Why the Poor Require Loans from Micro Financing Institutions - Term Paper Example

? MICROCREDIT Microcredit According to The Financial Express (2009), microcredit which is also known as microfinance is a financial loan which is given to poor people which acts as capital for beginning a business. The financial loan given through microcredit is usually a small amount of money for small scale ventures and it is essential for funding businesses of the impoverished. The aim of microfinance is to help those individuals who cannot access credit from regular banks due to insufficiency of adequate collateral. This paper describes micro financing in relation to the reason why the poor require loans from micro financing institutions. The description of the ways in which access to credit eradicates poverty is also discussed in this paper basing the argument on empirical studies. Usman, Malik and Shafiq (2011) explain that regular banks are generally meant for people with money and thus microfinance becomes very necessary for the millions of poor people across the world. Microcredit institutions offer the small financial loans in form of microcredit to the poor with a premise that these people have financial skills and talents which can be utilized through financing for their own benefit and the society in general. According to Vasanthakumari (2008, p. 137), microcredit is necessary for the poor because it offers them the chance to utilize their capabilities and hence progress both economically and socially. Because dependency on charity only sustains poverty, microfinance becomes necessary to enable the poor to utilize their creativity and potential which is possible if people’s energy is concentrated on business ventures and self development as described by Sin-Yu and Odhiambo (2011, p. 103). Microcredit is described by Madichie and Nkamnebe (2010, p. 301) as a form of finance that provides small loans to poor people which allows them to have an ability of self employment. According to Ghosh and Wright (2005, p. 298), microcredit targets poor people who need it to begin businesses and as a result it charges low interest rates as compared to the regular banking services. The Muhammad Yunus and Grameen Bank are credited for the introduction of microcredit as an economic innovation which targets poor people with an aim of empowering them and thus lead to a general development of the social systems. As a result of this innovation, Muhammad Yunus and Grameen Bank received a Nobel Peace Prize in 2006 because microfinance led to the empowerment of poor entrepreneurs, farmers and the unemployed. Durrani, Usman, Malik and Ahmad (2011, p. 138) illustrate that microcredit targets people in the unstable income bracket due to unemployment. Because poor people fail to meet the minimum financial qualification of regular banks before they acquire credit services, microfinance plays a significant in the economic progress of the poor. Poorer People Need Microcredit Lack of credit is attributed to the inability of the poor to progress economically and become wealthy as said by Haque and Harbin (2009, p. 4). Microcredit is therefore the best financial solution to the increased poverty especially in developing nations. The credit market within regular banks is full of imperfections and therefore microcredit acts to combat the problems related to the acquisition of credit from banks such as high collateral requirement. Sharma (2005, p. 288) explains that the difficulty of acquiring a loan from formal credit markets makes poor people to resolve into borrowing money from informal credit markets where they are vulnerable to exploitation. In the informal credit market, moneylenders give loans to the poor who have limited options and exploit them through charging exaggerated interest rates. In the developing economies, money lenders provide alternative credit services to the poor because the regular banks require very high financial qualifications for loans which the poor cannot attain. The role of microfinance in the eradication of poverty is therefore evident through the provision of loans to the poor at a very low interest rate without a collateral requirement. According to Madichie and Nkamnebe (2010, p. 312), money lenders within the informal credit market justify the high interest rates they charge with the high risks which are involved in loaning money to the poor. Because of the high interest rates, long term businesses which obtain their capital from the informal credit market cannot grow because the profits obtained are used to cover the interest of the loan. Therefore microcredit is the only credit service which enables the poor to invest in businesses whose growth and profit is guaranteed. Lack of exploitation in the microcredit services enables the poor to start long term businesses and thus enables them to grow out of poverty. The poor need microcredit basically because the regular banking institutions lend money only to the rich and therefore excluding the poor from the credit services. The regular banks exclude the poor because they are faced with challenges of obtaining asymmetric information before and after lending money to the poor. The regular banks find it hard to determine the kind of business investment the poor are likely to invest the loan in before advancing the loan hence decide to lend only to the rich who have promising business plans and proposals. Usman, Malik & Shafiq (2011) add that regular banks may find it difficult to monitor how poor investors use the loans that they are given to determine if it is used for a meaningful economic project. Therefore these banks give loans to the wealthy whose businesses are monitored by the market regulatory and evaluative agencies. Furthermore the poor are excluded from the lending of the regular banks because these institutions find it hard to determine the returns of the business investments which use credit as the source of capital. Therefore because of the exclusion of the poor by regular bank’s credit services due to problems of asymmetric information, microfinance is essential for the poverty stricken individuals. According to Haque and Harbin (2009, p. 7), poor borrowers find it difficult to choose the project that they should invest in and thus the formal credit market may be unable to establish the kind of business that a poor borrower eventually decides to begin. This creates a problem of limited liability because the value of the business investment of poor borrowers cannot match to the value of the collateral which is given. Hence regular banks exclude poor borrowers because they do not a guarantee of being able to repay the loan. Sharma (2005, p. 289) explains that it is through the evaluation of the collateral given for a loan that banks are able to make decisions of lending which are based on the assessment of the risks associated with involuntary default. Lack of sufficient wealth by poor people for the loan repayment therefore reduces the propensity of regular banks to lend money to them as capital for a business investment. Therefore microcredit is the best economic innovation for the poor borrowers who are excluded from the regular banks’ credit as a result the problem of limited liability. The high returns that regular banks expect out of the loans they offer illustrates the need of the microcredit services for the poor. The high risks associated with lending to poor borrowers cause the lenders to increase the rate of returns because of the uncertainty of giving loans to the poor. The high return rates expected of the regular banks leads to the perpetuation of poverty because businesses which use capital form credit facilities fail to grow because all returns go to the loan repayments of the loan. The Role of Credit in Eradication Poverty Microcredit helps the poor to develop economically and thus move out of their poor status. Haque and Harbin (2009, p. 7) explain that it is through microcredit that the poor are given more economic choices in the utilization of market opportunities for self growth. It is through microfinance that millions of poor people especially in developing nations have been enabled to start businesses which have grown into large establishments. Through the microfinance funded businesses, the poor have been allowed to generate income and hence increased investment. The income that people generate from various business investments plays an important role or eradicating poverty. Through microfinance, the poor are able to start businesses which eventually expand and therefore allow them to obtain a larger amount of credit which solves the poverty problem within the society. Vasanthakumari (2008, p. 136) asserts that credit availability to the poor plays the role of eradicating poverty by increasing the income of many households. This is made possible through the profits obtained from business ventures and in return provides people with food security. The ability of people to afford basic needs such as shelter, clothing and food shows that they are no longer poor. It is through microfinance that many people have been enabled to meet their essential needs. According to Zapalska, Brozik and Rudd (2007,p. 84), studies show that communities which have access to credit facilities increasingly spend capital on fixed assets leading to facilitated business growth. The microcredit loans are usually offered to poor borrowers in form of either fixed assets or a working capital for business ventures. These loans therefore increase the profitability margins of various business ventures of the poor and hence helping them to grow out of poverty. The provision of loans enables small businesses to acquire working capital which facilitates business activities which leads to efficient and effectiveness in the attainment of business goals. Sharma (2005, p. 288) adds that fixed assets such as equipment are recommended by microfinance institutions as the most appropriate investment of the credit offered to enable businesses increase their productivity with efficiency and cost effectiveness. Such investments increase the income of households and help them to become rich. The poverty which can arise from lack of control, limited income or external shocks to household income is thus prevented through microfinance. With time, businesses which are financed by microfinance loans grow and provide employment opportunities to other poor members of the society and thus reducing the levels of poverty within the community in general. Alam, Ellahi and Arif (2010, p. 182) assert that empirical studies demonstrate that there is efficient use of microcredit loans in business investments and growth of various businesses in developing countries. This is made possible by the informal appraisals that microfinance institutions perform on the investments and businesses that poor borrowers venture into. Additionally, the desire to escape the poverty and the financial inabilities related to it makes most poor borrowers invest efficiently in businesses and thus grow out of poverty. The active investments by poor borrowers include diversification of their business ventures as a measure of overcoming the risks associated to business ventures. Reduced risks means that the possibility of incurring losses is removed from businesses and hence lead to enhanced income and thus growth from poverty into wealth. The Financial Express (2009) shows that some microfinance institutions are involved in training poor borrowers in business matters which enable them to participate in profitable and meaningful business activities. Furthermore the microcredit institutions encourage members of poor communities to form groups with mandatory savings which act as substitutes for collateral in obtaining credit services and thus stimulate the growth of business ventures and the resultant reduction of the poverty levels within the community. Hudon (2009, p. 17)says that microcredit finance institutions provide larger amount of loans to borrowers with a good repayment history in addition to providing them with frequent loans which empower them to grow economically. Such borrows develop into large businesses which promote the community through provision of employment and training to its recruits from the community. Through increased loan amount and frequency in addition to the streamlining the monitoring of the disbursed loans, credit institutions therefore enable the power to grow out of poverty. According to Alam, Ellahi and Arif (2010, p. 187), some microfinance institutions provide insurance services to micro investments and individuals and thus covering them against possible loss. This promotes business existence and survival within the strong forces and risks within the business environment. Zapalska, Brozik and Rudd (2007,p. 87) illustrate that studies in the role of credit in the developing nations in the reduction of poverty demonstrate that the disadvantaged groups in these societies such as women are empowered financially and socially through microfinance. The women who access credit from microfinance institutions are allowed to begin small businesses which eventually grow into larger business establishments. The growth of businesses which are started by women through access to credit means that income is increased which empowers women to grow within the social class and improve their living standards. In addition, microcredit institutions encourage women to venture into new businesses which help them to grow into new markets and thus develop both economically and socially. Sin-Yu and Odhiambo (2011, p. 109) point out that some schools of thought say that microfinance institutions do not play an active role in the alleviation of poverty because the members of the public have limited access to these institutions. On the other hand Sharma (2005, p. 288) asserts that in developing nations, the number of microfinance institutions is increasing and the access of poor communities to the credit services is growing. Self sustaining credit institutions are however described to be more effective in eradication of poverty as opposed to those which depend on grants and subsidies to enable them survive in the credit market. The impact of self sustaining microfinance institutions in helping the poor is demonstrated by their abilities to survive the risks associated with providing loans to the poor. Husain (2008, p. 38) explain the shortcomings of microfinance and thus the limited impact on the eradication of poverty as being related to the small size of the loan given to the poor. Most of these loans are used to meet immediate needs of the poor as opposed to long time investment. This is due to the increased capital requirements for starting a business and the many risks of investing in many businesses. Additionally, the limited loan cannot significantly help small businesses to diversify investments as a way of reducing the business risks. The effectiveness of the microfinance loans in the alleviation of poverty would be possible through an increase of the amount of loans given however there institutions are limited by the risks of giving larger loans without collateral. Ho and Odhiambo (2011, p. 103) say that the awareness of the society on microcredit especially in developing nations is relatively low. This makes the utilization of credit facilities and investment into new business opportunities to be significantly low. The support of many governments for the microfinance institutions is limited and thus their impact on the eradication of poverty is not significant enough as explained by Imhanlahimi and Idolor (2010, p. 66). Therefore government support for the eradication of poverty through support for microfinance institutions is recommended especially within developing nations. Conclusion Microfinance acts the most effective approach of empowering the poor and thus helping them to grow out of poverty through provision of startup and operational capital for small business investments. The necessity of micro financing is demonstrated by the exclusion of the poor from credit services by the regular banks. The high minimum requirements for collateral by regular banks is high and cannot be afforded by the poor hence micro financing institutions have played a significant role especially in developing nations in the increasing the income and productivity of businesses and thus a general decrease in poverty. References Alam T, Ellahi N and Arif M 2010, “Micro Credit and Poverty Eradication A Case Study Of First Micro Credit Institution Of Pakistan”. Interdisciplinary Journal of Contemporary Research in Business, 2(8):182-192. 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Vasanthakumari, R 2008, "Micro Credit, Poverty and Empowerment: Linking the Triad", Indian Journal of Agricultural Economics, vol. 63, no. 1, pp. 136-143. Zapalska, A., Brozik, D and Rudd, D 2007, "The success of micro-financing", Problems and Perspectives in Management, vol. 5, no. 4, pp. 84-91.. Read More