Explained: What ails the existing microcredit model
Headline : Explained: What ails the existing microcredit model
- Studies suggest that the existing systems of microcredit have a limited impact on the long-term wellbeing of the recipients.
- Microcredit refers to the granting of very small loans to impoverished borrowers.
- Loans given as microcredit are often given to people who may lack collateral, credit history, or a steady source of income.
- The core idea is that a small loan will provide access to the larger economy to people who live outside the mainstream economy.
- It has an aim of enabling the borrowers to use that capital to become self-employed and strengthen their businesses.
- Microcredit agreements generally do not require any sort of collateral.
- At times it may not even involve a written agreement, as many recipients of microcredit are often illiterate.
- When borrowers demonstrate success in paying their loans on time, they become eligible for loans of even larger amounts.
- Conventionally, microcredit has been used mainly for entrepreneurs to begin production and attain self-sufficiency.
- However, there are other, mostly unexplored paths for the utilisation of microcredit for poverty alleviation and productivity-boosting measure, like:
- Supplement rural labourers
- Small microcredit loans can allow rural labourers to migrate to urban areas to find work during the lean season (when there is no work on farms).
- Those who migrated temporarily during the lean season experienced increased spending in both food and non-food areas, and increased their calories consumed.
- Address climate shocks
- It can also be used to reduce the effects of shocks like floods and drought.
- It can provide people with a form of insurance that both increases production before the shock and provides a safety net after.
- An example of a microcredit institution is the Grameen Bank in Bangladesh, founded in 1976 by Mohammed Yunus. It is a pioneering institution in the realm of micro finance.
- The bank has 8.4 million followers, 97% of whom are women, and the bank has repayment success rates between 95 to 98 percent.
- Microcredit falls under the larger umbrella of microfinance.
- Microfinance activities usually target low-income individuals, with the goal of helping them to become self-sufficient.
- Hence, microfinance activities have an aim of poverty alleviation as well.
- Microcredit has emerged as a tool for ensuring the welfare of the most impoverished in society, and boosting development alongside.
- However, some studies claim that certain flaws in microcredit transactions has led to limited benefits, and access to microcredit made very little difference to changing the lifestyles of borrowers.
- As per a study, indicators like Household business profits, business expenditures, consumption, consumer durables spending etc. saw only a 5% impact when microcredit was available.
Repayment schedules main reason for low impact of microcredit:
- To lower the risk of defaulting, microcredit lenders demand an initial repayment that is almost immediate.
- After that, borrowers are required to follow an inflexible weekly schedule for repayments.
- Due to this, borrowers are unable to use loans on investments that may take some time for benefits to be fully realised.
- Hence, they are forced to use the loans on short term investments that only boost production to an extent, and the overall growth of their income remains small.
Findings of various studies on improving impact of microcredit
Initial grace period:
- According to a study, borrowers who received an initial grace period were more likely to have started a new business.
- Such borrowers also reported higher profits and household incomes.
- However, there was also an increased rate of defaulting in this group.
- When borrowers switched from a weekly repayment schedule to a monthly one, there was an increase in incomes without the increased rate of defaulting.
- Under a monthly repayment schedule, borrowers scored 45% lower on the Financial Stress Index.
- Increases in income were more than double when compared to the borrowers under a weekly repayment schedule.
Mitigation of credit risk:
- The barriers to assessing credit risk can be mitigated by using community information.
- Communities can be an accurate source of information about credit risk for microcredit institutions.
- However, the implementation of such processes would require the elimination of bias and incentivising accurate information.