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					                                                    Table of Contents
1      Introduction to the World of Microfinance ................................................................................. 3
2      Brief Overview of status of Microfinance in India ..................................................................... 4
    2.1 Features of Indian MF Industry:........................................................................................... 5
3      Credit scoring model ................................................................................................................... 6
    3.1 Introduction: ......................................................................................................................... 6
    3.2 How does it work??? ............................................................................................................ 6
       3.2.1 Database for scoring: .................................................................................................... 7
    3.3 What Types of risk to predict?? ........................................................................................... 8
4      Risk management in microfinance.............................................................................................. 9
    4.1 Bank related measures:....................................................................................................... 10
    4.2 NABARD related measures: .............................................................................................. 11
    4.3 NGO related measures: ...................................................................................................... 11
    4.4 Government related measures: ........................................................................................... 12
5      Microfinance-Credit lending models ........................................................................................ 12
    5.1 Associations: ...................................................................................................................... 13
    5.2 Bank Guarantees: ............................................................................................................... 13
    5.3 Community Banking: ......................................................................................................... 13
    5.4 Cooperatives: ...................................................................................................................... 13
    5.5 Credit Unions: .................................................................................................................... 14
    5.6 Grameen: ............................................................................................................................ 14
    5.7 Group:................................................................................................................................. 14
    5.8 Individual: .......................................................................................................................... 14
    5.9 Intermediatories:................................................................................................................. 15
    5.10     Non-Governmental Organizations:................................................................................. 15
    5.11     Peer Pressure: ................................................................................................................. 15
    5.12     Rotating Savings and Credit Associations: .................................................................... 16
    5.13     Small Business:............................................................................................................... 16
    5.14     Village Banking: ............................................................................................................. 16
6      Grameen Bank Model ............................................................................................................... 17
    6.1 Method of Operation: ......................................................................................................... 17
7      Role of Self Help Groups & Microfinance Institutions ............................................................ 19
    7.1 Self Help Groups ................................................................................................................ 19
       7.1.1 Indicators of a good SHG ........................................................................................... 20
    7.2 Microfinance Institutions (MFI’s) ...................................................................................... 21
       7.2.1 Factors Influencing MFI Sustainability ...................................................................... 26
    7.3 Case study- Interest rate!! .................................................................................................. 29
       7.3.1 Borrowers’ Return on Investments ............................................................................. 29
8      Valuations of microfinance institutions .................................................................................... 31
    8.1 Backwards Looking Nature:............................................................................................... 31
    8.2 Lack of Comparables: ........................................................................................................ 32
    8.3 Using DCF in MFIs ............................................................................................................ 32
       8.3.1 Peculiarities involved in valuing MFI’s equity ........................................................... 33

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9    Legal framework in India.......................................................................................................... 39
  9.1 Types of Micro Credit Providers in India: ......................................................................... 41
10 Innovations required!!! ............................................................................................................. 42




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1 Introduction to the World of Microfinance
        The most important finding in the last two decades in the world of finance did not come from the
world of the rich or the relatively well-off. More important than the hedge fund or the liquid-yield option
note was the finding that the poor can save, can borrow (can indeed decide on loans to fellow poor), and
will certainly repay loans. This is the world of microfinance. A good definition of microfinance as provided
by Robinson1 is, ‗Microfinance refers to small-scale financial services for both credits and deposits — that
are provided to people who farm or fish or herd; operate small or microenterprises where goods are
produced, recycled, repaired, or traded; provide services; work for wages or commissions; gain income
from renting out small amounts of land, vehicles, draft animals, or machinery and tools; and to other
individuals and local groups in developing countries, in both rural and urban areas‘. For several decades,
many economies, including the Indian, experimented with subsidized credit for the poor. But the only
tangible outcome perhaps was the increase in Non-Performing Assets (NPA). Then came the realization
that the core issue for the poor was access to credit rather than the cost of credit. In fact one of the
contributions of microfinance can possibly be the ‗end of interest rate debate‘.
        Microfinance has proved time and again that it is access and not interest rates that are a
constraint for the poor. Another discovery followed, that the poor can and will save, and can indeed use
a wide range of financial services such as remittances facilities and insurance products. The most well
known and cited international example of a microcredit institution is the Grameen Bank in Bangladesh.
But there are numerous others. Even during the Asian financial crisis, Bank Rayat Indonesia not only
survived but thrived; as did BancoSol in Bolivia.
A bewildering range of players have jumped on to the microfinance bandwagon — for a variety of
reasons. There have been NGOs which gradually metamorphosed into lending institutions, developmental
professionals who have set up microfinance companies and banks that have experimented with working
exclusively with groups and therefore have ‗microfinance branches‘. These range from not-for profits that
see microfinance as having a role in ‗development‘, to commercial banks that view microfinance as
‗good, sound banking‘, an excellent way of raising deposits, and lending at low risk. In fact the success of
groups in microfinance has attracted the attention of wide-ranging players to use these groups for a
range of purposes. Several governmental schemes are being routed through microfinance, including a
very large project funded by the World Bank and being implemented in the state of Andhra Pradesh.
Similarly organizations like Hindustan Lever have looked at the potential of these groups as a channel for
retailing and have launched a programme called ‗Project Shakti‘ to tap the smaller villages through the
microcredit channel.
    Microfinance leaders are gaining prominence and it is said that some of the leaders, particularly
women, have been taking a more active role in other social spheres, including contesting elections for
the panchayat and so on. The Indian microfinance sector is a museum of several approaches found
across the world. Indian microfinance has lapped up the Grameen blueprint; it has replicated some
aspects of the Indonesian and the Bolivian model.



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2 Brief Overview of status of Microfinance in India

Preamble
        In Indian Scenario, the present structure of microfinance technology reveals that it is poised for
an economic transformation and livelihood restoration of the rural communities. Whereas the fact is
obvious that there is gap in best practices in credit delivery, lack of product diversification, customer
overlapping and duplications, consumption and individual loan demand with lack of mitigation measures,
less thrust on enterprise loans, collection of savings/loans and malpractices by Self Help Groups (SHGs)
and Micro Finance Institutions (MFIs) and highest interest rate prevailing in micro finance sector. All
these are clear syndromes, which tell us that the situation is moving without any direction. The system
does not any longer like to follow the traditional discipline and there is no Government Regulations to
regulate the micro finance industry.
        On the contrary, microfinance practitioners (MFIs) are not seemingly prepared for
commercialization but the situation is pushing them towards it, beyond their knowledge. There is no
alternative to commercialization as it is the crux of competition. Competition here refers to the market
share among the financial intermediaries that are targeting a market comprising customers having
similar needs or wants. Clearly, to be successful, the Micro Finance Institutions marketing strategy must
meet the customer‘s requirements.
        The MFI that is onto microfinance delivery must effectively position itself against competition
within the industry. Thus the importance of planning a marketing strategy is to find ways of effectively
positioning the MFI against competition in the mindset of the customers. This, in other words, is to build
an edge against the competition. In fact, the effectiveness of marketing programs depends on the
reaction of both customer and the competitor. Also an MFI should frequently compare its products,
prices, promotion and delivery of services with its close competitors to keep their market potential. Even
though Microfinance institutions are driven by mere social commitment to combat poverty, the scale and
performance of the microfinance sector is slowly approaching the banking system. Hence MFIs should
focus their credit approach in a more market-oriented perspective.


To summarize the above data following arguments can be put forth:
Considerable gap between demand and supply for all financial services
Majority of poor are excluded from financial services. This is due to, inter-Alia, the following reasons
           Bankers feel that it is fraught with risks and uncertainties.
           High transaction costs
           Unfavourable policies like caps on interest rates which effectively limits the viability of
            serving the poor.




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   While MFIs have shown that serving the poor is not an unviable proposition there are issues that
have constrained MFIs while scaling up. These include
          Lack of an appropriate legal vehicle
          Limited access to equity
          Difficulty in accessing low cost on-lending funds (as of now they are unable to offer savings
           services in a legitimate
          Limited access to Capacity Building support which is an important variable in terms of quality
           of the portfolio, MIS, and the sustainability of operations.
          About 56 % of the poor still borrow from informal sources.
          70 % of the rural poor do not have a deposit account
          87 % have no access to credit from formal sources.
          Less than 15 % of the households have any kind of insurance.
          Negligible numbers have access to health insurance.




2.1 Features of Indian MF Industry:

      About 60 % of the MFIs are registered as societies.
      About 20 % are Trusts
      About 65 % of the MFIs follow the operating model of SHGs.
      Large concentration in South India
      600 MFI initiatives have a cumulative outreach of 1.25 crore poor households
      NABARD‘s bank linkage program has cumulatively reached a total of 9.4 lakh SHGs with about
       1.4 crore households.




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3 Credit scoring model

3.1 Introduction:
      Credit scoring uses quantitative measures of the performance and characteristics of past loans to
predict the future performance of loans with similar characteristics. For lenders in rich countries in the
past decade, scoring has been one of the most important sources of increased efficiency. Lenders in rich
countries, however, score potential borrowers based on comprehensive credit histories from credit
bureaux and on the experience and salary of the borrower in formal wage employment. Most
microfinance lenders, however, do not have access to credit bureaux, and most of their borrowers are
poor and self-employed. The two chief innovations of microfinance—loans to groups whose members use
their social capital to screen out bad risks and loans to individuals whose loan officers get to know them
well enough to screen out bad risks—rely fundamentally on qualitative information kept in the heads of
people. Scoring, in contrast, relies fundamentally on quantitative information kept in the computers of a
lender. Can microfinance lenders use scoring to cut the costs of arrears and of loan evaluations so as to
improve efficiency and thus both outreach and profitability? Experiments in Bolivia and Colombia
(Schreiner 2000, 1999a, 1999b) suggest that scoring for microfinance can indeed improve the judgment
of risk and thus cut costs. For example, scoring may save a Colombian microfinance lender about
$75,000 per year (Schreiner, 2000). In present value terms, this approaches $1 million. Scoring is
probably the next important technological innovation in microfinance, but scoring will not replace loan
groups or loan officers, and it will never be as effective as it is in rich countries because much of the risk
of microloans is unrelated to characteristics that can be quantified inexpensively. Still, scoring can still be
useful in microfinance because some risk is related to characteristics that are inexpensive to quantify,
and current microfinance technologies do not seem to take advantage of this as much as they could.




3.2 How does it work???
      A credit-scoring model is a formula that puts weights on different characteristics of a borrower, a
lender, and a loan. The formula produces an estimate of the probability or risk that an outcome will
occur. For example, suppose a lender might want to estimate the likelihood (risk) that a given loan to a
given borrower will have at least one spell of arrears of seven or more days. A simple scoring model
might state that the base risk for very small loans to manufacturers is 0.12 (12 percent), that traders are
two percentage points (0.02) less risky, and that each $100 disbursed increases risk by half a
percentage point (0.005). Thus, a trader with a $500 loan would have a predicted risk of 12.5 percent
(0.12 - 0.02 + 5*0.005), and a manufacturer with a $1,000 loan would have a predicted risk of 18
percent (0.12 + 0.02 + 10*0.005). The weights in the formula are derived with statistics, but, the math
is the easy part; the difficult part is to collect data on the performance and characteristics of past loans,



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to graft scoring into the current loan-evaluation process, and to adjust the organization to accept a
technique so fundamentally different from what has been successful so far.


3.2.1 Database for scoring:
Microfinance lenders who want to use credit scoring in the future should start to collect appropriate data
now. Without a data base on the performance and characteristics of many past loans, scoring is
impossible; lenders with small portfolios may never be able to use scoring.
The data base should also include a full range of characteristics of the borrower, the lender, and the loan,
as well as data on the timing and length of each spell of arrears in each loan. These characteristics are
all simple and inexpensive to collect, and most microfinance lenders already collect them when the loan
officer visits a potential borrower.
Furthermore, all microfinance lenders who want to use scoring—even those who already have large,
comprehensive data bases—should start to quantify and record the subjective assessments of loan
officers. In the field, loan officers are still free to use their sixth sense and to sniff for hints of risk as they
see fit, but back at the office, they should convert their subjective judgments into quantitative forms
amenable to scoring. For example, they could rate potential borrowers as very below average, below
average, average, above average, or very above average on such qualities as reputation in the
community, entrepreneurship, experience with debt, and informal support networks.




TYPE 1:




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TYPE 2:
Formula scorecard
Forecast = 0.16 x ‘Basic risk’ + 0.05 x Manufacturer – 0.02 x Years in business + 0.01 x Days
late last loan
       ‗Manufacturer‘=1 if manufacturer, 0 if not
       Weights based on judgment or on data
       Characteristics and weights in the formula
       Vary by lender; one size does not fit all


Example 1: Formula risk forecast
        = 0.16 x 1 (Basic risk) + 0.05 x 0 (Retailer) – 0.02 x 5 (5 years in business) + 0.01 x 0 (No
arrears last loan)
        = 0.06 = Forecast risk of 6%


Example 2: Formula risk forecast
        = 0.16 x 1 (Basic risk) + 0.05 x 1 (Manufacturer) – 0.02 x 1 (1 year in business) + 0.01 x 5 (5
days late last loan)
        = 0.24 = Forecast risk of 24%


        Type of business: Business Weight (%pts.)
        Taxi –3.6
        Corner store –2.1
        Fried Street food –1.2
        Others 0
        Beauty salon +0.5
        Clothes making +1.4
        Farming +1.7
        Construction +2.3
        Carpentry +4.0




3.3 What Types of risk to predict??
                 Once data are in hand, microfinance lenders must choose what type of risk to predict.
        Scoring is most useful for risks that are costly for the lender and that the lender has some power

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    to control. For example, one-day spells of arrears may be frequent but not very costly, whereas
    fifteen-day spells may be infrequent but very costly. Scoring is probably better used to predict
    fifteen-day spells than one-day spells. Likewise, scoring could be used to predict default due to
    the death of the borrower, but lenders have little control over this risk, even if they can predict
    it. Given these criteria, six basic types of scoring models are relevant for microfinance. The first
    model predicts the likelihood that a loan currently outstanding or currently approved for
    disbursement under the standard loan-evaluation process will have at least one spell of arrears
    of at least x days (Schreiner, 2000 and 1999b). This information can be used to guide risk-based
    pricing or to mark potential loans for extra review or outstanding loans for a preventive visit from
    a loan officer even before they fall into arrears. The second type of model predicts the likelihood
    that a loan x days in arrears now will eventually reach y days of arrears. This information can be
    used to prioritize visits by loan officers to delinquent borrowers. The third type of model predicts
    the likelihood that a borrower with an outstanding loan in good standing will choose not to get a
    new loan once the current one is repaid (Schreiner, 1999a). This information can be used to offer
    incentives to good borrowers who are likely to drop out. The fourth type of model predicts the
    expected term to maturity of the next loan of a current borrower. Likewise, the fifth type of
    model predicts the expected size of disbursement of the next loan. Sixth and finally, the ultimate
    scoring model combines information from the first five models with knowledge of the expected
    revenue of a loan with a given term to maturity and disbursement and with knowledge of the
    expected costs of drop-outs, loan losses, and monitoring borrowers in arrears. This ultimate
    model—currently used by credit-card lenders in rich countries—estimates the financial present
    value of the relationship with the client. It gauges not the client‘s risk but rather her profitability.
    Of course, estimating profitability does not imply that lenders must reject all unprofitable clients;
    it merely helps them to know better the trade-offs between profits and depth of outreach
    (Schreiner, 1999c). Most microfinance lenders will most likely start with one of the simple models
    and, if they find that the first one works well, add the other simple models one at a time.




4 Risk management in microfinance


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      Micro finance assets fall under the ―Other Retail assets‖ category under Basel II and has been
   assigned a risk weight of 75%. Like the Germans lobbied with the Basel committee, based on
   empirical research and lowered the risk weight for SME assets, Banks can study the historical data
   related with frequency of risk factors, severity of risk events, probability of defaults and actual
   defaults in micro credit and shall bring out a case to the RBI for prescribing a reduced risk weight to
   Micro finance assets under the Basel II. In which case, as the micro finance portfolio would require
   lower capital, it would encourage more banks to enlarge the exposure under the micro finance
   portfolio, which would be perceived as less risk portfolio and this will lead to greater outreach to the
   poor with more inclusive financial sector growth.


   Risk is inherent in any lending activity and so also in lending to SHGs and MFIs by banks, where no
   collaterals are taken. Risk management aims at identifying the risks, measuring them, evolving
   strategies for risk mitigation, implementing the strategies and monitoring the risk. Microfinance
   portfolio is mainly exposed to the Credit risk and Operational risk. Credit risk is the possibility of
   losses associated with diminution in the credit quality of the SHGs or NGOs or MFIs or CBOs as the
   case may be. E.g. SHG not repaying the loan installment and becoming delinquent Operational risk
   is the risk of loss resulting from inadequate or failed internal processes, people and systems or from
   external events. E.g. SHG leader commits a fraud and uses SHG Bank loan proceeds of another
   member for her use. The risk factors (having potential to cause a loss to the bank in the near term)
   which are bound to be prominent at the SHG & NGO level have been looked into in-depth, from the
   view point of implementing Branch Manager‘s perception.




4.1 Bank related measures:
             Banks should ensure that only a part of the group shares the SHG Bank loan (the Loan
              not shared by all members) at any given point of time so as to maintain the peer
              pressure in the group.
             Banks should encourage the SHGs to take short term loans (of 8 months, 10 months and
              12 months periods) initially and build a credit history in the bank.
             Banks should give the repeat loans to the SHGs within a short period, which will reinforce
              the message to others that once the SHG closes the loan, they will get the next higher
              loan quickly.
             Banks shall ask the SHGs to take up a restructuring exercise after each loan and before
              the release of the subsequent loan, which will add to the stability of the group. (.i.e.
              removing any member if they violated any rules in the previous loan cycle or changing
              the leader if required)
             After 2 or 3 successful loan repayments, when an individual member of a SHG wants a
              larger loan of above Rs50,000 (1136.36 US dollars) in a SHG bank loan, such individual




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             cases may be segregated from the group loan and migrated by the banks and considered
             under the Individual loan schemes.
            Banks should ensure that the SHG loan reaches the ultimate SHG members in a
             transparent way.
            Banks shall encourage the SHG members to come to the bank in rotation every month.
            Banks may put in place a MIS that will supply the required extensive data on SHGs
             lending, for the better risk management.
            For SHG loans of upto Rs2 lakhs (4545.45 US dollars) also, the credit risk rating tool
             suggested in this study as given in the annexure I, shall be used to internalize the
             process of risk based lending.
            For SHG loans of above Rs2 lakhs (4545.45 US dollars) categories, Banks shall rate the
             groups (using the credit risk rating tool given in the annexure II) every year on an
             ongoing basis and offer risk based pricing.
            Banks shall offer Micro insurance products to the SHGs in tie up with the insurance
             companies to protect against the life and non-life risks.
            Banks shall enter into strategic alliance with NGOs and share the group promotion costs.
            Banks shall consider the credit risk rating tools suggested in this study as given in the
             annexure I and II as a base and shall develop their own SHG credit risk rating tools to
             suit their context. The calibration on the risk rating scale can be linked with credit
             decision making especially with reference to loan amount, tenure and pricing of the loan.
             The risk based pricing will encourage the SHGs to keep up the credit discipline and
             enforce the repayment ethics.




4.2 NABARD related measures:
            It shall increase their group promotion grants to NGOs
            It shall form Micro Credit Information Bureaus at the district level as a pilot and make
             available the credit histories of the SHGs to the banks over online.
            It shall organize more capacity building programs for NGOs and CBOs on basic risk
             management strategies in Micro finance.
            It shall offer capacity building grants to NGOs for conducting Micro finance risk
             awareness programs for SHG leaders




4.3 NGO related measures:
     NGO shall take up internal auditing of SHGs through their field staff and ensure that the external
      audit by Chartered accountants be taken up once in a year.




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     The contents of the balance sheet and Income & Expenses of the SHG should be explained to all
      the members of SHG and ensure financial transparency.
     NGOs should arrange for need based micro enterprise management training to the SHGs before
      recommending them for larger loans for group activities and should offer handholding support
      during the initial period of commencement of the new activity.
     NGOs shall select active SHG leaders as their field staff to prevent the staff turnover problem.
     NGOs should train more than one person in SHG accounts writing.
     NGOs shall insist that leaders of SHGs should be changed once in 2 or 3 years as per the
      provisions of the group bye laws.
     NGOs shall form Federation of SHGs (CBOs) and train them to take up the responsibility from the
      NGOs for monitoring of SHGs.




4.4 Government related measures:
     Government departments should limit the delivery responsibilities of the SHGs for selective
      programs only matching with its capability.
     Government should change the mode from rapid growth to consolidation phase so as to ensure a
      growth with stability and improve the quality of the groups.


  Conclusion:

      The essence of finance is the prediction of the risk of whether borrowers will keep their promises.
      Risk estimates are based on information, and in microfinance, this information is usually
      qualitative and informal and resides with group members or with loan officers. Credit scoring
      takes a different tack. It predicts risk based on quantitative information that resides in the
      management-information system of the lender. Up to now, microfinance lenders have depended
      almost exclusively on informal, qualitative information.




5 Microfinance-Credit lending models

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       There are various lending models through which micro credit or micro finance services can be
forwarded. They are as follows:




5.1 Associations:
This is where the target community forms an 'association' through which various microfinance (and
other) activities are initiated. Such activities may include savings. Associations or groups can be
composed of youth, or women; they can form around political/religious/cultural issues; can create
support structures for micro enterprises and other work-based issues.
In some countries, an 'association' can be a legal body that has certain advantages such as collection of
fees, insurance, tax breaks and other protective measures. Distinction is made between associations,
community groups, peoples organizations, etc. on one hand (which are mass, community based) and
NGOs, etc. which are essentially external organizations.




5.2 Bank Guarantees:
As the name suggests, a bank guarantee is used to obtain a loan from a commercial bank. This
guarantee may be arranged externally (through a donor/donation, government agency etc.) or internally
(using member savings). Loans obtained may be given directly to an individual, or they may be given to
a self-formed group.
Bank Guarantee is a form of capital guarantee scheme. Guaranteed funds may be used for various
purposes, including loan recovery and insurance claims. Several international and UN organizations have
been creating international guarantee funds that banks and NGOs can subscribe to, to on lend or start
micro credit programmes.




5.3 Community Banking:
The Community Banking model essentially treats the whole community as one unit, and establishes
semi-formal or formal institutions through which microfinance is dispensed. Such institutions are usually
formed by extensive help from NGOs and other organizations, who also train the community members in
various financial activities of the community bank. These institutions may have savings components and
other income-generating projects included in their structure. In many cases, community banks are also
part of larger community development programmes which use finance as an inducement for action.




5.4 Cooperatives:
A co-operative is an autonomous association of persons united voluntarily to meet their common
economic, social, and cultural needs and aspirations through a jointly-owned and democratically-



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controlled enterprise. Some cooperatives include member-financing and savings activities in their
mandate.




5.5 Credit Unions:
      A credit union is a unique member-driven, self-help financial institution. It is organized by and
comprised of members of a particular group or organization, who agree to save their money together
and to make loans to each other at reasonable rates of interest.
The members are people of some common bond: working for the same employer; belonging to the same
church, labor union, social fraternity, etc.; or living/working in the same community. A credit union's
membership is open to all who belong to the group, regardless of race, religion, color or creed.
A credit union is a democratic, not-for-profit financial cooperative. Each is owned and governed by its
members, with members having a vote in the election of directors and committee representatives.




5.6 Grameen:
      The Grameen model emerged from the poor-focused grassroots institution, Grameen Bank, started
by Prof. Mohammed Yunus in Bangladesh. It essentially adopts the following methodology:
A bank unit is set up with a Field Manager and a number of bank workers, covering an area of about 15
to 22 villages. The manager and workers start by visiting villages to familiarize themselves with the local
milieu in which they will be operating and identify prospective clientele, as well as explain the purpose,
functions, and mode of operation of the bank to the local population. Groups of five prospective
borrowers are formed; in the first stage, only two of them are eligible for, and receive, a loan. The group
is observed for a month to see if the members are conforming to rules of the bank. Only if the first two
borrowers repay the principal plus interest over a period of fifty weeks do other members of the group
become eligible themselves for a loan. Because of these restrictions, there is substantial group pressure
to keep individual records clear. In this sense, collective responsibility of the group serves as collateral
on the loan.




5.7 Group:
        The Group Model's basic philosophy lies in the fact that shortcomings and weaknesses at the
individual level are overcome by the collective responsibility and security afforded by the formation of a
group of such individuals.
The collective coming together of individual members is used for a number of purposes: educating and
awareness building, collective bargaining power, peer pressure etc.


5.8 Individual:
      This is a straight forward credit lending model where micro loans are given directly to the
borrower. It does not include the formation of groups, or generating peer pressures to ensure

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repayment. The individual model is, in many cases, a part of a larger 'credit plus' programme, where
other socio-economic services such as skill development, education, and other outreach services are
provided.




5.9 Intermediatories:
Intermediary model of credit lending position is a 'go-between' organization between the lenders and
borrowers. The intermediary plays a critical role of generating credit awareness and education among the
borrowers (including, in some cases, starting savings programmes. These activities are geared towards
raising the 'credit worthiness' of the borrowers to a level sufficient enough to make them attractive to
the lenders.
The links developed by the intermediaries could cover funding, programme links, training and education,
and research. Such activities can take place at various levels from international and national to regional,
local and individual levels.
Intermediaries could be individual lenders, NGOs, micro enterprise/micro credit programmes, and
commercial banks (for government financed programmes). Lenders could be government agencies,
commercial banks, international donors, etc.




5.10 Non-Governmental Organizations:
NGOs have emerged as a key player in the field of micro credit. They have played the role of
intermediary in various dimensions. NGOs have been active in starting and participating in micro credit
programmes. This includes creating awareness of the importance of micro credit within the community,
as well as various national and international donor agencies. They have developed resources and tools
for communities and micro credit organizations to monitor progress and identify good practices. They
have also created opportunities to learn about the principles and practice of micro credit. This includes
publications, workshops and seminars, and training programmes.




5.11 Peer Pressure:
Peer pressure uses moral and other linkages between borrowers and project participants to ensure
participation and repayment in micro credit programmes. Peers could be other members in a borrowers
group (where, unless the initial borrowers in a group repay, the other members do not receive loans.
Hence pressure is put on the initial members to repay); community leaders (usually identified, nurtured
and trained by external NGOs); NGOs themselves and their field officers; banks etc. The 'pressure'
applied can be in the form of frequent visits to the defaulter, community meetings where they are
identified and requested to comply etc.




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5.12 Rotating Savings and Credit Associations:
Rotating Savings and Credit Associations (ROSCAs) are essentially a group of individuals who come
together and make regular cyclical contributions to a common fund, which is then given as a lump sum
to one member in each cycle. For example, a group of 12 persons may contribute Rs. 100 (US$33) per
month for 12 months. The Rs. 1,200 collected each month is given to one member. Thus, a member will
'lend' money to other members through his regular monthly contributions. After having received the
lump sum amount when it is his turn (i.e. 'borrow' from the group), he then pays back the amount in
regular/further monthly contributions. Deciding who receives the lump sum is done by consensus, by
lottery, by bidding or other agreed methods.




5.13 Small Business:
      The prevailing vision of the 'informal sector' is one of survival, low productivity and very little value
added. But this has been changing, as more and more importance is placed on small and medium
enterprises (SMEs) - for generating employment, for increasing income and providing services which are
lacking.
Policies have generally focused on direct interventions in the form of supporting systems such as
training, technical advice, management principles etc.; and indirect interventions in the form of an
enabling policy and market environment.
A key component that is always incorporated as a sort of common denominator has been finance,
specifically micro credit - in different forms and for different uses. Micro credit has been provided to
SMEs directly, or as a part of a larger enterprise development programme, along with other inputs.




5.14 Village Banking:
           Village banks are community-based credit and savings associations. They typically consist of 25
to 50 low-income individuals who are seeking to improve their lives through self-employment activities.
Initial loan capital for the village bank may come from an external source, but the members themselves
run the bank: they choose their members, elect their own officers, establish their own by-laws, distribute
loans to individuals, and collect payments and savings. Their loans are backed, not by goods or property,
but by moral collateral: the promise that the group stands behind each individual loan.




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6 Grameen Bank Model
    The origin of Grameen Bank can be traced back to 1976 when Professor Muhammad Yunus, a
Fulbright scholar at Vanderbilt University and Professor at University of Chittagong, launched a research
project to examine the possibility of designing a credit delivery system to provide banking services
targeted to the rural poor. In October 1983, the Grameen Bank Project was transformed into an
independent bank by government legislation. The organization and its founder, Muhammad Yunus, were
jointly awarded the Nobel Peace Prize in 2006; the organization‘s Low-cost Housing Programme won a
World Habitat Award in 1998.
    Yunus believes that in developing countries, people should stop looking for jobs and start creating
them. A poor person should take a small loan and start her own business -- and that will make her big
enough to employ others. That has been Grameen Bank's philosophy since its inception. "The way we
have designed education encourages students to work hard and study hard to get the best jobs. We need
to discuss what to do so that we can go to work for ourselves. Human beings are not slaves so we need
not work for someone else as a rule," Yunus notes. Grameen requires all the children of its borrowers to
attend school so that they can work towards a better life.




6.1 Method of Operation:

        The Grameen Bank operates through a network of bank branches located in rural areas. These
branches comprise a bank manager and a number of centre managers representing between 15 to 22
villages. Credit officers visit these villages and through rigorous selection decide to finance small
voluntary groups of five individuals who show commitment to viable income-generating activities, such
as rice-husking, machine repairing, pottery and garment making, weaving, buying of milk cows, goats,
etc. Borrowers have freewill to choose the nature of their productive or investment activity based on the
skills they possess.
        A borrower can only receive loans by forming part of a borrowing group, as trust and peer
pressure are the operational mandates for ensuring the repayment of loans. In this way, the pressures of
collective responsibility replace the need for conventional collateral requirements and give the GB system
its strength. Initially, only two group members receive a first loan, for which they are given a six week
period to begin repaying the principal and interest before the remaining members in the group become
eligible for receiving loans. New loans for any member are only available once all previous loans have
been repaid.
        The Grameen Bank aims to keep interest rates as close as possible to the market rate, normally
about 16 percent, while maintaining an overarching goal of programme sustainability. GB requires a
repayment scheme based on 50 weekly installments, and encourages savings by allowing 5 percent of
loans to be credited to a group fund. The Grameen Bank receives most of its loanable funds on



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commercial terms from the central bank, other financial institutions, the money market, and from
various aid organizations.
        The Bank works to simultaneously address the greater social development agenda of the poor,
including housing, education, sanitary water, environmental health, and other basic social and economic
needs. To increase its efficiency, the Bank also invests heavily in its human resources, to ensure staff
members are dedicated and well-trained on both the Grameen credit system as well as the particulars of
the rural villages in which the Bank serves.




Successes and Potential Benefits of the Grameen Bank Microcredit System:
            1. The Grameen Bank exhibits an average of 97 percent repayment rates;
            2. GB members enjoy an average household income at least 25 percent higher than
                nonmembers;
            3. The number of GB members living below the poverty line has sharply decreased;
            4. The landless benefit most, followed by marginal landowners;
            5. There has been a shift from agricultural wage labour to self-employment and petty
                trading— a shift which results in an indirect positive effect on the employment and wages
                of other agricultural wage laborers, and which has impacted poverty alleviation and
                economic improvement at a national level;
            6. Group savings have proven as successful as group lending.




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7 Role of Self Help Groups & Microfinance Institutions


7.1 Self Help Groups
Self-Help Group (SHG) is a small voluntary association of poor people, preferably from the same socio-
economic background. They come together for the purpose of solving their common problems through
self-help and mutual help. The SHG promotes small savings among its members. The savings are kept
with a bank. This common fund is in the name of the SHG. Usually, the number of members in one SHG
does not exceed twenty.


The SHGs comprise very poor people who do not have access to formal financial institutions. They act as
the forum for the members to provide space and support to each other. It also enables the members to
learn to cooperate and work in a group environment. The SHGs provide savings mechanism, which suits
the needs of the members. It also provides a cost effective delivery mechanism for small credit to its
members. The SHGs significantly contribute to the empowerment of poor women. Creation of SHGs can
be done by Non Governmental Organizations (NGOs) Social Workers, health workers, village level
workers, etc Informal Associations of local people Development oriented government departments Banks
Bank personnel and other individuals.


The SHG-bank linkage program is targeted to reach the poorest sections, which are bypassed by the
formal banking system. Therefore, it is essential that only the very poor be considered as the target
group for the SHG -bank linkage program. An SHG can be all-women group, all-men group, or even a
mixed Group. However, it has been the experience that women's groups perform better in all the
important activities of SHGs. Mixed group is not preferred in many of the places, due to the presence of
conflicting interests.


As soon as the SHG is formed and a couple of group meetings are held, an SHG can open a Savings Bank
account with the nearest Commercial or Regional Rural Bank or a Cooperative Bank. This is essential to
keep the thrift and other monies of the SHG safely and also to improve the transparency levels of SHG's
transactions. Opening of SB account, in fact, is the beginning of relationship between the bank and the
SHG. The Reserve Bank of India has issued instructions to all banks permitting them to open SB
accounts in the name of registered or unregistered SHGs.


By initially managing their own common fund for some time, SHG members not only take care of the
financing needs of each other, but develop their skills of financial management and intermediation as
well. Lending to members also enhances the knowledge of SHG members in setting the interest rate and
periodic loan installments, recovering the loan, etc.



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7.1.1 Indicators of a good SHG

●        Homogeneous membership: As far as possible, the membership of an SHG may comprise
people from comparable socio-economic background. Though difficult to define in clear terms, a major
indicator of homogeneity in membership is absence of conflicting interests among members.
●        No discrimination: There should not be any discrimination among members based on caste,
religion or political affiliations
●        Small membership: Ideally, the group size may be between 15 and 20, so that the members
are participative in all activities of the SHG. In a smaller group, members get opportunity to speak
openly and freely. However, the membership may not be too small that its financial transactions turn out
to be insignificant.
●        Regular Attendance: Total participation in regular group meetings lends strength to the
effectiveness of SHGs. To achieve this, the SHGs should place strong emphasis on regular attendance in
the group meetings.
●        Transparency in functioning: It is important that all financial and non-financial transactions
are transparent in an SHG. This promotes trust, mutual faith and confidence among its members.
Maintenance of books of accounts as also other records like the minutes book, attendance register, etc.,
are important.
●        Set of Byelaws: The SHG may discuss and finalize a set of byelaws, indicating rules and
regulations for the SHG's functioning and also roles and responsibilities of members. It is better to have
a written set of byelaws. The Self Help Promoting Institution (SHPI) and bank may guide the SHGs in
this.
●        Thrift: The habit of thrift (small savings) is fundamental to the SHG and helps in building up a
strong common fund.
●        Utilizing savings for loaning: Once an SHG has accumulated sizeable amount in the form of
savings say for a period of about 3-6 months, the members may be allowed to avail loans against their
savings for emergent consumption and supplementary income generating credit needs.




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7.2 Microfinance Institutions (MFI’s)
Informal institutions that undertake micro finance services as their main activity are generally referred to
as micro Finance Institutions (MFI‘s). While both private and public ownership are found in the case of
formal financial institutions offering micro finance services, the MFI‘s are mainly in the private sector.


Micro finance service providers include apex institutions like National Bank for Agriculture and Rural
Development (NABARD), Small Industries Development Bank of India (SIDBI), and, Rashtriya Mahila
Kosh (RMK). At the retail level, Commercial Banks, Regional Rural Banks, and, Cooperative banks
provide micro finance services. As on March 31, 2007, 28.94 lakh SHGs had outstanding bank
loans of Rs.12, 366.49 crore. While commercial banks accounted for 70.8 per cent of the
outstanding loans, RRBs and cooperative banks accounted for 22.7 per cent and 6.5 per cent,
respectively.


MFI‘s in India can be broadly sub-divided into three categories of organizational forms as given in Table
below:


Table 1: Legal Forms of MFI‘s in India

Types of MFI’s                           Estimated    Legal Acts under which Registered
                                         Number*

 Not for Profit MFI’s

a.) NGO - MFI‘s                          400 to 500   Societies Registration Act, 1860 or similar
                                                      Provincial Acts
                                                      Indian Trust Act, 1882

b.) Non-profit Companies                 10           Section 25 of the Companies Act, 1956

Mutual Benefit MFI’s

a.)   Mutually    Aided   Cooperative 200 to 250      Mutually Aided Cooperative Societies Act
Societies (MACS) and similarly set                    enacted by State Government
up institutions

For Profit MFI’s

a.)      Non-Banking         Financial 6              Indian Companies Act, 1956
Companies (NBFCs)                                     Reserve Bank of India Act, 1934




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NGO MFI’s: There are a large number of NGOs that have undertaken the task of financial
intermediation. Majority of these NGOs are registered as Trust or Society. Many NGOs have also helped
SHGs to organize themselves into federations and these federations are registered as Trusts or Societies.
Many of these federations are performing non-financial and financial functions like social and capacity
building activities, facilitate training of SHGs, undertake internal audit, promote new groups, and some of
these federations are engaged in financial intermediation. The NGO MFI‘s vary significantly in their size,
philosophy and approach. Therefore these NGOs are structurally not the right type of institutions for
undertaking financial intermediation activities, as the byelaws of these institutions are generally
restrictive in allowing any commercial operations. These organizations by their charter are non-profit
organizations and as a result face several problems in borrowing funds from higher financial institutions.
The NGO MFI‘s, which are large in number, are still outside the purview of any financial regulation. These
are the institutions for which policy and regulatory framework would need to be established.


Non-Profit Companies as MFI’s: Many NGOs felt that combining financial intermediation with their
core competency activity of social intermediation is not the right path. It was felt that a financial
institution including a company set up for this purpose better does banking function. Further, if MFI‘s are
to demonstrate that banking with the poor is indeed profitable and sustainable, it has to function as a
distinct institution so that cross subsidization can be avoided. On account of these factors, NGO MFI‘s are
of late setting up a separate Non-Profit Companies for their micro finance operations. The MFI is
prohibited from paying any dividend to its members. In terms of Reserve Bank of India‘s Notification
dated 13 January 2000, relevant provisions of RBI Act, 1934 as applicable to NBFCs will not apply for
NBFCs (i) licensed under Section 25 of Companies Act, 1956, (ii) providing credit not exceeding Rs.
50,000 ($1112) for a business enterprise and Rs. 1, 25,000 ($2778) for meeting the cost of a dwelling
unit to any poor person, and, (iii) not accepting public deposits.


Mutual Benefit MFI’s: The State Cooperative Acts did not provide for an enabling framework for
emergence of business enterprises owned, managed and controlled by the members for their own
development. Several State Governments therefore enacted the Mutually Aided Co-operative Societies
(MACS) Act for enabling promotion of self-reliant and vibrant co-operative Societies based on thrift and
self-help. MACS enjoy the advantages of operational freedom and virtually no interference from
government because of the provision in the Act that societies under the Act cannot accept share capital
or loan from the State Government. Many of the SHG federations, promoted by NGOs and development
agencies of the State Government, have been registered as MACS. Reserve Bank of India, even though
they may be providing financial service to its members, does not regulate MACS.


For Profit MFI’s: Non Banking Financial Companies (NBFC) are companies registered under Companies
Act, 1956 and regulated by Reserve Bank of India. Earlier, NBFCs were not regulated by RBI but in 1997
it was made obligatory for NBFCs to apply to RBI for a certificate of registration and for this certificate
NBFCs were to have minimum Net Owned funds of Rs 25 lakhs and this amount has been gradually


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increased. RBI introduced a new regulatory framework for those NBFCs who want to accept public
deposits. All the NBFCs accepting public deposits are subjected to capital adequacy requirements and
prudential norms. There are only a few MFI‘s in the country that are registered as NBFCs. Many MFI‘s
view NBFCs more preferred legal form and are aspiring to be NBFCs but they are finding it difficult to
meet the requirements stipulated by RBI. The number of NBFCs having exclusive focus on mF is
negligible.


Capital Requirements
NGO-MFI‘s, non-profit companies MFI‘s, and mutual benefit MFI‘s are regulated by the specific act in
which they are registered and not by the Reserve Bank of India. These are therefore not subjected to
minimum capital requirements, prudential norms etc. NGO MFI‘s to become NBFCs are required to have
a minimum entry capital requirement of Rs. 20 million ($ 0.5 million). As regards prudential norms,
NBFCs are required to achieve capital adequacy of 12% and to maintain liquid assets of 15% on public
deposits.


Foreign Investment
Foreign investment by way of equity is permitted in NBFC MFI‘s subject to a minimum investment of
$500,000. In view of the minimum level of investment, only two NBFCs are reported to have been able
to raise the foreign investment. However, a large number of NGOs in the development - empowerment
are receiving foreign fund by way of grants. At present, over Rs.40,000 million ($ 889 million) every year
flows into India to NGOs for a whole range of activities including micro finance. In a way, foreign donors
have facilitated the entry of NGOs into micro finance operations through their grant assistance.


Deposit Mobilization
Not for profit MFI‘s are barred, by the Reserve Bank of India, from mobilizing any type of savings. Mutual
benefit MFI‘s can accept savings from their members. Only rated NBFC MFI‘s rated by approved credit
rating agencies are permitted to accept deposits. The quantum of deposits that could be raised is linked
to their net owned funds.


Borrowings
Initially, bulk of the funds required by MFI‘s for on lending to their clients was met by apex institutions
like National Bank for Agriculture and Rural Development, Small Industries Development Bank Of India,
and, Rashtiya Mahila Kosh. In order to widen the range of lending institutions to MFI‘s, the Reserve Bank
of India has roped in Commercial Banks and Regional Rural Banks to extend credit facilities to MFI‘s
since February 2000. Both public and private banks in the commercial sector have extended sizeable
loans to MFI‘s at interest rate ranging from 8 to 11 per cent per annum. Banks have been given
operational freedom to prescribe their own lending norms keeping in view the ground realities. The
intention is to augment flow of micro credit through the conduit of MFI‘s. In regard to external
commercial borrowings (ECB) by MFI‘s, not-for-profit MFI‘s are not permitted to raise ECB. The current


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policy effective from 31 January 2004, allows only corporates registered under the Companies Act to
access ECB for permitted end use in order to enable them to become globally competitive players.


Interest Rates
The interest rates are deregulated not only for private MFI‘s but also for formal baking sector. In the
context of softening of interest rates in the formal banking sector, the comparatively higher interest rate
(12 to 24 per cent per annum) charged by the MFI‘s has become a contentious issue. Since most MFI‘s
have lower business volumes, and provide doorstep service, their transaction costs are far higher than
that of the formal banking channels.


Collateral requirements
All the legal forms of MFI‘s have the freedom to waive physical collateral requirements from their clients.
The credit policy guidelines of the RBI allow even the formal banks not to insist on any type of collateral
and margin requirement for loans up to Rs 50,000 ($1100).


Regulation & Supervision:
India has a large number of MFI‘s varying significantly in size, outreach and credit delivery
methodologies. Presently, there is no regulatory mechanism in place for MFI‘s except for those that are
registered as NBFCs. As a result, MFI‘s are not required to follow standard rule and it has allowed many
MFI‘s to be innovative in its approach particularly in designing new products and processes. But the flip
side is that the management and governance of MFI‘s generally remains weak, as there is no compulsion
to adopt widely accepted systems, procedures and standards. Because the sector is unregulated, not
much is known about their internal health.


To address the issue of need for a differential regulatory framework, the latest committee sought
answers to the following questions and concerns facing private MFI‘s in the Country:


(i) Is non-existence of a separate differential regulatory framework a critical bottleneck hindering the
growth of the sector?


(ii) Will MFI‘s be sustainable in medium term? If so, will they continue to focus on the poor?


(iii) Is access to public / member deposit the key issue for their sustainability?


(iv) Can MFI‘s finance loans for income generation at interest rates, which are sustainable by the rural
poor?


(v) Is it possible to evolve commonly agreed standards for MFI sector covering performance, accounting
and governance issues, which can open up possibilities of self-regulation?


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(vi) Has the sector reached a critical mass where regulation becomes important?


The Committee observed that while a few of the MFI‘s have reached significant scales of outreach, the
MFI sector as a whole is still in evolving phase as is reflected in wide debates ranging around (i)
desirability of NGOs taking up financial intermediation, (ii) unproven financial and organizational
sustainability of the model, (iii) high transaction costs leading to higher rates of interest being charged to
the poor clients, (iv) absence of commonly agreed performance, accounting and governance standards,
(v) heavy expectations of low cost funds, including equity and the start up costs, etc.


The current debate on development of a regulatory system for the MFI‘s focuses on three stages. Stage
one - to make the MFI‘s appreciate the need for certain common performance standards, stage two -
making it mandatory for the MFI‘s to get registered with identified or designated institutions and stage
three - to encourage development of network of MFI‘s which could function as quasi Self-Regulatory
Organizations (SROs) at a later date or identifying a suitable organization to handle the regulatory
arrangements. The Committee recommended that while the MFI‘s may continue to work as wholesalers
of micro Credit by entering into tie-ups with banks and apex development institutions, more
experimentation have to be done to satisfy about the sustainability of the MFI model. Such
experimentation needs to be encouraged in areas where banks are still not meeting adequate credit
demand of the rural poor.


In regard to offering thrift products, the Committee felt that, while the NGO-MFI‘s can continue to extend
micro credit services to their clients, they could play an important role in facilitating access of their
clients to savings services from the regulated banks. As regards allowing NGO-MFI‘s to access deposits
from public / clients, the Committee considers that in view of the need to protect the interests of
depositors, they may not be permitted to accept public deposits unless they comply with the extant
regulatory framework of the Reserve Bank of India. As no depositors' interest is involved where they do
not accept public deposits, the Reserve Bank of India need not regulate MFI‘s.


As regards the high interest rates being charged by the MFI‘s, the Committee felt that the lenders to
MFI‘s may ensure that these institutions adopt a ‗cost-plus- reasonable-margin‘ approach in determining
the rates of interest on loans to clients.




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7.2.1 Factors Influencing MFI Sustainability

        Since the competition will be more in micro finance industry in the upcoming years, the Five
Fold Factors like Challenges in Interest Rate, Win Over, Marketing Strategies, Customer Feedback and
Analysis and Marketing Audit have to be considered for catering to the needs of the rural customer need
thereby sustaining the credit operations by Micro Finance Institutions.
        a) Challenges in Interest Rate
        In micro finance industry, the commercial banks charge 12% interest for the loan amount on a
monthly diminishing method (monthly rest) for the principal loan amount outstanding. Hence the interest
paid by a customer will be much less when compared to the flat interest method (annual rest) applied by
the Micro Finance Institutions for their clients.


        In recent years, the SHG members are becoming aware of the latest prevailing rate of interest in
the banking industry and have already started questioning the Micro Finance Institutions to reduce the
interest rate. It is very difficult for Micro Finance Institutions to convince the SHG members by explaining
their operational cost involved in the operations. Further competition will force Micro Finance Institutions
to revise their interest rates towards survival.


        The pressure to lower interest rates may cause MFIs to look for ways and means to lower
operational costs via efficiencies, technological innovations, etc. Hence MFIs who can use technologies
and effective monitoring and management will be successful in lowering their interest rates will sustain in
the industry. Those MFIs who are unable to lower their costs are stuck with high interest rates and
eventually lose their client base. Hence interest rate will be a real challenge for the Micro Finance
Institutions for their sustainable credit operations.


        b) Win Over
        Competitiveness is a pre-requisite to remain in business. Competitors can be a resource rather
than a threat; and hence MFIs can adapt and/or improve on a competitor's product to sustain their
operations. In the competitive environment, developing creative means to increase operational efficiency
is a must. As an example, some microfinance institutions have already experimented with credit rating
systems and also have introduced palm pilots in the credit assessment process.
        The use of high-end information technology, however, has only started recently. It will play
crucial role for the future success in the microfinance industry. Developing effective market research and
marketing means is an additional key area of action to meet the challenges of competition.


        c) Marketing Strategies
        Microfinance like any other service businesses is more difficult to manage using traditional
Marketing approach. MFIs require not only external marketing but also internal marketing mechanisms.
Hence there is a felt need to motivate the employees and interactive marketing, to create employees



                                                                                                   Page 26
skills in the service provider. MFIs planning to professionalize its services must deliver ―high touch‖ as
well as ―high tech‖ in their delivery mechanisms.
        The Micro Finance Institutions can build an edge against the competition by means of adopting
the Three Fold Marketing strategies to retain the customer base.
   i.   Competitive Differentiation
  ii.   Product Differentiation
 iii.   Managing Service Quality


        i) Competitive Differentiation
        Micro Finance Institutions frequently face difficulty of differentiating their services from those of
competitors, particularly when the market is facing intensive price competition. The solution to price
competition is to develop a differentiated offer, delivery and brand image. The offer can include
innovative features to distinguish it from competitor offers. The customer expects loans for income
generation/consumption/education/housing Micro Finance Institutions or banks. These loan products can
be constituted under Primary Loan Service Package (PLSP). To retain customers and also for loan
value addition, along with PLSP, the Micro Finance Institutions can add Secondary Loan Service
Packages (SLSP) such as information dissemination on low cost housing technology, housing insurance
for Housing customers, EDP trainings, market support services, etc to non farm loan customers and
setting up agriculture clinics along with respective MFI branches to give technological inputs like soil
testing, pesticides, yield seeds, fertilizers, drip irrigation, crop insurance, monsoon/rainfall insurance etc.
to the agriculture loan customers. Also credit counseling and education/career guidance cell can be
established in each branch for the education loan applicants.


        ii) Product Differentiation
        The marginal communities who are the customers of MFIs should be perceived as valuable
customers. By designing products to the evolving needs of clients, the MFI can build client loyalty
through customer service thereby increasing the customer base. This means that the financial services
offered by a Micro Finance Institution must be designed in response to the needs and capacities of the
clientele.
        MFI Terms and condition on loans, and repayment should respond to the particular needs and
capacity of the client group. It is more important, that the products should be tested before launching in
the market. Product testing is used to gauge the perception of the customers on the suitability and
demand of the new products. This practice is yet to be made popular among the financial intermediaries.
        Microfinance should operate at ever new frontiers facilitated by research and development
leading to new products, demand and services in:
       Social security such as pension plan, life and health insurance
       Area Specific Loan Products (Loan for disaster, consumption, housing, education, micro-
        enterprise, Marriage etc and various poor- friendly savings products)
       Managing risk associated with natural calamities and personal/social disasters


                                                                                                      Page 27
        iii) Managing Service Quality
        The prime focus of MFIs to differentiate from Banks is to deliver consistently higher quality
service. The key factor is to meet or exceed the target customer‘s service quality expectations in
providing timely credit. The MFIs must change the attitude of seeing the borrowers as beneficiaries into
customers. Further the MFIs should retain their customers from one time borrower towards permanent
customers by taking into consideration of five determinants of service quality viz. reliability,
responsiveness, assurance, empathy and tangibles.
        d) Customers' Feedback and Analysis
        MFIs should be tuned and responsive to the client needs by product evolution, financial viability,
institutional soundness and social impact. For these reasons, marketing research has to be pursued and
new product ideas should be explored surveying customer needs, reacting towards client demands and
actions taken by competitors. This should be the basis of drawing a marketing plan and the way of
serving the customers.
        A Micro Finance Institution can explore new opportunities through signals from the market about
customers, competitors and overall environment in which the Micro Finance Institution operates.
Customers can voice their demand in the form of direct feedback to credit supervisors or field workers or
during group meetings for designing need based products.


        e) Marketing Audit
        A financial intermediary like MFI may find that performance problems occur in regular
frequencies. In fact, trying to deal with such problems the credit managers may neglect other important
responsibilities. Realistically, marketing is one of the major areas, where rapid changes in objectives,
policies, strategies and programs has to be reviewed and re-designed periodically. Because of the rapid
changes in the marketing environment, each MFI should periodically assess its marketing effectiveness
through marketing audit. Marketing audit is an in-depth assessment of marketing function to sustain
micro finance interventions.
        Conclusion
        The   Micro   Finance   Institutions   should   realize   that   real   customer   service   through
commercialization should be the bottom line for moving forward. In a competitive environment,
customer satisfaction and commercialization should be the driving force for survival and growth. It is
expected that competition will promote good governance and prudential management in MFIs, improve
access to finance, more innovations and variety and pave the way for commercialization of microfinance
sector. It is not a miss to conclude that the MFIs should consider the Five Fold Factors like Challenges
in Interest Rate, Win Over, Marketing Strategies, Customer Feedback and Analysis and Marketing Audit
as institutional challenges for catering to the needs of the rural customer need thereby sustaining the
credit operations by Micro Finance Institutions.




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7.3 Case study- Interest rate!!
Studies of a sample of MFI borrowers in Chile, Colombia, and the Dominican Republic show borrowers
were paying relatively high effective interest rates, averaging 6.3% per month. But these interest
payments made up a tiny fraction of their overall costs, ranging from 0.4% to 3.4%. (Castello, Stearns,
and Christen)


Example (from CGAP Occasional Paper No. 1):
           •    Take the case of a Bolivian woman who sells merchandise from a blanket that she
                spreads every day on a street in La Paz.
           •    Her sales, and thus her income, are directly proportional to the time she is sitting on the
                street, offering her goods. Because of her shortage of working capital, she spends two
                hours of each ten-hour workday traveling to purchase supplies from her wholesaler,
                whose warehouse is outside the city. These two hours produce no sales or income for
                her.
           •    If a working capital loan allows her to buy inventory for three days at a time instead of
                one, she can save eight hours in travel time each six-day week. This translates into a
                17% increase in selling time, and thus in her sales, every week.
           •    If the amount of the working capital loan is double her daily sales, and her gross profit is
                25% of sales, then she could afford to pay 40% a month on the loan and still come out
                slightly ahead. A loan from an MFI at, say, 5% per month would be immensely
                advantageous to her.




7.3.1 Borrowers’ Return on Investments
   •   Poor borrowers are able to pay interest rates that reflect the real cost of loans and still increase
       their profits and create more jobs.
   •   MFIs charging very high interest rates almost always find that demand far outstrips their ability
       to supply it. Most of their customers repay their loans, and return repeatedly for new loans. This
       pattern demonstrates the customers' conviction that the loans allow them to earn more than the
       interest that they have to pay.
   •   A poor entrepreneur, especially one engaged in trading, can generate greater benefits from
       additional units of capital than a highly capitalized business because he or she begins with so
       little. Studies covering India, Kenya, and the Philippines found that the average return on
       investments in Micro-businesses ranged from 117 to 847 percent.
      A study of clients of the Centre for Agricultural and Rural Development (CARD), a Philippines
       MFI, showed that returns to capital in a random sample of clients averaged 117% (M. Hossain
       and C. Diaz, Reaching the Poor with Effective Micro credit: Evaluation of a Grameen Bank
       Replication in the Philippines, 1997)




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   Another study in the late 1990s collected information from 215 micro enterprises in India and
    Kenya.     The businesses were selected randomly and were of various types and locations. The
    average annual incremental return on investment, after subtracting the opportunity cost of
    labour, was 847%. (Malcolm Harper, Profit for the Poor: Cases in Microfinance (London:
    Intermediate Technology Publications, 1998), 15.
•   Interest rates charged by moneylenders are overwhelmingly higher than those of MFIs.     It is
    common for moneylenders to charge effective interest rates in excess of 10% per month.      A
    standard loan from a money lender in the Philippines is the ―5/6loan‖–for every 5 pesos
    borrowed in the morning, six must be repaid by evening. This amounts to a DAILY interest rate
    of 20 %.




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8 Valuations of microfinance institutions

        The microfinance sector is evolving from being predominantly grant driven to a stage where it is
looking forward to attracting commercial capital. MFIs have been successfully utilizing commercial debt
funds and are increasingly looking forward to commercial sources of equity.
        In the past an MFI that achieved a Financial Self Sufficiency of 100% was assumed to have
reached the epitome of sustainability. However, Financial Self Sufficiency may not necessarily mean
commercial sustainability. In the most widely accepted definition of FSS, the cost put to equity is just the
inflation rate, which we know is not true. The cost of equity depends on the risky-ness of the business
the equity is invested in and will always exceed the inflation rate by an amount equal to at least the risk-
free rate. In effect FSS puts no real cost to equity.
        Thus, there is a need to value equity investments in microfinance which puts a market cost to it.
In the absence of market information, (as the sector is still in a nascent stage and MFI‘s stock don‘t
trade except for a few MFIs in Latin America), it is natural for most investors to value an MFI based on its
Book Value – utilizing a valuation range constructed from multiples of book value . Book value –
variously called shareholder equity and net worth – is broadly defined as total assets minus total
liabilities. This difference is the excess value a business has generated in its life. Book value is then
multiplied by pre-determined coefficients to create the valuation range. However, the Book Value method
may not be appropriate for valuing MFIs because of the following reasons:


8.1 Backwards Looking Nature:

         Book value is sum of the total excess value generated by a business. Hence, book value
measures only what a business has done, and does not necessarily have bearing on what it will do. In
mature companies and industries, past history is often a strong indicator of future performance; in such
situations, book value is an effective tool for determining a company‘s present value. Microfinance,
however, is not a mature industry, nor are many MFIs truly mature companies. Prior operating history is
therefore not a good predictor for future results.
        Historically, the microfinance industry operated along purely social lines. MFIs sourced operating
funds from donors and philanthropic organizations in the form of grants, soft loans, and subsidized loans.
These investments did not require profit maximization; at most, some investments required a nominal
interest rate and future return of capital. MFIs utilized these funds as budgets, not as commercial equity
investments; the firms did not have an incentive to build a surplus. Excess funds were generally utilized
to explore new niches or to lower borrowing costs. Additionally, microfinance activities were often only
one of many initiatives under an NGO‘s umbrella. Excess profit generated through microfinance quickly
flowed back into other parts of the NGO.
        MFIs looking for commercial financing have refined their outlook to marry their social missions
with the profit seeking ends of capitalism. Managing their businesses for profit while offering financial
services to the poor and very poor allows MFIs to dramatically scale their businesses. Commercially

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financed MFIs will necessarily operate very differently than they have in the past; investments can no
longer be viewed as budgets, and an entire class of investors will demand profit maximization. Examining
their history of value creation – the premise behind a book value valuation approach – is a misleading
method of determining an MFI‘s value creation potential.




8.2 Lack of Comparables:
        Without commercial history in the microfinance sector comparables to assess potential MFI
profitability and an MFI‘s risk profile do not exist. Selecting the appropriate coefficients for book value is
impossible in such an environment. Multiple coefficients for the book value approach are based upon two
factors: one, the return to an investor a unit of book value will yield, and two, the return an investor
expects from a particular investment. In practice, the amount of profit delivered per unit of book value
(or sales or assets, or otherwise) is generally not known to any degree of specificity. This value is
generally determined by examining multiples ascribed to similar companies or by examining a ―standard‖
long term business model of a company or industry. Owing to its unique evolution and young age,
microfinance sector does not have a set of comparable companies from which to draw from. A long term
―standard‖ business model for the microfinance sector is also difficult to ascertain; at this stage, no one
knows if a 2% return on assets, a 20% return on sales, or a 15% return on net portfolio outstanding is
appropriate. Without either tool, determining the appropriate multiples is impossible.
        The situation is further complicated by the differences between microfinance firms. Due to the
youth of the industry, a plethora of models continues to persist. Each model has different operating
profiles, different profit potentials, and carries different risks. Some key differences include:
        •       Full Grameen model vs. Self Help Group – Grameen hybrid
        •       Livelihood consulting vs. pure MFI
        •       Full intermediation vs. service company operations
        •       Significant regional variations
        A multiple used to value one microfinance firm rarely transfers to another. Hence, even after a
handful of MFIs successfully source investments in the near to medium term, selecting book value
multiples based on comparables will be difficult. An effective approach must both be forward looking and
function in a nascent industry. A valuation approach that meets these requirements is the discounted
cash flow (DCF) valuation.


8.3 Using DCF in MFIs
        Free Cash Flows are defined as cash flows that remain after we subtract from expected revenues
any expected operating costs and the capital expenditures necessary to sustain, and hopefully improve,
the cash flows. The Free Cash Flows to Equity (FCFE) represent the free cash available to the equity
holder of the company and are good measure of the company‘s capacity to pay dividends and provide
capital gains opportunity to its equity investors. Discounted FCFE is therefore, is appropriate way to




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value equity of a company which is in its initial life cycle stage, does not trade in public and so far has
not paid dividends like most MFIs.




8.3.1 Peculiarities involved in valuing MFI’s equity

        Financial services firms including MFIs have certain peculiarities, and therefore FCFE calculation
has to be more measured and careful.

        1) Regulation:      Banks and financial services firms are heavily regulated. In general, these

regulations take three forms. First, banks are required to maintain capital ratios to ensure that they do
not expand beyond their means and put their claimholders or depositors at risk. Second, financial service
firms are a minimum level of Net Owned Funds or Net Worth. Third, entry of new firms into the business
is often restricted by the regulatory authorities.


        From a valuation perspective, assumptions about growth are linked to assumptions about
reinvestment. With financial service firms, these assumptions have to be scrutinized to ensure that they
pass regulatory constraints, particularly relating to capital adequacy levels.


        2) Reinvestment:       If we define reinvestment as necessary for future growth, there are other

problems associated with measuring reinvestment with financial service firms. Primarily, – net capital
expenditures and working capital, could be considered as reinvestments required for growth. However,
measuring either of these items at a financial service firm can be debated.


        Unlike manufacturing firms that invest in plant, equipment and other fixed assets, financial
service firms invest primarily in intangible assets such as brand name and human capital. Not
surprisingly, the statement of cash flows to a bank show little or no capital expenditures and
correspondingly low depreciation. Similarly, if we define working capital as the different between current
assets and current liabilities, a large proportion of a bank‘s balance sheet would fall into one or the other
of these categories. Changes in this number can be both large and volatile and may have no relationship
to reinvestment for future growth. For example a bank may accrue a large interest cost on its deposits
while the actual payouts on account of withdrawals are much less. The bank‘s cash flow would in this
case, gets artificially inflated.
        The challenge then is to find an appropriate and valid discount rate for discounting the FCF. The
answer may lie in doing a Monte Carlo Simulation.


        Monte Carlo simulation in traditional capital budgeting use repeated random sampling from
probability distributions of crucial primary variables underlying cash flows to arrive at output distributions
or risk profiles of probable cash flows in the project for a given management strategy. Simulation
attempts to imitate a real world decision setting by using a mathematical model (consisting of operating


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equations or identities) to capture the important functioning characteristics of the project as it evolves
through time encountering random events, conditional on management's preset operating strategy.


        A Monte Carlo simulation usually follows these steps: Modeling the project through a set of
mathematical equations and identities for all the important primary variables, including a description of
interdependencies among different variables and across different time periods.


        Specifying probability distributions for each of the crucial variables, either subjectively or from
past empirical data.


        A random sample is then drawn (using a computer random number generator) from the
probability distribution of each of the important primary variables enabling (with the help of the modeling
equations and identities) the calculation of net cash flows for each period.


        The process is repeated many times, each time storing the resulting cash flow sample
observations so that finally a probability distribution for the project's cash flows can be generated (along
with its expected value, standard deviation and other statistics).


        Thus simulation in capital budgeting is useful in assessing the probability distribution of cash
flows, from which the expected value of cash flows and the appropriate risk adjusted discount rates can
be determined and used to derive a single value expected valuation.
        For validating a discount rate
        Simulating the Free Cash to Equity is an excellent way of validating the equity valuation in a start
up. The FCE distributions returned by the simulation can be used to estimate the annual FCEs at a
certain probability value (p-values in statistical jargon). The FCEs at low p-values (such as 1%) can be
viewed as Certainty Equivalents of the projected most likely FCEs. Certainty Equivalent (CE) of a cash
flow (say C1) is the smallest certain pay-off for which an investor would exchange the risky cash flow
(C1). The value calculated by discounting the CE at risk free/discount rate adjusted for moderate risk,
and the value calculated by discounting the projected most likely FCEs at a certain discount rate
reflective of investor's return expectations are close enough, then that particular investors return is
arguably justified for the riskiness built into the most likely FCE projections.




Standard measures of efficiency for microfinance institutions include:
    •   Adjusted operating expense / Loan portfolio
    •   Adjusted personnel expense / Loan portfolio
    •   Adjusted administrative expense / Loan portfolio
    •   Average salary / GNP per capita
    •   Cost per borrower


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  •   Yield on gross portfolio = Cash financial revenue from gross loan portfolio / Average gross loan
      portfolio
  •
FORMULAES:
  •   Adjusted operating expense as percentage of loan portfolio by region =
      (Operating expense + In-kind donations) / Average gross loan portfolio
  •   Operating Expense = Personnel expense + Administrative expense
  •   Personnel Expense = Personnel salary + Benefits expense
  •   Administrative Expense = Depreciation + Office Supplies + Rent and Utilities + Transportation
      + Other Administrative Expenses




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MIX recognizes many general definitions of microfinance but employs a functional definition of
microfinance for reasons of analysis. Microfinance services – as opposed to financial services in
general – are retail financial services that are relatively small in relation to the income of an
individual, household or enterprise. Specifically, the average balance of microfinance services is no
greater than 250% of the average income per person (GNI per capita). The definition can
alternatively be expressed in the following terms, using the example of a lending institution:




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9 Legal framework in India

         The importance of extending the benefits of a developed financial system cannot be stressed
enough in India, especially since the country has among the world's highest ratios in terms of savings
rate-to-GDP. In the absence of a meaningful social security system, it is critical to ensure that poor
people can use the banking system to save some money. Still, according to Pawan Kumar Bansal,
minister of state for finance for the government of India, only 10-12 automated teller machines exist per
million population in India vs. 50 per million in China and 500 per million in South Korea.
The Reserve Bank of India has tried to introduce no-frills bank accounts which underprivileged sections
of society can use. Migrant workers from different parts of India who live in shanties in big cities often
find it quite difficult, however, to produce the documents that banks need under the new 'Know your
Client' norms. The KYC norms are a fall-out of a new law called the 'Prevention of Money Laundering
Act' passed by India's federal government. The law aims to make India compliant with international
norms on money laundering but several sections of the bill have had unintended consequences. In the
absence of a national identification such as a social security number, a large percentage of the
population cannot produce the many documents required to even open a bank account. Since poor
people cannot use the banking system, they often find it difficult to access most other financial products
as well. There is an ongoing debate in India as to whether the current legal environment for the financial
sector accommodates the specific characteristics of microfinance and, if not, what kind of legal
amendments or revisions are needed. The outcome of this debate is still open.
To clarify the above point, the report presents with three broad scenarios, which logically follow from
each other. All three scenarios have their unique pros and cons. This approach clearly spells out the
strengths and weaknesses of each case. They are as follows:
         Scenario 1 called ‗Focus on Formal Banking Infrastructure : It assumes that the recent
growth of the Self-help group (SHG)-bank linkage model and its ready acceptance and success in terms
of outreach, viability, and positive impact on the livelihoods of the poor advocates a focus on the formal
banking sector as a provider of microfinance. As this sector to date is already under prudential regulation
by the central bank, proponents of this scenario do not see a need for major regulatory changes or
adjustments. An important – and hotly debated – corollary is that linkages with SHGs and similar
microfinance services provided by the formal sector should be a profitable business niche for the
respective supplier as otherwise it would not be sustainable in the long run. Only then can it be rightly
claimed that the existing formal banking sector should be the main provider of microfinance services in
India.
         Scenarios 2 and 3 are more skeptical about the potential role of the regulated banking sector in
the future. They follow the lines of arguments in many other countries where the role of the banking
sector is negligible, even though they acknowledge the success of the SHG-bank linkage model. Both
scenarios start from the proposition that the SHG-bank linkage model alone cannot satisfy the huge
demand for microfinance in India.



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Under the heading ‗Amend Existing Legislation for MFIs‘, Scenario 2 looks at the current legal
environment for microfinance institutions (MFIs) such as Non-Banking Financial Companies (NBFCs),
microfinance NGOs and federations of SHGs. For each type of MFI, challenges and constraints under the
existing laws are listed and possible remedies pointed out.
Scenario 3 is similar to scenario 2, only that according to this scenario it is more promising to introduce
a new special law for microfinance than to follow the piecemeal approach of making a number of smaller
changes in various laws that effect MFIs.


RBI defines Micro Credit as:
         Micro Credit is defined as provision of thrift, credit and other financial services and products of
very small amount to the poor in rural, semi-urban and urban areas for enabling them to raise their
income levels and improve living standards. Micro Credit Institutions are those which provide these
facilities.
DOES RBI ENFORCE INTEREST RATES?
         No. The reform of the interest rate regime has constituted an integral part of the financial sector
reforms initiated in our country in 1991. In consonance with this reform process, interest rates applicable
to loans given by banks to micro credit organizations or by the micro credit organizations to Self-Help
Groups/member-beneficiaries has been left to their discretion. The interest rate ceiling applicable to
direct small loans given by banks to individual borrowers, however, continues to remain in force.


DOES RBI IMPOSE THE TERMS & CONDITIONS FOR ACCESSING MICRO CREDIT?
         No. Banks have been given freedom to formulate their own lending norms keeping in view
ground realities. They have been asked to devise appropriate loan and savings products and the related
terms and conditions including size of the loan, unit cost, unit size, maturity period, grace period,
margins, etc
IS FOREIGN INVESTMENT ALLOWED IN MICRO CREDIT PROJECTS?
         Govt. of India with their notification dated August 29, 2000 have included ‗Micro Credit/Rural
Credit‘ in the list of permitted non-banking financial company (NBFC) activities for being considered for
Foreign Direct Investment (FDI)/Overseas Corporate Bodies (OCB)/Non-Resident Indians (NRI)
investment to encourage foreign participation in micro credit projects. This covers credit facility at micro
level for providing finance to small producers and small micro enterprises in rural and urban areas.




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9.1 Types of Micro Credit Providers in India:




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10 Innovations required!!!

         Microfinance institutions in India and Indonesia lead the world in the use of biometrics and
smart cards. These recent innovations in microfinance have led to lower administration costs and
greater efficiency for borrowers, dispelling the myth that the use of these advanced technologies is cost
prohibitive for microfinance.
Biometrics applies biological authentication systems, such as fingerprints, for identification in
transactions. Biometric authentication has proved useful in places where biometric teller machines
(BTMs) can be installed and literacy rates are low. The BTMs reduce the need for microfinance
administrators because borrowers can go to the BTM for identification and authorization. It also increases
efficiency to borrowers, particularly those less literate, because they can avoid signatures and
paperwork.
         Smart cards contain real time financial information, allowing a borrower to walk up to a BTM,
ATM, or MFI and instantly make transactions. Smart cards track customer interactions to build real-time
credit histories and provide greater detail about the borrowers. The innovations will likely phase out the
paper ledger books that MFIs retain for each borrower and record every transaction in.
Bob Annibale, global director of Citigroup‘s microfinance operations, recently commented that a growing
challenge for microfinance will be to find savings products for the world‘s poorest. The difficulty will arise
in delivering these products scalable at a low cost.
         This report suggests the implementation of these technologies will aid in that challenge and it will
be of great benefit, both the borrower and the MFI. Biometrics will provide a great method of identifying
people and decreasing the possibilities of fraud. Smart cards will be a huge benefit to MFIs in efficiently
processing transactions, both for accuracy and timeliness. BTMs will provide an efficient way for many
people to deposit and withdraw. However, the proliferation of BTMs may be constrained in reaching the
poorest of the poor due to substantial requirements in power and communications infrastructure. In any
case, these new technologies represent the wave of the future and will be popping up throughout the
world.




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