Effects of micro finance institutions on small and medium size enterprises in Cameroon | chapter two
LITERATURE REVIEW
This chapter focuses on some of the concepts of microfinance
and the role they play in the development of SMEs. The concepts chosen are
those that are in relation with the area of this thesis. The chapter opens with
an overview of microfinance. This shows the various products and services that
MFIs have and explain how they are of importance to the development of SMEs,
and the extent to which transaction cost affects the delivery of these products
and services. The next centre of attention is SME growth and development. This
gives an idea on how firms are considered by financial institutions before they
are offered their services. The type of microfinance is significant in getting
the services. This is explained and further to look for what determines the
capital structure of a business. This will explain why some firms prefer borrow
to equity capital and vice versa. The next concern is to investigate hey some
firms face problems to get loans. Further, the methodology of MFI is presented
and moving forward we shall also illustrate and explain what the MF triangle is
and how it is achieved. Lastly, I tried to show the theoretical links between
microfinance and SME development.
2.1 The concept of microfinance.
Micro finance is
defined as a development tool that grants or provides financial services and
products such as very small loans, savings, micro-leasing, micro-insurance and
money transfer to assist the very or exceptionally poor in expanding or
establishing their businesses. It is mostly used in developing economies where
SMEs do not have access to other sources of financial assistance (Robinson,
1998). In addition to financial intermediation, some MFIs provide social
intermediation services such as the formation of groups, development of
self-confidence and the training of members in that group on financial literacy
and management (Ledgerwood, 1999). There are different providers of
microfinance (MF) services and some of them are; nongovernmental organizations
(NGOs), savings and loans cooperatives, credit unions, government banks,
commercial banks or non-bank financial institutions. The target group of MFIs
are self-employed low income entrepreneurs who are; traders, seamstresses,
street vendors, small farmers, hairdressers, rickshaw drivers, artisans
blacksmith etc (Ledgerwood, 1999).
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2.2
Microfinance products and services for SMEs development.
According to Bennett
(1994) and Ledgerwood (1999) MFIs can offer their clients who are mostly the
men and women who could be below or slightly above the poverty line a variety
of products and services. The most prominent of their services is financial,
that they often render to their members without tangible assets and these
members mostly live in the rural areas, a majority of whom may be illiterate.
Formal financial institutions do not often provide these services to small
informal businesses run by the poor as profitable investments. They usually ask
for small loans and the financial institutions find it difficult to get
information from them either because they are illiterates and cannot express
themselves or because of the difficulties to access their collateral (farms)
due to distance. It is by this that the cost to lend a dollar will be very high
and there is no tangible security for the loan. The high lending cost is
explained by the transaction cost theory. The transaction cost can be
conceptualized as a non-financial cost incurred in credit delivery by the
borrower and the lender before, during and after the disbursement of loan. The
cost incurred by the lender include; cost of searching for funds to loan, cost
of designing credit contracts, cost of screening borrowers, assessing project
feasibility, cost of scrutinizing loan application, cost of providing credit
training to staff and borrowers, and the cost of monitoring and putting into
effect loan contracts. On the other hand, the borrowers may incur cost ranging
from cost associated in screening group member (group borrowing), cost of
forming a group, cost of negotiating with the lender, cost of filling paper
work, transportation to and from the financial institution, cost of time spent
on project appraisal and cost of attending meetings, etc (Bhatt and Shui-Yan,
1998). The parties involved in a project will determine the transaction cost
rate. They have the sole responsibility to reduce the risk they may come across
(Stiglitz, 1990). Microfinance triangle comprise of financial sustainability,
outreach to the poor, and institutional impact. There are costs to be incurred
when reaching out to the poor and most especially with small loans
(Christabell, 2009). The financial institutions always try to keep this cost as
minimum as possible and when the poor are in a dispersed and vast geographical
area, the cost of outreach increases. The provision of financial services to
the poor is expensive and to make the financial institutions sustainable
requires patience and attention to avoid excessive cost and risks (Adam and Von
Piscke, 1992). The deliveries of MF products and services have transaction cost
consequences in order to have greater outreach. Some microfinance institutions
visit their clients instead of them to come to the institution thereby reducing
the cost that clients may suffer from (FAO, 2005). For MFIs to be sustainable,
it is important for them to have break-even interest rates. This interest rates
need to be much higher so that the financial institutions revenue can cover the
total expenditure (Hulme and Mosley, 1996a). The break-even rate which is higher
than the market rate is defined as the difference between the cost of supply
and the cost of demand of the products and services. The loan interest rates
are often subsidised (Robinson, 2003). The loans demanded by smaller
enterprises are smaller than those requested by larger ones but the interest
rates remain the same. This indicates that, per unit cost is high for MFIs
targeting customers with very small loans and possessing small savings accounts
(Robinson, 2003). Even though the interest rate is high for applicants
requesting very small loans, they are able to repay and even seek repeatedly
for new loans. The social benefits that are gained by clients of MFIs supersede
the high interest charged (Rosenberg, 1996). The high interest rate is also as
a means to tackle the problem of adverse selection where a choice is made
between risky and non-risky projects. The good members suffer at the expense of
the bad ones (Graham Bannok and partners, 1997). Microfinance members admit
that convenience is more important to them than return (Schmidt and Zeitinger,
1994). Low-income men and women have a serious hindrance in gaining access to
finance from formal financial institutions. Ordinary financial intermediation
is not more often than not enough to help them participate, and therefore MFIs
have to adopt tools to bridge the gaps created by poverty, gender, illiteracy
and remoteness. The members also need to be trained so as to have the skills
for specific production and business management as well as better access to
markets so as to make profitable use of the financial resource they receive
(Bennett, 1994).
In providing
effective financial services to the poor requires social intermediation. This
is “the process of creating social capital as a support to sustainable
financial intermediation with poor and disadvantaged groups or individuals”
(Bennett, 1997). Some microfinance institutions provide services such as skills
training, marketing, bookkeeping, and production to develop enterprises. Social
services such as health care, education and literacy training are also provided
by some MFIs and both enterprise development and social services can improve
the ability of the low-income earners to operate enterprises either directly or
indirectly (Legerwood, 1999). The services provided to microfinance members can
be categorise into four broad different categories:
Financial intermediation or the provision of financial
products and services such as savings, credit, insurance, credit cards, and
payment systems should not require ongoing subsidies.
Social intermediation is the process of building human and
social capital needed by sustainable financial intermediation for the poor.
Subsidies should be eliminated but social intermediation may require subsidies
for a longer period than financial intermediation. Enterprise development
services or non-financial services that assist micro entrepreneurs include
skills development, business training, marketing and technology services, and
subsector analysis. This may or may not require subsidies and this depends on
the ability and willingness of the clients to pay for these services. Social
services or non-financial services that focus on advancing the welfare of micro
entrepreneurs and this include education, health, nutrition, and literacy
training. These social services are like to require ongoing subsidies and are
always provided by donor supporting NGOs or the state (Bennett, 1997;
Legerwwod, 1999)
2.3 SME growth and development.
The purpose or goal
of any firm is to make profit and growth. A firm is defined as an
administrative organisation whose legal entity or frame work may expand in time
with the collection of both physical resources, tangible or resources that are
human nature (Penrose, 1995). The term growth in this context can be defined as
an increase in size or other objects that can be quantified or a process of
changes or improvements (Penrose, 1995). The firm size is the result of firm
growth over a period of time and it should be noted that firm growth is a process
while firm size is a state (Penrose, 1995). The growth of a firm can be
determined by supply of capital, labour and appropriate management and
opportunities for investments that are profitable. The determining factor for a
firm‟s growth is the availability of resources to the firm (Ghoshal, Halm and
Moran, 2002). 10 Enterprise development services or business development
services or nonfinancial services are provided by some MFIs adopting the
integrated approach. The services provided by nonfinancial MFI services are;
marketing and technology services, business training, production training and
subsector analysis and interventions (Ledgerwood, 1999). Enterprise development
services can be sorted out into two categories. The first is enterprise
formation which is the offering of training to persons to acquire skills in a
specific sector such as weaving and as well as persons who want to start up
their own business. The second category of enterprise development service
rendered to its clients is the enterprise transformation program which is the
provision of technical assistance, training and technology in order to enable
existing SMEs to advance in terms of production and marketing. Enterprise
development services are not a prerequisite for obtaining financial services
and they are not offered free of charge. These charges are subsidized by the
government or an external party since to recover the full cost in providing the
services will be impossible by the MFI. The enterprise development services may
be very meaningful to businesses but the impact and knowledge that is gained
cannot be measured since it does not usually involve any quantifiable
commodity. It has been observed that there is little or no difference between
enterprises that receive credit alone and those that receive both credit
packages and integrated enterprise development services (Ledgerwood, 1999).
2.3.1 Minimal equity requirement Firms rely mostly on informal sources of
finance for start-up capital for their businesses since credit markets are
limited. A majority of the start-up capital is from personal savings and
borrowed money from friends and relatives. Minimal amount of funds as start-up
is borrowed from the formal institutions such as banks. The granting of loans
is much easier to large firms than small ones (Gary and Guy, 2003). MFIs
consider members ability to repay debt and assess the minimal sum small scale
businesses can contribute as equity before offering a loan. This is to say a
business should not be financed entirely with borrowed money. When a business
is in the start-up phase, it requires at least a certain amount resources for
the MFI to consider the application for a loan. In a situation where the firm
is unable to provide the said equity capital, some MFIs require household items
to be pledge as a security before the loan can be granted. These MFIs also
apply some sort of financial and psychological measurements and when they
consider that correct to any prospective borrower it is then that the loan can
be granted. It is generally said that people care more on things that they have
worked for or items 11 that they own (Zeller, 2003). This and other reasons
explain why MFIs deem it necessary for borrowers to have minimal equity
contribution before applying for a loan. The source of the minimal equity
capital is known by the MFIs because the client may be at high risk of non-respecting
the terms of repayment had it been the funds were borrowed from somewhere. This
means that a business with little borrowed capital with good market standing
will have a upper hand in getting financial assistance from the MFIs
(Ledgerwood, 1999).
2.3.2 Market
size.
The size of the microenterprise market is estimated by the
MFIs to know if it can be benefited from financial services, in case self-reported
credit need be confused with the repayment capacity and effective demand. The
market for MFIs takes into consideration the type of microenterprise being
financed and the characteristics of the population group
2.3.3 Characteristics of the target population
Female clients:
The main focus in many MFIs is to empower the women by
increasing their financial power and position in the society so as to have
equal opportunity as men (Moyoux, 2001). The poorest people in the society are
known to be women and they also are responsible for the child up bringing
including education, health, and nutrition. There are cultural barriers that
exist between the women that make them to stay at home making them to have the
constraint to have access to financial services. Some banks are unwilling to
lend to the women because their access to property is limited and they also
have fewer sources of collateral security. Based on experience, women generally
are very responsible and are affected by social forces. When the income of a
woman is increased, the effect is noticed throughout the household and to the
community than when that same amount is increased to a man. They also have a
high repayment loan and savings rate than their male counterparts (Ledgerwood,
1999). A study carried out by the World Bank’s sustainable banking for the poor
with the title of the project “ Worldwide Inventory of Microfinance
Institutions” found that female programs are group based with the
characteristic of having small loan size and short loan term (Paxton,1996). The
level of poverty: poverty alleviation is the focal point of microfinance
institutions and the poorest form a majority of the population. The outreach of
MF services to the poor is measured in terms of scale, the number of clients that
is reached and the depth of the clients they reach (Ledgerwood, 1999).
Institutions that are contributing in the fight against poverty are very
effective in the improvement of the welfare of those under and those just above
the poverty line (Hulme and Mosley, 1996). Geographic focus: MFIs serve both
urban and rural areas but their focus is more in the rural areas. Products and
services offered by the MFIs are aimed towards meeting the expectations of the
target location or area. Those in the rural areas are different from those in
the urban areas and the infrastructural development in these areas also
matters. Markets are very important for microenterprises irrespective of the
area where the firm is located. The difficulty to produce and distribute or deliver
the goods because of lack of infrastructure will hinder or retard the growth of
businesses thus limiting the financial services that will be demanded. An
example of a reduce transaction cost will be the availability of good road
network. Grameen Banks is a typical MFI that is successful and it has branches
in the same geographical areas where their clients live (Ledgerwood, 1999).
2.4 Types of
microenterprises.
The type of population to be serve and the activities that
the target market is active in and also the level or stage in development of
the business to be financed is determined by the MFIs. SMEs differ in the level
in which they are and the products and services offered to them by the MFIs are
towards meeting the demands of the market. SMEs are financed differently and
the financing is determined by whether the firm is in the start-up phase or
existing one and also whether it is stable, unstable, or growing. The type of
activities that the business is involve in is also determined and this can be;
production, commercial or services activities (Ledgerwood, 1999).
2.4.1
Existing or start-up microenterprises.
In identifying the
market, MFIs consider whether to focus on already existing entrepreneurs or on
potential entrepreneurs seeking for funds to start up a business venture.
Working capital is the main hindrance in the development of already existing
SMEs and to meet up, the borrow finance mostly from informal financial services
such as; families, friends, suppliers or moneylenders. The finances got from
these informal financial services have high interest rates and services offered
by the formal sector or not offered by these informal financial services. 13
MFIs see it less risky to work with existing microenterprises because they have
a history of success (Ledgerwood, 1999). Businesses that are financed by MF
from scratch consider that they will create an impact in the society by
alleviating poverty by increasing their level of income. An integrated approach
lay down the foundation for start-up businesses to pick up since financial
services alone will not help them. They need other services such as skills
training and to equip them with all the necessary tools that can hinder them
from obtaining loans. Existing businesses with part of their capital being
equity is preferred by most MFIs to work with since the level of involvement is
high and consequently lower risk (Ledgerwood, 1999).
2.4.2 Level
of business development.
MFIs provide their
products and services based on the level of development of the businesses. SMEs
can be grouped into three main levels of business development that profit from
access to financial services. - Unstable survivors are groups that are
considered not credit worthy for financial services to be provided in a sustainable
way. Their enterprise are unstable and it is believe they will survive only for
a limited time and when MFIs focus on time to revert the situation by providing
them other extra services, it is noticed that costs increases and time is also
wasted. - Stable survivors are those who benefit in having access to the
financial services provided by MFIs to meet up with their production and
consumption needs. Stable survivors are mainly women who engage in some sort of
business activities to provide basic needs such as food, child health, water,
cooking for the household, etc. These types of microenterprises rarely grow due
to low profit margins which inhibit them to reinvest and an unstable
environment due to seasonal changes which makes them to consume rather than to
invest in the business. - Growth enterprises are SMEs with high possibility to
grow. MFIs focusing on these types of microenterprise are those that have as
objective to create jobs, and to move micro entrepreneurs from an informal
sector to a formal sector.
MFIs prefer to provide products and services to meet the
needs of this group since they are more reliable and posing them the least risk
(Ledgerwood, 1999).
2.4.3 Type of
business activities.
The business activity
of a microenterprise is equally as important as the level of business
development. There are three main primary sector where an enterprise may be
classified; production, agriculture and services. Each of these sectors has its
own risk and financing needs that are specific to that sector. MFIs are
motivated to finance in a particular sector by providing the products and
services that are relevant to that sector after analyzing the purpose for the
loan, term of the loan, and the collateral on hand for each of the sectors.
Some MFIs target only one sector where as others provide products and services
for more than one sector. Their actions are determined by their objectives and
the impact the wish to achieve (Ledgerwood, 1999).
2.5 The
supply of microfinance services to clients.
The approach taken by
an MFI will depend on the degree to which these MFIs will provide each of these
services and whether it follows a “minimalist” approach or “integrated”
approach. The minimalist approach offers only financial intermediation but they
can sometimes offer partial social intermediation services. This approach is
based on the fact that there is a single “missing piece” for the growth of enterprises
and it is assumed to be the lack of affordable, accessible, short-term credit
which the MFIs can offer. The integrated approach takes a more holistic view of
the client. This approach creates avenue for a combination or range of
financial and social intermediation, enterprise development and social
services. MFIs take advantage of its nearness to the clients and based on its
objectives, it provides those services that are recognized as most needed or
those that have a comparative advantage in providing.
2.5.1 Financial intermediation.
MFIs have as main
objective to provide financial intermediation which involves the transfer of
capital or liquidity from those who have excess to those who are in need both
at the same time. “Finance in the form of savings and credit arises to permit
coordination. Savings and credit are made more efficient when intermediaries
begin to transfer funds from firms and individuals that have accumulated funds
and are willing to shed liquidity, to those that desire Financial
intermediation Working capital Fixed asset loans Savings Insurance Social
intermediation Group formation Leadership training Cooperative learning
Enterprise development services Marketing Business training Production training
Subsector analysis Social services Education Health and nutrition Literacy
training to acquire liquidity” (Von
Pischke, 1991, p27). It is visually known that almost all MFIs provide credit
services. Other MFIs also provide some financial products such as; savings,
insurance, and payment services. Each MFI has its objectives and the choice of
the financial service to provide depends on the demands of its target market
and its institutional structure. Two important considerations when providing
financial services are; to respond effectively to the demand and preference of
clients and to design products that are simple and easy to understand by the
clients and easily managed by the MFI. The common products that MFIs provide
include; credit, savings, insurance, credit cards, and payment services. These
points are briefly described and also show how financial services are provided
to SMEs. Credit: These are borrowed funds with specified terms for repayment.
People borrow when there are insufficient accumulated savings to finance a
business. They also take into consideration if the return on borrowed funds
exceeds the interest rate charged on the loan and if it is advantageous to
borrow rather than to postpone the business operations until when it is
possible to accumulate sufficient savings, assuming the capacity to service the
debt is certain (Waterfield and Duval, 1996). Loans are usually acquired for
productivity reasons; that is to generate revenue within a business.
Savings: Savings mobilisation in microfinance is a very
controversial issue. They have been increase awareness among policy makers and
practitioners on the vast number of informal savings schemes. MFIs such as
credit union organisations around the world have been very successful in
rallying clients to save (Paxton, 1996a, p8).
Insurance: This is one of the services and products that are
experimented by MFIs. Many group lending programs offer insurance or guarantee
scheme as collateral and the Grameen bank is a typical example of MFI in this
scheme. One percent of the loan is required to be presented by the group member
as their contribution for the insurance for the loan (Ledgerwood, 1999).
Credit cards: These are cards that allow borrowers to have
access to a line of credit if and when they need it. This card is also use to
make purchase assuming the supplier of the goods will accept the credit card or
when there is a need for cash. The card is also called a debit card when the
client is accessing his or her own savings (Ledgerwood, 1999).
Payment Services:
payment services include cheque cashing and cheque writing opportunities for
clients who retain deposits (Caskey, 1994). In addition to cheque cashing and
cheque writing privileges, payment services comprise the transfer and
remittance of funds from one area to another (Ledgerwood, 1999).
2.6 Determinants of capital structure by SMEs.
SMEs have some
important aspects that are considered when taking decisions on their financial
structure. A firm’s history is a more important factor in determining the
capital structure than its characteristics. The cost of debt to equity is
compared; the increase in risk and the cost of equity as debt increases is also
compared before taking the decision. The advantage of debt by SMEs due to tax
reduction is also considered. The costs of capital remain unchanged when there
is a deduction in taxes and interest charges. This indicates that using cheaper
debt will be favourable to the business than using equity capital due to
increase risk (Modigliani and Miller, 1958 and 1963). Firms would seek a good
portion of their capital structure as debt to a certain level so as to take
these tax advantages. An over reliance on debt as capital by SMEs will have a
negative effect in the business activity in that it will increase the
probability of the firm to go bankrupt (Myers, 1984). Myers (1977) determines
the capital structure of SMEs. The pecking order theory (POT) was used to
explain why firms will choose a particular capital structure than the other.
The POT stipulates that SMEs average debt ratio will vary from industry to
industry because these industries have varied asset risks, asset type and the
requirements for external capital (Myers, 1984). Firms in one industry will
have certain aspects that are common to most than to firms in a different industry
(Harris and Raviv, 1991). The decisions are made taking into consideration
information asymmetry, agency theory, and the signalling theory. The signalling
theory describes signs and the effectiveness or how a venture will progress in
an uncertain environment (Busenitz et al., 2005). The main idea behind this
theory is that there is an information signal that alerts the stakeholders of
what is happening in the business (Deeds et al., 1997). The success of a
business in the future is determined by the availability of information to the
firm. The stakeholders of a business require signals to find the way of the 18
asymmetry of information between what is known and what is unknown (Janney and
Folta, 2003). The outsiders get to know about a particular venture based on the
signals it sends out. These signals need to be favorable because it is from it
that potential investors will be informed and thus show the intention to invest
in the venture. The cost of equity will be high when poor signals are noticed by
outsiders and this will restrain potential investors (Busenitz et al., 2005).
Firms get access to venture capital when they have a good goodwill (Prasad,
Bruton and Vozikis, 2000, p168). Good signals to the outsiders of a firm can be
described as equal to due diligence with reduced time and input (Harvey and
Lusch, 1995). New businesses have problems in getting a favorable position in
the market. Their existence is determined by their size and age. If it
continues to exist, it means it is capable of maintaining its size or it is
expanding. This of course goes with time and when they continue to exist, it
means resources are acquired or unlimited (Freeman, 1982). This process of
gaining stability and to survive makes the firm to gain legitimacy and thus can
be trusted as a successful business since it emits positive signals (Singh,
Tucker and House, 1986). Firms with unlimited resources at the infancy stage
are easy to go bankrupt and die in this early stage (Aldrich and Auster, 1986;
Carroll and Delacroix, 1982; Freeman, Carroll and Hannan, 1983; Romanelli,
1989; Singh, Tucker and House, 1986; and Stinchcomb, 1965). Firms that are
young and small are incapable of getting the available resources for the proper
functioning of its business activities and they are always associated with
external organizations in a vertical manner for support (Stinchcomb, 1965). The
integration of the young firm with a well-established one gains ground for
available resources such as funding and legitimacy (Hannan and Freeman, 1984;
Singh et al., 1986). Businesses employing this approach to gain legitimacy are
at risk since they are not independent. The other activities will have an
influence in the outcome of the other. Its competitors along with others get to
know the inner dependent firm which the competitor will use it as its strength.
They get to know the weaknesses of the opposing firm but at the same time they
will enjoy the benefit of transaction cost. The reduction of costs is due to
the fact that they integrate with others to realize their objectives. This is
done by gaining the inside of the quality of work, production and ideas within
its top level. It is realized that there is no target equity mix and this is
due to the fact that they exist two different kinds of equity. The two are at
extremes meaning one at the top and the other at the bottom of the pecking
order. These differences are caused by the costs of information 19 asymmetry.
External sources of funding have more moral hazard problems and consequently
the demand for own or internal finances are of paramount to the firm (Myers,
1984). This moral hazard is explained by the fact that SMEs are very close
entities; that is owned and or controlled by one person or few people (Watson
and Wilson, 2002). POT emphasises; Ang (1991) on the use of owned capital
rather than outside capital by SMEs and also explain why SMEs are denied or has
a hindering factor in seeking for external sources of finance. World Bank
(2000) reiterates the fact that SMEs are more likely to be denied new loans for
their businesses than larger firms when in need. They consider SMEs to lack the
skills to manage risk and the high transaction costs in lending to them
compared to the amount that is borrowed (Hallberg, 1994). SME lack managerial
skills, resources and experience to motivate the potential investors to invest
on them. They view them as high risk business concerns and some well to do SMEs
may be hindered critical financing (Kanichiro and Lacktorin, 2000). SMEs and
providers of debt and equity need to have a cordial relationship to avoid the
problem of information asymmetry and conflicts of interests. All SMEs require
financing to grow and the source may be internal or external. The external
sources constitute loans, equity infusions, subsidies, or government grants.
The internal source is income generated from cash flows that are reinvested.
Many SMEs are self –financing by friends and family members at the beginning
stage of development but when it gets to a later stage in development, external
financing become necessary. Banks find it hard to grant loans to SMEs until
when they find it have a stable growth. More so they need to have a track
record of their activities, sufficient collateral or adequate guarantees.
Businesses that are viable and have good market positions during periods of
recession will have difficulties in obtaining bank financing. Credit
availability to SMEs depends on the financial structures in place, legal
systems, and the information environment. SMEs in countries with more effective
legal system have less financing obstacles since the laws protect property
rights and their enforcement are implemented to financial transactions (Beck et
al., 2005b)
2.7 Some problems faced by SMEs to acquire capital
from formal financial institutions.
Formal financial
institutions have failed to provide credit to the poor and most of whom are
found in developing countries and to be more specific in the rural areas. The
reasons given by Von Pischke (1991: 143-168) is that their policies are not
meant to favour the poor. The poor are mostly illiterate and banks lack those
skills to target these rural customers. In these areas, the population density
is very low causing high transaction cost by the financial institutions since
they need to move for long distances and also takes time to meet the customers
(Devereux et al 1990:11). SMEs in developing countries are considered to be too
unstable by banks to invest in. Due to this instability, the banks consider
SMEs to have high risk and the costs these banks suffer to monitor the
activities of the SMEs are high. Hossain (1998), Bhattacharya, et al. (2000)
and Sia (2003) identify that formal financial institutions (banks) are
reluctant to lend to SMEs since investing in SME activities is considered by banks
to be very risky. They find it risky in the sense that if invested in, and in
an event of unfavourable business conditions, they have low financial power,
assets, and easily go bankrupt (Sia, 2003). The cost of borrowing from banks is
very high and this prevents SMEs to borrow from this institution but these
costs to borrow are sometimes subsidized by the government (Meagher, 1998). The
application process for a loan is long and difficult for SMEs to meet up with
the demands (Hossain, 1998). The collateral demanded by banks for a loan is
based on fixed assets and which are very high in other to hinder these
businesses to acquire loans. They cannot afford these collaterals which
include; estates, and other fixed assets valued usually at 200% of the loan
(Meagher, 1998). The major setback that prevents SMEs to get funding from
external sources is the problem of information asymmetry. That is the magnitude
of the deviation of the correct information that is needed by the lending
institution (Bakker, Udell, &Klapper, 2004). Banks use cash flows and
profitability to measure or to assess the worthiness of a business. This is a
very expensive and, not a good method to measure the credit strength of rural
SME. Production and distribution in the rural areas is influenced by social
factors that are often neglected by enterprises in developing countries (Otero
et al 1994: 13). Agriculture dominates rural activities in developing countries
and is dependent on the weather conditions for its output. An enterprise in this
sector is considered risky because its outcome is undetermined.
2.8 Organization of microfinance institutions.
2.8.1
Cooperative financial institution:
This is a financial institution that can be termed
semiformal. It constitutes credit unions, savings and loan cooperatives and
other financial cooperatives. They are generally identified as credit unions or
savings and loan cooperatives and provide savings and credit services to its
members. There are no external shareholders and run the same as a cooperative
and implementing all its principles. Members who are at the same time customers
make the policy of the cooperative. They are either elected or work on
voluntary bases. They are not often subjected to banking regulations but have
their own regulations and are under the supervision of the ministry of finance
of the country. Individual financial cooperatives in a country are often govern
by a league that coordinate activities of these credit unions, trains and
assist its affiliates, act as a place where the deposit and provide inter
lending facilities and act as a link between external donors and the
cooperative system (Schmidt, 1997).They raise capital through savings but to
receive loans is not easy. Loans are delivered following the minimalist
approach where the requirements for loans are not often difficult to meet by
customers; little collateral, character and co-signing for loans between
members. These loans are usually loans within the savings of the member
(Schmidt, 1997).
2.8.2 Group Lending:
This method of providing small credits to the poor is most
use by microfinance that provides loans without collateral. The interest charge
is around not much different from that of commercial banks but far lower than
interest charge by individual by money lenders (Natarajan, 2004). The Grameen
bank is a typical example of microfinance institution using this method. The
repayment rate is very high since each member is liable for the debt of a group
member (Stiglitz, 1990). Group formation is made by members who know themselves
very well or have some social ties. Loans are not granted to individuals on
their own but to individuals belonging to a group; and the group acts as a
collateral which is term social collateral. This is to avoid the problems of
adverse selection and also to reduce costs of monitoring loans to the members
who must make sure the loan is paid or they become liable for it (Armendariz,
1994).
2.8.3 Individual Lending:
This is the lending of loans to individuals with collateral.
Besley and Coate (1995) say despite the advantages of lending to groups, some
members of the group may fail to repay their loan. Montgomery (1996) stresses
that this method of lending avoids the social costs of repayment pressure that
is exerted to some group members. Stiglitz (1990) highlights that members in
group lending bear high risk because they are not only liable for their loans
but to that of group members. Navajas et al. (2003) and Zeitingner (1996)
recommend the importance of routine visits to the clients to make sure the loan
is use for the project intended for. These monitoring is vital but at the same
time increases the cost of the microfinance institution.
2.8.4 Self-help groups (SHG):
This is common among women in the rural areas who are
involved in one income generating activity or another (Ajai 2005). Making
credit available to women through SHGs is a means to empower them. This group
is an institution that helps its members sustainably with the necessary inputs
to foster their lives.SHG provides its members with not only the financial
intermediation services like the creating of awareness of health hazards,
environmental problems, educating them etc. These SHGs are provided with
support both financial, technical and other wise to enable them engage in
income generating activities such as; tailoring, bee keeping, hairdressing,
weaving etc. It has a bureaucratic approach of management and are unregistered group
of about 10 – 20 members who have as main priority savings and credit in mind
(Ajai, 2005). The members in the SHG have set dates where they contribute a
constant and equal sum as savings. These savings are then given out as loans to
members in need for a fixed interest rate (Bowman, 1995).
2.8.5 Village
Banking:
This is a method of lending to individual members to have
constant access to money for their Micro-enterprise daily transactions (Mk
Nelly and Stock, 1998). Borrowers are uplifted using this method because they
own SME that earn money sustainably. This enables them to acquire a larger loan
sum which gives them higher profit when introduced into the business and of
course the interest with this high sum is high making the bank financial sustainable.
Village banking as of the 90s has gained grounds and certain adjustments are
made to suit partner institutions (Nelson et al; 1996). Hatch and Hatch (1998)
Village banking loan and savings growth rate increases as the bank continue to
exist.
2.9 The
triangle of microfinance.
The performance of
the financial sector in providing financial intermediation for small and
medium size enterprises
can be evaluated
in three vital
dimensions: financial sustainability, outreach, and
welfare impact (Zeller
and Mayer, 2002).
They went further to say that this 23microfinance triangle is the main
policy objective of these microfinance institutions which are aimed towards development. The
internationally agreed objectives
of development are the
Millennium development Goals
(MDGs). These MDGs
are to alleviate
poverty and this
is done in many dimensions of welfare such as increasing access to
education, health, nutrition, women’s empowerment and of course basic needs
(Morduch et al, 2003). Donor organisations and
governments differ in
the microfinance objective
which is of
prominence to them;
i.e. financial
sustainability, depth of
outreach, and welfare
impact. This influences
their perceptions on the
relative efficiency on
the different microfinance
institutions and how financial
policies are designed
and evolve (Stiglitz,
1992; Krahnen and
Schmidt, 1994). The financial sector can contribute to the
development of SMEs either directly or indirectly. The direct influence
is by increasing
the access to
financial services to
the poor. There
are three distinguished ways
to how access
to financial services
can influence income generation activities and consumption
stabilization of the poor (Zeller et al, 1997). The indirect method is by
supporting a sustainable financial system as a prerequisite for social and
economic growth. There has been a paradigm shift in thinking about relevant
policies for the development of the financial
sector and precisely
in the field
of microfinance in the 1990s.
This shift is
as a consequence of
the failures of
small farmer credit
and successes of
some few MFI.
The financial policy has
changed due to this
shift and it
is based on
the assumed lapses
between the demand for credit and savings services, and how these
services can be access by a specific target group. It was before now more
emphases were laid on improving the outreach to small farmers in the 1960s and
1970s, and in the 1980s and 1990s to the poor. This was focused on serving more
of the poor (breadth of outreach) and the poorest of the poor (depth of
outreach) (Zeller and Mayer, 2002).MFIs were focusing on the poor and in order
to have access to or supply of MF
services with demand
has been constant
for MFIs trying
to serve clientele outside the border line of formal
financial institutions (Von Pischke, 1991).
In the 1960s and 1970s the government was the main actor in
the provision of these services to the population, and parastatal development
banks and agricultural credit projects of prime concern. The new approach to
microfinance started in the mid 1980 due to the awful failures of development
banks and the
good outcome of
some microfinance innovations
to serve the poor
(Adams,1998). Some institutions
cropped up with permanent financial institutions that became sustainable by
building up a cost effective MFI. These institutions with the innovative
approaches recognises that
risks and high transaction
costs which results
partly from information asymmetries
and moral hazards
are the core
causes of the
difference between demand and
supply for financial services(Stiglitz and Weiss, 1981).
The main objectives of microfinance institutions are
prioritised differently by different authors.
Researchers like Otero
and Rhyne, (1994);
Christen et al.,
(1995) argues that increasing access
to reach the
poorest of the poor (depth
of outreach) and
sustainability are compatible
objectives. Although Hulme and Mosley
(1996), Lapenu and Zeller (2002), with others
argue that they
may be a
trade-off between augmenting
outreach to the
poorest and attaining financial
sustainability. This trade-off
is as a
result from the
fact that MFI transaction costs
have a high fixed
cost element which
makes unit cost
for smaller savings and smaller loans high as compared to
larger financial transactions. This rule
of reducing unit transaction costs with larger transaction size generates the
trade-off between better outreach to the poor and financial sustainability,
regardless of the borrowing technology used (Zeller and Mayer, 2002). The
financial sustainability of
the financial institutions
and outreach to the
poor is
two of the
three policy objectives
of the contemporary
developments in the
field of microfinance. Welfare
impact is the
third policy objective
that relates to
the development of the
financial system and
precisely on economic
growth and poverty
alleviation and food insecurity.
Innovation in the institutional domain and the expansion of
microfinance institutions rely on public intervention and financial
support. The state
and donor transfers
such as international NGOs subsidises
the costs of
most microfinance institutions
reaching a greater
number of clients below the
poverty line. These costs include the opportunity costs of
forgoing other assistance to public investments such as in primary education
when limited funds are used for microfinance (Zeller et al.1997). The subsidy
dependent index Yaron (1992)has become the universally accepted
measure to quantify
the amount of
social costs involved
in running the activities of a financial
institution. Zeller and
Sharma (1997) argue
whether public sector development are
economically or financially
sustainable and to find
out that they
compared social costs with social benefits to know which one will have a
greater impact on the society.
The crucial triangle
of microfinance is
a triangle that
reflects the three
policy objectives of MF of outreach, financial sustainability
and impact. Some of these objectives contribute more impact and at the same
time inadequate outreach. The other
objectives may produce
limited impacts but are
very much financially
sustainable (Zeller and
Mayer, 2002). The impact of finance can
be increased through
complementing non-financial services
such as SMEs
or marketing services, or
training of borrowers
that raise the
profitability of loan
financed projects (Sharma and
Buchenrieder, 2002). The MF impact assessment studies
reviewed suggested that the poorest amongst the poor can gain from
microfinance by having a constant consumption through the management of their
savings and borrowing habits.
It is noted that the management of loans for productive purposes
with the aim to raise income and assets is effectively done by those just below
or just above the poverty line. An increase in
financial services will
have a positive
outcome in the
welfare of the
poorest but not necessarily to lift them from poverty
because of the lack of access to market, technology, and other factors that
raise production.
Fig
2: the critical triangle in achieving economic sustainability of microfinance
The microfinance triangle
illustrated in the
figure above consist
of an inner
circle that represents the
different types of
institutional innovations such
as employment of
costs reducing information that
improves financial sustainability. Institutional
innovations that contribute to
improving the impact
are designing demand-oriented services
for the poor
and more effective training
for the clients.
Outreach to the
poor such as
more effective targeting mechanisms or to introduce lending
technologies that attract a particular group of clients. The outer circle
presents the socio-economic environment
as well as
the macroeconomic and
the sector policies that
in one way
or the other
affect the performance
of financial institutions (Zeller and Mayer, 2002).
2.10 Theoretical links between microfinance and SME
development
Accessing credit is
considered to be
an important factor
in increasing the
development of SMEs. It is thought
that credit augment
income levels, increases employment and
thereby alleviate poverty. It is believed that
access to credit
enables poor people
to overcome their liquidity constraints and undertake
some investments such
as the improvement
of farm technology inputs thereby
leading to an increase in agricultural production (Hiedhues, 1995). The main
objective of microcredit according to Navajas et al, (2000) is to improve the
welfare of the poor
as a result
of better access
to small loans
that are not
offered by the
formal financial institutions.
Diagne and Zeller (2001) arguethat insufficient access to
credit by the poor just below or just above
the poverty line
may have negative
consequences for SMEs
and overall welfare. Access to credit further increases
SMEs risk-bearing abilities; improve
risk-copying strategies and enables consumption smoothing overtime. With
these arguments, microfinance is assumed to improve the welfare of the poor.
It is argued
that MFIs that
are financially sustainable
with high outreach
have a greater livelihood and
also have a
positive impact on
SME development because
they guarantee sustainable access
to credit by the poor (Rhyne and Otero, 1992).
Buckley (1997) argue
that, the indicators
of success of
microcredit programs namely
high repayment rate, outreach
and financial sustainability does
not take into
consideration what impact it has
on micro enterprise operations and only focusing on “microfinance evangelism”.
Carrying out research
in three countries;
Kenya, Malawi and
Ghana, Buckle (1997)
came to the conclusion that
there was little
evidence to suggest
that any significant
and sustained impact of
microfinance services on
clients in terms
of SME development,
increased income flows or
level of employment.
The focus in
this augment is
that improvement to
access to microfinance and
market for the
poor people was not
sufficient unless the change
or improvement is accompanied by changes in technology and or technique.
Zeller and Sharma
(1998) argue that
microfinance can aid
in the improvement
or establishment of family
enterprise, potentially making
the difference between alleviating poverty and
economically secure life.
On the other hand, Burger (1989) indicates that microfinance tends to
stabilize rather than increase income and tends to preserve rather than to
create jobs.
Facts by Coleman (1999) suggest that the village bank credit
did not have any significant and physical asset accumulation. The women ended
up in a vicious cycle of debt as they use the money from
the village banks
for consumption purposes
and were forced
to borrow from money
lenders at high
interest rate to
repay the village
bank loans so
as to qualify
for more loans. The main
observation from this study was that credit was not an effective tool to help
the poor out of poverty or enhance their economic condition. It also concluded that the poor are too poor
because of some other hindering factors such as lack of access to markets,
price stocks, unequal land distribution but not lack of access to credit. This
view was also shared by Adams and Von Pischke (1992).
A study of
thirteen MFIs in
seven countries carried
out by (Mosley
and Hulme (1998) concludes that household income tends
to increase at a decreasing rate as the income and asset position of the
debtors is improve. Diagne and Zeller (2001) in their study in Malawi suggest
that microfinance do not
have any significant
effect in household
income meaning no
effect on SME development. Investing in
SME activities will
have no effect
in raising household income because the infrastructure
and market is not developed.
Some studies have
also argued that
using gender empowerment
as an impact
indicator; microcredit has a negative impact (Goetz and Gupta, 1994;
Ackerly, 1995; Montgomery et al, 1996). Using a “managerial control” index as
an indicator of women empowerment, it came to conclusion that the majority of
women did not have control over loans taken by them when married. Meanwhile, it
was the women who were the main target of the credit program. The management of
the loans were made by the men hence not making the development objective
of lending to the women
to be met
(Goetz and Gupta,
1994). Evidence from
an accounting knowledge as an
indicator of women
empowerment concluded that
women are marginalised when it comes to access to
credit (Ackerly, 1995).
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