Effects of micro finance institutions on small and medium size enterprises in cameroon | chapter two


Effects of micro finance institutions on small and medium size enterprises in Cameroon | chapter two



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).


 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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