcohol, tobacco, fast food, gambling, pornography, weapons. They
invest considering ethical or even moral aspects. They do not run only for profit. They can be called
sustainable investors and aim for strong financial performance, but also believe that these investments
should be used to contribute to advancements in environmental, social and governance (ESG)
practices. They may actively seek out investments-such as community development loan funds or
clean tech portfolios-that are likely to provide important societal or environmental benefits. Some
investors embrace social responsibility investment strategies to manage risk and fulfill fiduciary
duties: they review ESG criteria to assess the quality of management and the resilience of their
portfolio companies in dealing with future challenges.

What strategies do sustainable and responsible investors use?

Traditionally, responsible investors have focused on one or both strategies. The first is ESG
incorporation, the consideration of environmental, community, other societal and corporate
governance (ESG) criteria in investment analysis and portfolio construction across a range of asset
classes. An important segment, community investing, seeks explicitly to finance projects or
institutions that will serve poor and underserved communities in the United States and overseas. The
The second strategy, for those with shares in publicly traded companies, is filing shareholder
resolutions and practicing other forms of shareholder engagement. Sustainable investing strategies
work together to encourage responsible business practices and to allocate capital for social and
environmental benefit across the economy.

14. Commercial investors:

Commercial investors include institutional investment funds, mutual funds, private funds, or
individual investors. They are the investors who seek the maximum return on the investment. They
are not genuinely concerned about the social aspect but meet the regulatory requirement set by the
local authority and the state government. They are interested in making investment in the projects
that yield maximum return. They may become ready to invest in businesses of alcohol, tobacco,
gambling, pornography, weapons, or any sorts of business even if they clearly know that this business
actual1y harms society.

15. Debt and equity investment an introduction:

Microfinance has received significant attention from the donor community, based upon its potential
as a powerful tool for poverty alleviation. As such, many millions of dollars have been spent on
promoting microfinance programs around the world. During the last decade, the microfinance
community has recognized the limitations of donor and government subsidies in reaching a
significant scale and scope of operations. As many microcredit programs apply the so-called
graduation principle in their lending operations, increasing the size of repeat loans according to their
repayment record of previous loans, it was essential to raise/attract sufficient funds to sustain that
process. Thus, many MFIs are moving away from donor funding into the more traditional sources of
capital financing that typical corporations use. There are two sources of financing that microfinance
institutions can use; they are equity and debt.

Equity Investments:
The term transformation or commercialization has changed the MFIs from un-regulated nonprofit
institutions to regulated and profit-making institutions. This transformation has encouraged the equity
investors into MFIs. Over the last few years, there has been a rapid increase in equity investment in
some of the larger, established MFIs across Nepal. However, there are many informal institutions
helping the ultra-poor through the financial assistance of donors and the communities. In the context
of Nepal, the NRB has classified the microfinance as 'D' class financial institutions and they are able
to collect the major portion of the capital in the form of equity. The more than average profit earned
by the MFIs has encouraged the investors to make investment in the form of equity. Many of the
commercial banks have managed the MFIs by investing the institutional fund in the form of equity
shares.

Debt investments:
Debt capital is often the first choice, either in the form of borrowings from commercial and central
banks, or from wholesale lending institutions. Debt obligations are attractive, as they not only provide
a steady source of income for the owners, but they also provide a stable source of funds often at a
subsidized rate for the issuers. In Nepal, the MFIs are funded by the commercial banks and finance
companies as well as the whole sale lending institutions. There are three wholesale lending
institutions i.e., Rural Self Reliance Funds, Rural Microfinance Development Center, and Sana Kisan
Bikash Bank. NRB has made compulsion to invest 5 percent, 4.5 percent and 4 percent from the A,
B and C class financial institutions in deprive sectors and they are mostly doing so through MFIs.
This directive has made easy to MFIs in Nepal to collect debt capital at subsidized rate. However, in
foreign developed countries, the MFIs have collected funds from open market through debt and
equity.
 16. Microfinance investment funds (MFIFs):
Many investment structures were created as vehicles to fund development initiatives, such as MFIs.
In the mid-l990s the first commercially focused investment structures emerged, targeting MFIs such
as Profund, launched in 1995. The original promoters of these investment vehicles were development
agencies and non-profit organizations. All these initiatives had a common goal: to increase the
development impact by investing collectively in a diversified pool of MFIs. This approach afforded
clear advantages to these development investors, notably the sharing of costs and experience.

Today the investors in these funds are still mainly the original participants in the microfinance
industry: non-profit organizations and development agencies. Recently, though, an increasing number
of MFIFs are being set up to mobilize the traditional capital markets, clearly targeted to these
commercial investors. It is interesting to note that the most commercially oriented investment funds
invest exclusively in debt instruments of MFIs, whereas the funds promoted by development-oriented
institutions have a greater mix of investments with equity as well as debt products.

Microfinance investment funds are the institutions that channel funds to the microfinance sector. The
term covers a diversified range of vehicles with different missions, objectives and types of
shareholders. MFIFs' sponsors range from NGOs or development agencies to commercial players. A
useful definition is that microfinance investment funds are vehicles which have been specifically set
up to invest in microfinance assets in which social or commercial, private, or institutional investors
can invest. Private investors, institutional investors, donors, development agencies, NGOs, INGOs,
invest in the form of loan and shares in the MFIF (Microfinance investment funds) and the fund
collected is used to invest in MFIs in the form of loan and shares at near market interest rates.
Microfinance Investment Funds examples are; Accion Gateway, Accion Investments in Microfinance

Microfinance investment funds (MFIFs) are increasingly seen as a core part of the funding of
microfinance institutions (MFIs). MFIFs take various legal forms and structures set up by a variety
of players. But all serve the same purpose, which is to channel increasing funding to micro-
entrepreneurs via MFIs in developing countries and transition economies.
The requirement of a financial return for most MFIFs was also probably less apparent as the
stakeholders did not create them for a financial return, but for a social return. The MFIFs with a
commercial orientation would precisely target the MFIs which are more sustainable while the MFIFs
focusing on social returns would try to ensure that the MFIs that are primarily motivated by social
concerns also become sustainable.

MFIFs are also a convenient tool to invest collectively in a wide and diversified range of MFIs.
Suppliers of funds can reach more local institutions through such diversified vehicles. The latest
developments demonstrate that whenever a microfinance investment fund is structured appropriately
for its targeted investors, there is no lack of financial resources. Even private donors and development
agencies that have been the traditional sources of funding for microfinance are increasingly keen to
create such structures to attract additional providers of financial resources.

The most were created since the mid to late 1990s. The creation of these structures has mobilized
funding to MFIs which otherwise would not have been invested in this sector. These structures also
help private donors or development agencies to pool their assets and diversify their investments,
rather than holding direct investments in MFIs. The participation of the most active private donors
and development agencies has prompted others to join these initiatives. Microfinance investment
funds specifically targeted at private and institutional investors are just starting to emerge. We have
seen that MFIs are transforming into more formal structures to appeal to potential investors and
provide a solid base for their continued growth.

Types of MFIFs

Microfinance investment funds can be classified in three main categories:

i. Microfinance development funds. ·
ii. Quasi-commercial microfinance investment funds,
iii. Commercial microfinance investment funds,
 i. Microfinance Development Funds:
Microfinance development funds are commonly cooperatives or non-profit entities. Their aim is to
make capital available to MFIs through sustainable mechanisms to support their development and
their growth without necessarily seeking a financial return. The investors in these structures seek a
social return with the aim of maintaining the real inflation-adjusted value of their original capital if
possible. This objective usually translates into favorable financial conditions for MFIs, usually
subsidized or provided below market rates. Technical assistance may be provided by related
institutions. The main investors would be private donors and development agencies as well as private
individuals and corporations. These funds do not usually provide grants and donations to MFIs
because doing so would deplete capital. Due to the nature of their investor base and their social
approach, microfinance development funds are very complementary to commercial and quasi-
commercial microfinance investment funds. These funds should prepare MFIs for access to capital
markets by focusing on approaching sustainability, including green field institutions. As MFIs
become sustainable, commercial investment funds should take over by providing larger resources in
market terms.

ii. Quasi-Commercial Microfinance Investment Funds:

Funds in this category have clearly stated financial objectives including returns larger than those in
the development funds. They nevertheless have a clear development mission and the determination
to pursue it. They are usually not actively distributed to new investors, unlike the more commercially
oriented investment funds. These funds are owned by development finance institutions, NGOs or by
other institutions close to the development world. In many cases, a few private investors have joined
these funds, motivated by the presence and the experience of these development finance institutions:
Some quasi-commercial investment funds have fared significantly better than the commercial funds
over the last few years, due to their higher proportion of equity holdings. In general, their total assets
are smaller than those of the microfinance developments funds. They make investments in debt and
equity with the anticipation of a future participation in MFI's capital. In a similar manner, quasi-
commercial MFIFs can facilitate the transition of ownership of MFIs from NGOs and development
actors to the commercial sector. Attracting private investors to microfinance through investment
funds started only recently.
 iii. Commercial Microfinance Investment Funds:
These funds are new, the most commercial and heterogeneous of the three categories. They also are
by far the smallest microfinance investment funds investing in equity, they represent. The main
distinction between commercial microfinance investment funds and the previous category of funds is
the nature of the investors targeted. These funds tend to target private investors and usually invest
primarily in the most mature MFIs. They favor loans, with equity representing no more than 10 to
20% of their portfolios. Commercial microfinance investment funds would clearly target private and
institutional investors. Development agencies and private donors would appear only as initial
investors or as facilitators in structures with subordination tranches. These funds would be actively
distributed by the original promoter and external distributors. The nature of the investors targeted by
commercial investment suggests that these funds have clearer objectives than others. These funds
provide investors with a stable return based on the loan portfolio, and they hope to achieve an
additional return with limited investments in MFI equity.
The first microfinance investment fund with the objective of targeting private investors was the Dexia
Micro-Credit Fund. It was launched in Luxembourg in 1998 by the bank Dexia-BIL. The owners are
private individuals and a few commercial institutional investors. This fund demonstrates that a
microfinance vehicle specifically targeted at private investors can attract sizeable amounts of money.
This fund invests primarily in microfinance loans. Other similarly structured microfinance investment
funds that target private investors that include some equity positions in their portfolios have recently
been launched. These two funds have monthly net asset valuations which enable investors to
subscribe to or redeem these funds each month. The four commercial microfinance investment funds
with an equity portfolio in MFIs are Impulse, Micro Vest, responsibility Global Microfinance Fund,
Triodos Fair Share Fund.

17. Microfinance investment vehicles (MIVs):

The term "investment vehicle" refers to any method by which individuals or businesses can invest
and ideally grow their money. There is a wide variety of investment vehicles like shares of different
companies, debentures and other forms of loan and many investors choose to hold at least several
types in their portfolios. This can allow for diversification while minimizing risk.
MIVs are independent investment entities that specialize in microfinance, with more than 50 percent
of their noncash assets invested in microfinance. They are either self-managed or managed by an
investment management firm and are open to multiple investors. MIVs may issue shares, notes, or
other financial instruments. The success of MFIs led to the emergence of microfinance investment
vehicles. In the mid-1990 the first MIVs appeared, and the number of funds dramatically increases in
the early 2000's. MIVs have become a gateway for microfinance investment and according to CGAP
(Consultative Group to Assist the Poorest) there are over 100 MIVs managing over $7.5 billion in
assets. About 40% of global microfinance investment is channeled through MIVs to MFIs.
There are three forms of investments:
i. Fixed Income Funds:
Investment funds and vehicles invest most of the fund in microfinance debt instruments.
ii. Mixed Funds:
Investment funds and vehicles of which invest in both debt and equity of microfinance.
iii. Equity Funds:
Investment funds and vehicles of which they invest most funds in microfinance equity.

Investment strategy of MIVs:

These institutions are in practice in western countries. MIVs mostly finance '"large" microfinance
investees, those that have more than USD 100 million in total assets. Only 6% of the microfinance
portfolio of MIVs was allocated to microfinance investees with less than USD 10 million in total
assets. 'More than 100 MIVs do finance MFIs all around the world; through debt and to a lesser extent
equity investment. 81.6% of the investments were made through loans, 17.6% through equity, 0.5%
through guarantees and 0,3% through other types of tools. Geographically speaking, 72% of the MIVs
investments are made in Eastern Europe, Central Asia, and Latin America (Micro Rate, 2010).

Funding Sources:
MIVs on average raise more than 50% of their capital from private institutional sources. This is the
case for all strategy types except Mixed Funds for whom the main source of funding is retail investors.
Public sector investors are active suppliers of capital to MIVs, more specifically to Fixed Income
Funds. They collect the funds by issuing claims against them like equity shares, bonds and other long
term and short-term securities.
History of MIV:
MIVs have a brief history but have developed a lot over the last fifteen years. At the very beginning,
the first established funds were working with equity investment, trying to show that it was possible
to invest in microfinance. The story of PROFUND is illustrative of the origins. It was created in the
early 1990s by a set of main players in the microfinance industry to invest in Latin American MFIs
and establish the fact that "investing in microfinance" was a real possibility. It was very rapidly
followed by other initiatives but in a slightly unique way. The typical pattern is the following: one
(or a few) known player(s) in the US or in Europe establish a fund with the technical collaboration of
some major actors of the finance and banking industry (usually involved in such deals as part of their
own social responsibility involvements). The fund receives starting capital coming either from donors
(very often already involved in microfinance projects) or from the partner bank itself. The fund is
capitalized over time through calls for investments most of the time from the Socially Responsible
Investment (SRI) community. The funds are then provided to MFIs as loans (usually senior debt)
most of the time in short or medium term, resulting in the establishment of a new type of SRI in
Europe and/or the US and a new source of funding for MFIs in developing countries.

18. Culture of labor division:

The culture of labor division refers to the way Micro Finance Institutions (MFIs) organize and
allocate tasks and responsibilities among their staff members. It encompasses the division of labor,
roles, and responsibilities within the MFI, and can significantly impact its efficiency, effectiveness,
and overall performance. Here are some key aspects related to the culture of labor division as a matter
of MFIs:

i. Specialization of roles: MFIs often have various departments and functions, including loan
officers, credit analysts, client relationship managers, risk managers, operations staff, and
administrative personnel. The culture of labor division involves assigning specific roles and
responsibilities to individuals or teams based on their expertise, skills, and qualifications.
Specialization allows employees to focus on their areas of strength and contribute to the
overall functioning of the MFI.
 ii. Clear job descriptions: Establishing clear job descriptions is essential for defining roles,
responsibilities, and expectations of each position within the MFI. Well-defined job
descriptions help employees understand their duties, authority levels, and accountability,
reducing confusion and promoting efficient workflow. Clear job descriptions also aid in
recruitment, performance evaluation, and career development within the MFI.

iii. Delegation and empowerment: A healthy culture of labor division involves delegating
authority and empowering employees to make decisions within their assigned roles.
Delegation allows for efficient task execution and fosters a sense of ownership and
responsibility among employees. Empowerment enables staff members to contribute their
expertise and creativity, leading to innovation and improved performance.

iv. Teamwork and collaboration: While the labor division emphasizes specialization, it is
equally important to promote teamwork and collaboration among staff members. MFIs should
encourage open communication, information sharing, and collaboration across departments
and functions. Effective collaboration ensures coordination, constructive interaction, and the
efficient flow of information and resources within the MFI.

v. Training and professional development: MFIs should invest in training and professional
development programs to enhance the skills and capabilities of their staff members. Training
can be focused on technical skills, such as credit analysis, risk management, customer service,
and soft skills, including communication, leadership, and problem-solving. Continuous
learning and development opportunities contribute to a culture of labor division by equipping
employees with the necessary skills to excel in their roles.

vi. Performance measurement and incentives: MFIs should establish performance

measurement systems to assess the performance of individual employees and teams. Clear
performance metrics and targets help align the efforts of employees with the MFI's objectives.
Incentive systems, such as performance-based bonuses or recognition programs, can motivate
staff members to achieve prominent levels of productivity and quality in their work.
vii. Adaptability and flexibility: The culture of labor division should be adaptable and flexible
to accommodate changes in the MFI's environment, evolving business needs, and
technological advancements. MFIs should encourage employees to embrace new
responsibilities, adapt to changing roles, and acquire new skills as required. This flexibility
enables MFI to respond effectively to market dynamics and the evolving needs of its clients.

Promoting a positive culture of labor divisions within MFIs can result in improved efficiency,
employee satisfaction, and overall organizational performance. By allocating tasks and
responsibilities effectively, ensuring clear communication and collaboration, and investing in staff
development, MFIs can create an environment that supports individual growth and collective success.

19. Opportunities for Microfinance in Nepal:

Microfinance is gathering momentum to become a significant force in Nepal. There are various
microfinance models working with the help of NGOs, Nepal government, private sectors, and other
national and international donors. The groups of (often) poor women without collateral have become
an accepted part of rural finance. In Nepalese context, there is the great opportunity to establish and
run the micro credit and MFIs because of the huge existing demand - supply gap. Currently, the
number of MFIs has increased, and few of them have shown the courage to reach the ultra-poor in
the rural area too, but the real access to finance for rural people is not yet enough. Most of the financial
institutions are concentrated in urban and semi urban areas. Still, they are not in reach of the ultra-
poor because they live in urban areas.

Despite the impressive figures, the supply side of microfinance in Nepal is still presently grossly
inadequate to fill the gap between demand and supply but it holds the promise to act as a great
opportunity for the financial sector and the economy. The opportunity for MFIs in Nepal is
tremendous if they can reach the poor with good planning. Since the infrastructure of the rural area
is not optimal for conducting the MF activities directly, they should plan step by step. The government
is helping MFIs through liberal policies, and it should assist the MF is through further subsidies and
grants and encourage them to serve in the rural area. Serving in the rural area increases the
administrative cost but it can be minimized through efficient management. In Nepalese context, all
the MFIs which currently exist have been earning quite good.

The opportunities of MFIs in Nepal can be highlighted in the following points.

• Huge existing demand-supply gap
• Substantial number of deprive people
• Limited No. of institutions in rural sectors
• More than average Profit
• High volume of interested investors and donors
• Government policy is in favor of MFIs
• Facility of subsidies, soft loan, and donations

20. Challenges of Microfinance Sector in Nepal:

Microfinance sector in Nepal, as in most other developing countries, has made a considerable
progress particularly in scale of outreach despite many challenges it has been facing. Quite a few
institutional micro-lenders in the form of microfinance banks, financial-intermediary nongovernment
organization (FINGOs (Financial Intermediary NGOs) or microfinance NGOs), savings and credit
cooperative societies have been established across the country. And these organizations have been
able to reach poor households with micro financial services, particularly microcredit and savings
services. Most of these organizations have been performing well financially maintaining high loan
portfolio quality and desirable operational self-sufficiency.

However, they lag in social performance indicators. The focus on clients' protection and economic
growth seems to be almost ignored from the side of MFIs and the agencies concerned. Microfinance
programs are concentrated in easily accessible areas, but the remote hilly/mountain areas are still
deprived of institutional microfinance services.

i. Limited capacity
Although there are quite a few institutional micro lenders in the country in different corporate form,
most of them still have limited institutional capacities to deliver quality and broad microfinance
services to the poor households living across the country. Most of the institutions do not have an
adequate number of competent and committed human resources essential for effective delivery and
management of their services as per the best microfinance practices.

The medium and bigger MFIs are still struggling to have friendly and well-forming computer
software to have an automated operating system and management information systems (MIS)
required to implement and manage their complex operations effectively and efficiently. Moreover,
most of the microfinance banks still do not have the right operational policies and systems or risk
management, asset and liability management, and cash management. Despite such a lack, most micro-
lenders disburse loans to as many clients as possible, so they have easy access to loan funds from
banks and financial funds.

ii. Poor physical and economic infrastructures

Poor physical and economic infrastructures are found to be the major constraints for limited access
of microfinance in the remote rural and hill/ mountain areas of the country. These areas have
extremely poor road networks and transport facilities. Economic infrastructures, such as the presence
of banks, telecommunication offices, post offices, etc. are lacking in these areas. These factors have
caused difficulty for both MFIs and clients, MFIs operating in hill/mountain districts find difficulty
in managing their cash as the banks’ branches do not exist near their operating areas or even in the
district headquarters.

Likewise, the clients living extremely far from the market centers due to lack of poor road network
and transport infrastructures cannot produce as much as they can even though they have quality land
and favorable environment lo grow crops in their localities. Easy availability of funds to the poor
families could not make much difference unless the infrastructures for economic development are
improved in such areas.

iii. Lack of appropriate training institute for microfinance

There are a few training institutes in the country which offer some theoretical microfinance courses
occasionally; but none of them are conducting need-based practical or operational skills development
training programs with the purpose of developing suitably qualified human resources for MFIs. To
run an MFI smoothly, the organization's staff should have adequate knowledge and skills in
microfinance operation, such as identification of poor households in a community, orientation of
eligible members before enrolling them as members into a microfinance program, conducting regular
group meeting, supervision and monitoring of operations, internal control, credit operation
management, branch management, etc. So far, the MFIs have learned the operating skills from each
other.

RMDC's extensive experience in institutional capacity building of MFIs shows that need-based
practical training programs, for instance on-the-job training onsite technical assistance, well
organized exposure visit to best practices, interactive problem-solving workshops, etc. are essential
to develop right human resources required to run an MFI efficiently and effectively. Mere theoretical
courses conducted in classrooms will not help much with the MFIs, particularly for the beginner ones.
Although RMDC (Rural Microfinance Development Center) has fulfilled the training needs of MFIs
to a larger extent in the earlier years, the growing training needs of MFIs could not be fulfilled by its
resources alone. Hence, the microfinance industry needs a specialized training institute which could
conduct such practical training courses.

iv. Poor supervision and monitoring of financial cooperative societies

Cooperative societies have been recognized as one of the important institutions for rural development
and poverty reduction in the country. Banks and financial institutions, in the recent years, have been
disbursing their mandatory deprived sector (microcredit) funds to the poor through financial
cooperative societies as the microfinance NGOs and specialized microfinance banks are in extremely
limited number. The financial cooperative societies, if they can perform well financially, could also
be a right vehicle to channel a large amount of deprived sector funds to the rural and remote areas in
the long run as these institutions are in substantial number and are found in every nook and corner of
the country. Structurally these institutions are self-regulated as they are locally owned and managed.
It is observed that most of the financial cooperative societies are not even up to the basic standard in
terms of governance and management, accounting and financial management, credit operation,
internal control, and monitoring, etc. Offsite and onsite supervision and monitoring of these
institutions from the concerned regulatory and supervisory bodies, which is essential to improve their
institutional capacities, is found extremely poor in the country.
 v. Limited business development services to microfinance clients
MFIs in the country offer only financial services, such as micro saving, micro-credit, and few of them
also provide remittance services linking with commercial banks. Few MFIs occasionally organize
training on agriculture or livestock from their own resources or donor funds. But none of the MFIs
has been providing systematically designed business development services to the clients although the
institutions recognize the importance of entrepreneurial skills development of clients which will
ensure the growth of clients as well as the sustainability of the microfinance industry in the country.

vi. Supply of deprived sector funds in the market

It is mandatory for class A, B and C type banks and financial institutions to disburse at least 5%, 4.5%
and 4% of their total loan portfolios respectively to the deprived sector. Since these commercially
oriented banks and financial institutions do not have their own experience in micro-lending, they are
found not to follow the best microfinance practices while lending directly to the poor. As a result,
outcomes and impact of these financial institutions' direct lending program have been seen negatively
or harmful to the microfinance industry. Wholesale lending to MFIs also appears challenging for the
banks and financial institutions as there are an extremely limited number of credit-worthy MFIs in
the country. This situation has caused unhealthy competition among the banks and financial
institutions for lending to the few viable MFIs. It has been observed that most of the institutions lend
to MFIs even at negative interest rate to meet their mandatory targets and thereby to get escaped
themselves from the high penalty charge from the regulatory body. The financial institutions do not
also undertake an in-depth appraisal of an MFI before lending to it. These unhealthy behaviors of
financial institutions would distort the whole financial system.

vii. Microfinance Mission Drift

A particular MFI states in its preamble (document) that its objective is poverty reduction. To achieve
the goal, the institution must reach out to many poorer households including ultra-poor families with
quality and appropriate microfinance products and services. Having many poorer clients, this type of
MFI would have a lower loan size. And these MFIs can meet their operational costs and maintain
their desired financial health by increasing staff productivity in terms of number of borrowers per
staff and operational efficiency. But, in recent years,
 particularly the larger MFIs or microfinance banks in the country have been found deviated from
their original mission of poverty reduction by offering most of their services to non-poor and less
poor clients with higher loan size with the objective of increasing their volume of businesses and
thereby raising up their institutional profitability. It has been observed that the extremely poor or
ultra-poor households have been left-out from their microfinance programs because of their larger
loan size and inappropriate operating modality not suited to the poor clients. Besides, the staff are
geared up toward reaching physical target by poaching clients of other MFIs. This scenario has been
found in the microfinance programs being implemented directly by the development banks or
commercial banks or by the microfinance banks owned by the banks.

viii. Over-indebtedness of microfinance clients

The situation of over-indebtedness arises when a microfinance client borrows such an amount which
is beyond her or his capacity. This scenario has been widely observed in recent years in the country,
particularly in the geographical areas where many micro lenders are present. Field offices of the
MFIs, to meet their periodic target, try to disburse loans to many clients without making a detailed
appraisal of them. And the clients having no idea about the consequences of over-indebtedness
borrow a larger amount of loan when they are offered easy loans from different MFIs. As a result,
some MFIs have already started facing the loan default problem. It is high time to take necessary
steps by the MFIs, the regulators, and the lenders to protect the clients and thereby to minimize the
risks to the microfinance industry.

A case of Bangladesh:
Oversaturation of microcredit banks has led to dependency on microcredit for consumption and other
non-entrepreneurial purposes in rural Bangladesh. Many households reported holding upwards of
four loans at a time. In this overcrowded debt- market, it is common to cover old debts by taking out
new loans from various sources (and frequently from the same sources), often with the
encouragement of field officers.