A SIMPLE REPRESENTATION OF THE ACTIVITIES OF MICRO FINANCE INSTITUTIONS
Annesha Zeheen

Introduction

This paper attempts to graphically present a simplified version of the activities of a microfinance institution (MFI) with a view to facilitating our understanding of its activities and role in economic development, creating an enabling environment for MFIs to work, promoting and fostering sustainable development of microfinance institutions and comprehending the need and ways to regulate them.

The main function of a microfinance institution is to provide sustainable financial services mainly to the small borrowers and clients. Intially 5 to 6 like-minded persons mostly women organize a Group, several groups make a Center. Usually memebrs have to attend the weekly meetings and deposit weekly savings. The loans are mostly provided against little or no collateral, but repayment rate is generally commendable because of the peer pressure originated from members of groups. MFIs’ services are not limited to credit, but include savings, insurance, money transfers and others. The credit-deposit methods include group-lending and -liability, short repayment period with frequent installments, pre-loan savings requirements, gradually increasing loan sizes, and an implicit guarantee of ready access to future loans if present loans are repaid fully and promptly[1]. (Microfinance Gateway 2009).
Borrowers take micro-loans for starting or expanding small busenesses, fro the profit of which they repay the loan, meet their basic needs and improve their living conditions. Most of the micrbusinesses are buying wholesale goods to sell in markets, making and selling crafts, sewing dresses, rice husking, machine repairing, buying rickshaws, raising poultry and farming. Repayment of loans and interest earned from borrowers allows the microfinance institution to make subsequent loans.[2] (Microplace 2009).

Historically MFIs originated from welfare and relief-oriented missionary attidute backed by government and donor grants, which along with surplus income were the main source of funding of microfinance activities. With the development of microfinance market and declining donors’ resources, members savings and commercial loans have assumed most prominent sources of loan funding of MFIs.Microfinance institutions proved that it was actually possible to build viable businesses through lending to the small clients.

The phenomenal growth of this sector in Bangladesh both in terms of outreach and product development called for formulation of guidelines and suggesting a regulatory framework for the microcredit sector. Accordingly, the Microcredit Regulatory Authority (MRA) has been established by the Government of Bangladesh effective August 2006 with a view to creating an enabling environment for NGO-MFIs to work, promote and foster sustainable development of microfinance institutions in Bangladesh. Some of the activities of MRA are partially funded by DFID (MRA 2009). This paper tries to provide MRA with a framework for regulating functions of microfinance institution working in the country.

The paper is organized in the following way. Section II of the paper describes types of microcredit. In Section III different kinds of activities of the MFIs have been enumerated. Sections IV and V analyze interactions of different kinds of activities of MFIs and available regulatory options respectively. The final Section gives a set of conclusions.

II. Two Types of Micro credits
Microcredit has been segregated into to parts for analytical convenience. The part of microcredit that is explained within this framework can be called Endogenous Micro Credit (NMC) and the other part determined outside the model has been called Exogenous Micro Credit (XMC). Thereby micro credit (MC) is the total of NMC and XMC.

III. Two Kinds of Activities of a Microfinance Institution
All microfinance institutions have two kinds of activities. The first type of activities may be called Stationary activities and the second, Expansionary activities. An activity of providing slightly incremental microcredit (NMC) to its clients out of the fund received from repayment of outstanding microcredit and interest payments may be called Stationary activity. This process can continue forever so long there is no overdue / non performing loan. While Expansionary activities include accepting deposits, borrowing funds on commercial and concessionary terms from central bank, commercial banks, other financial institutions, the money market, and accepting donations from bilateral and multilateral aid organizations for furthering its activities. This type of activity forces clients to save into a locked-in deposit account. Locked in savings is a kind of deposit accounts called ‘Group Fund’ (generated through compulsory savings)[3] from which depositors are not allowed to withdraw (Wright 2004). These borrowed funds and locked in savings along with open access savings from clients are used by the MFIs as a part of their expansionary activity to meet growing microcredit (XMC) demand by the clients with latter’s improvement in economic position. Both types of activities have been discussed in the following paragraphs.

a. Stationary Activity
In our microfinance model, as a part of its stationary activity, an MFI extends Endogenous Micro Credit (NMC) for micro commercial activities, which is a function of interest rate (i), except the credit taken to meet emergency requirement (er) and other interest non-sensitive borrowings.

Formally, NMC = c(i) + er and c΄< 0. ... .... [1]

This has been represented by a downward sloping curve in the northwest quadrant of Figure-1.

Presently interest rates in the microfinance market are higher than the bank interest rates on the plea of higher administrative cost associated with making tiny loans, high risk involved with collateral free loans and substantial cost requirement of a loan officer to oversee loan repayments (Microfinance Gateway 2009). With increases in efficiency in micro credit operations through learning process and competition among MFIs, interest rate has a tendency to become equal to financial market rates. Moreover, as MFIs would further integrate with formal financial market, arbitrage would try to keep the rates aligned between MFI rate and financial market rate. In our model, we consider MFIs to be efficient and therefore interest rates are equal to financial market rate.

The next issue in microfinance is repayment of credit. Repayment depends mostly on peer pressure as generally no collateral is taken against microcredit. Following Grameen Bank, most MFIs encourage formation of groups to ensure collective responsibility. In Grameen Bank’s (2009) words, “Borrowers are organized into small homogeneous groups. Such characteristics facilitate group solidarity as well as participatory interaction. Organizing the primary groups of five members and federating them into centers has been the foundation of Grameen Bank's system. ... Only if the first two borrowers begin to repay the principal plus interest over a period of six weeks, do the 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, the collective responsibility of the group serves as the collateral on the loan.” Peers could also be other members in a borrowers group, community leaders, NGOs themselves and their field officers, banks etc.
Peer pressure is very difficult to measure; instead we have used ‘number of groups’ which can be easily measured. More the number of groups more are the outreaches of an MFI. Thereby the words: ‘peer pressure’, ‘number of groups’ and ‘outreach’ have been used to mean the same. Nevertheless, it should be pointed out that group-based systems are not the only way of delivering financial service, though it has proved remarkably successful. Wright (2004) noted, ‘most of the international credit union movement serving million of members in a wide variety of settings through out world do not use groups or group guarantee mechanisms at all’. However, Grameen Bank (2009) claims that because of the peer pressure generated by the groups, repayment of microcredit is most often around 95 percent of the outstanding loans. It should also be accepted that there are other reasons for high repayment rates that include self-interest and the motivation of borrowers.

In our paper, repayment has been shown as a function of number of groups assuming that all groups exert similar peer pressure. With the increase in numbers of group, loan disbursement and their repayment would also increase because of the reasons discussed in the foregoing paragraph. Accepting Grameen Bank experience, the impact of groups is represented at southeast quadrant of Figure 1.

Formally, RP = g(GR), and g΄> 0. ... .... [2]
Where RP is repayment of loans and GR is the number of groups.

In our study we have assumed 0 percent default rate which would not be impractical looking at the performance figures of some MFIs including Grameen Bank. The assumption implies that all credits are repaid timely. Thereby, we can write,
NMC = RP ... .... [3]
This has been shown as 450 line located in southwest quadrant.
[pic]

These relationships discussed in the foregoing paragraphs that contribute to the location of equilibrium pairs of i and GR are summarized in the four quadrant diagram in Figure-1. We can now derive from these three relationships, a CR curve located in the northeast quadrant that represents equilibrium pairs of i and GR.

Using lines of these three quadrants, we can find a downward sloping CR curve, showing
CR = ƒ1 (i, GR) ... .... [4]

b. Expansionary Activity

Sources of loanable fund of a typical MFI performing expansionary activity are compulsory savings of group-members, voluntary saving deposits, borrowing from banks, loan from Palli Karma Sahayak Foundation (PKSF) of Bangladesh, surplus and donations. Of these, micro-savings by group members and borrowing from banks are two most important sources. We have dealt with them separately. First, compulsory micro saving of group members can be seen as a function of number of groups. More the groups are more will be savings.

Formally, MS = s(GR) and s΄> 0. ... .... [5]

Diagrammatically this has been shown in southeast quadrant of Figure-2.

[pic]

Loanable funds collected through borrowings from the financial sector, from government agencies and from other NGOs may be called ‘borrowed fund’ (BF) which varies with the variation of formal market interest rate (r).

Formally, BF = b(r) + OF and b΄< 0. ... .... [6]

Where, OF is all sources of fund except compulsory micro savings (MS) and BF. This relationship has been shown in northwest quadrant of Figure-2.

The southwest quadrant represents an equilibrium condition. The line touching BF and MS axes represents supply of total loanable fund available from micro savings and borrowing from the market. The line is drawn at a distance from the origin on each axis equal to the total exogenously determined demand for microcredit (XMC) by the clients. The demand is exogenous because it does not depend on interest rate nor on group formation rather it depends on opportunities for micro-business. When market opportunities possibly resulting from macroeconomic developments in a country are higher a micro-entrepreneur is ready to borrow from an MFI and even from rural lenders whose interest rates can be very high.

Using lines of these three quadrants of Figure-2, we can find an upward sloping FL curve located at the northeast quadrant, showing
FL= ƒ2 (r, GR) ... .... [6]

All of the relationships discussed so far that contribute to the location of equilibrium pairs of r and GR in an MFI with expansionary activity are summarized in the four quadrant diagram in Figure-2.

IV. Interaction of FL and CR Curves

At this stage, we have two figures explaining stationary and expansionary activities of MFIs. The first one gives the equilibrium pairs of i and GR of an MFI with stationary activities, we call it CR curve. The other shows the equilibrium pairs of r and GR of an MFI with expansionary activities that we call FL curve. As explained in Section III (a) interest rate (i) in the microcredit market is assumed to be equal to the rates (r) prevalent in the formal financial market. In that case, combining the curves in the same quadrant is possible. We can find the single i and GR pair that gives equilibrium in both types of activities of an MFI, the interaction of CRFL curves.
[pic]

Figure-3 provides us with a platform for analyzing the need and effects of any policy initiatives.

V. Regulatory Options

Since there is limited scope to regulate stationary activities, a regulatory body may only try to influence interest rates in the microcredit market. Fixation of interest rates, even for a temporary period by an authority would be unwise in the era of liberalization. The part of the microcredit which is not interest sensitive may be encouraged or discouraged by a regulatory body according to its preferences.

As for the expansionary activities, a regulatory authority may attempt to influence slope and position of an FL curve. Regulators if imposes any kind of liquidity requirement availability of resources will go down which will in turn shrunken supply of micro credit. Regulators can liberalize or impose restrictions on availability of government or public sector funds so that total amount of borrowed fund goes up or down. Though unwanted, a regulatory authority may fix an interest rate to encourage/discourage the amount of microcredit.

A microcredit regulatory office may issue micro-bills which could be bought and sold to influence supply of total loanable fund like open market operations of any central bank. Securitization of receivables has already started; MFIs may also be allowed to float micro-stocks in a micro-stock exchange.

VI. Summery and Conclusions

The paper provides a simple graphical model for understanding operations of microfinance institutions (MFIs). It assumes that each MFI has two kinds of activities, first, stationary activity and second, expansionary activity. Each activity has been assumed as a market, where equilibrium is arrived at by the interaction of demand and supply. Using Figure-1, the paper attempts to explain that an MFI can survive and continue its credit extension activity so long loans are fully repaid. In that case funds can be revolved. Most of the MFIs in Bangladesh are able to continue their functions as repayment ratio is almost 100 percent. Loan repayments are commendable because of the peer pressure originated from members of groups. Coherence among group members is so strong that it works as collateral against loans. Thereby, on the supply side, we have taken repayment of loans as a function of number of groups. On the demand side, microcredit has been taken as a function of interest rate. Interest rates are high in microcredit market but not as high as in rural loan market. Interest rates are coming down to equate with the rate of formal financial market as efficiency and competition are increasing and as banks and financial institutions are entering in to microcredit market. There is of course a part of credit which is not function of interest rate. As for example, during disaster or calamities credit is needed whatever interest rate is and credit is provided by most MFIs even without interest rate. Considering both demand and supply sides, we can find an equilibrium credit-repayment (CR) curve. The role of regulators of microcredit institutions is limited in this market.

While ensuring stability, an MFI simultaneously undertake expansionary activities. Here, group members are forced to save. These microsavings are therefore taken as a function of ‘number of groups’ or outreach. Micro savings are mostly locked-in, that is cannot be withdrawn even at the time of emergency. Of course there is open-access microsavings which are saved and can be withdrawn at the members own will. Open access savings are also function of groups and not of interest rate. MFIs can take national and international donations, government funds and can borrow from formal financial market at the prevailing rate. Borrowing has been taken as a function of financial market loan rate. Taking savings and borrowed fund together an MFI try to meet the exogenous demand for microcredit; equilibrium is established in the expansionary market.

Regulators if imposes any kind of reserve/liquidity requirement, availability of resources will go down which will in turn shrunken supply of micro credit. Regulators can liberalize or impose restrictions on availability of government or public sector funds so that total amount of borrowed fund goes up or down. Other instruments like micro-bills, micro-securities etc can also be used for the purpose. Though unwanted, a regulatory authority may fix an interest rate to encourage/discourage the amount of microcredit.

Economic activity of a country generally changes with the net effect of monetary and fiscal policies of a country. Any microcredit regulatory authority has less access to macroeconomic policy formulation. Therefore, regulatory institution can not influence change in demand for exogenous microcredit. This is where further research is necessary.

The main problem of this type of representation is that it is over-simplified. However, it may work as a basis for correction, improvement and further research on functioning of microcredit and creating an enabling environment for MFIs by regulatory authority.

-----------------------
[1] Microfinance Gateway
[2] https://www.microplace.com/learn_more/microfinancehowitworks
[3] Graham A N Wright (2004), Microfinance Systems, Designing Quality Financial Services for the Poor. The University Press Limited, Dhaka, Bangladesh.

-----------------------
R

i

GR

Figure – 1: Stationary Activity of an MFI

RP

FL

GR

i = r

L

F

r

Figure – 2: Expansionary Activity of an MFI

MS

GR

BF

NMC

450

C

CR

Figure-3: Interaction of Stationary and Expansionary Activities of an MFI