Microfinance is regarded as an effective tool for poverty reduction. The World Bank has proposed a set of strategies for attacking poverty: promoting opportunity, facilitating empowerment, and enhancing security (World Bank 2000). Microfinance provides access to financial services that can help to reduce poverty by both promoting opportunities and facilitating empowerment. In general, formal financial services are not available to poor people because of the high interest rates, collateral requirements, complicated application procedures, and long admissions processing. The high interest rates caused by high transaction costs are ascribed to the lack of collateral and the small loan amounts desired. The biggest contribution of microfinance has been showing that lending to the poor is feasible and that keeping good repayment records is achievable when institutions are appropriately designed. One of the successful models of microcredit is Grameen Bank, which provides loans to 7.9 million borrowers, of which 97% are women. The bank's accumulated loans are worth US$8.17 billion and the repayment rate is 98%. Other successful microfinance institutions (MFIs) are Banco Sol in Bolivia, Bank Rakyat Indonesia (BRI) in Indonesia, and ASA and SafeSave in Bangladesh. Various types of MFIs are now operating around the world.

These successful experiences of MFIs have prompted academic studies to identify the mechanisms for solving the problems associated with asymmetric information. Although many studies are being conducted, the practices of microfinance continue to evolve and are rapidly expanding in scope. Reflecting the increased interest, the United Nations set the year 2005 as the “International Year of Microcredit,” and, subsequently, Dr. Muhammad Yunus and Grameen Bank were awarded the Nobel Prize for Peace in 2006. These successive events were the outcome of the good reputation for the performance of microfinance over several decades which led to a new phase in microfinance. Microfinance has attracted the attention of various circles who consider it a good business opportunity. As a result, the microfinance “field” has changed into a microfinance “industry,” and the idyllic era that just celebrated the success of Grameen Bank is now over. In fact, Grameen Bank itself has introduced a new credit scheme, Grameen Bank II, as well as a Grameen Bank mobile phone program,1 and Grameen-Obopay which makes full use of information technology.

As the industry has grown, the focus of microfinance has shifted from that of a social movement to the integration of microfinance into the formal financial sector (Ledgerwood and White 2006). This integration has led some to argue that microfinance and formal financial business are irreconcilable; they condemn the practice of pursuing profit as deviating from the mission of microfinance (regarded as mission drift). For example, in 2007 Banco Compartamos, one of the biggest MFIs in Mexico, held an initial public offering (IPO). Shareholders sold 30% of their existing stockholdings, resulting in a record amount of profit taking.2 Dr. Yunus criticized Compartamos for being on the moneylender's side and asserted that Compartamos, which charged 100% interest on some loans, was generating profits on the backs of poor people to win investors' money, compromising the movement's idealistic principles.3

There are arguments for and against microfinance institution IPOs and profit taking,4 but what is important is the fact that dynamic changes in microfinance are continuously expanding its scope and transactions with various types of circles. At the same time, this substantial expansion is increasing the possibility of access to financial services for poor and low-income people. By narrowly defining microfinance, one can limit its prospects in poverty reduction and in seeking out promising microfinance opportunities.


A. What Is Microfinance?

What is microfinance? Microfinance offers poor people access to basic financial services, such as loans, savings, money transfer services, and microinsurance.5 Initially, MFIs provided microcredit as their sole financial product. Among the various types of microcredit schemes, which vary according to location and MFI, Grameen Bank is regarded as the prototype of microcredit. Grameen Bank credit is motivated by a social mission: its ultimate goal is overcoming poverty, empowering the poor, especially women, and supporting start-up self-employment businesses. In essence, the schemes involve non-collateralized, jointly liable, group-based lending with a frequent installment schedule.

Today, group lending is just one element that makes microfinance different from conventional banking (Armendáriz de Aghion and Morduch 2005). There are several other elements that make microfinance work effectively, including progressive lending, repayment schedules with weekly installments, public repayment, and the targeting of women. As a result, lending that does not involve groups has increased.

Kono and Takahashi (2010) in this issue address the impacts, innovative mechanisms, and recent challenges of MFIs through a review of the existing published literature. Specifically, they describe the accumulated empirical evidence on microcredit, the recent theoretical developments on the mechanisms underlying the high repayment rates, and the problems and possible remedies associated with microinsurance operations. The distinction between this article and previous literature surveys, such as Armendáriz de Aghion and Morduch (2005), is that the authors focus more on recent topics and draw attention to new theoretical developments in a comprehensive way through the use of simple models.

B. Microfinance as a Financial Service

In the 1960s and 1970s when microfinance was mainly provided through the public sector, its usefulness was discredited as a result of the low repayment rates due to lax government management. But microfinance schemes have succeeded in broadening financial outreach to the poor and have demonstrated that a high repayment rate is achievable. Furthermore, the pioneering Grameen credit schemes showed that microfinance consists of various elements, including poverty reduction, empowerment of the poor, increasing income, creation of business opportunities, investment, and family risk management. The emphasis of microfinance has been on poverty reduction and empowerment, i.e., the social mission, but in recent years, the focus has shifted from social aspects to financial function. Although the benefits of access to financing are clear, poor people were widely considered “unbankable,” as the small amounts of their loans and deposits are costly and unprofitable products for banks. However, decades of experience in microfinance have revealed that the problems of the high transaction costs associated with information asymmetry can be solved with appropriate institutional designs and improvement of the financial system.

Development practitioners are becoming all the more convinced of the importance of the financial system. Efficient, well-functioning financial systems are crucial in channeling funds to productive uses and in allocating risks to those who can best bear them, thus boosting economic growth, improving opportunities and income distribution, and reducing poverty (World Bank 2008). Therefore, the importance of financial access, which entails not only obtaining credit but also making deposits and money transactions, and obtaining insurance, has become broadly recognized.

In developing countries, especially in rural areas, the credit market is segmented. Information problems in the rural credit market are severer than in urban and conventional markets; hence, it is easy for poor people in rural areas to face financial constraints. One of the important roles of finance is to allocate credit to optimize the intertemporal problems of output and consumption. Without a credit market, people have to cover their consumption and investment using their income in the current period. The income of poor people, however, is too small and unstable to sufficiently cover both consumption and investment. For instance, a sudden decrease in income because of illness of the head of a household means that family members have to find another income source. If this is impossible, they have to reduce their investment and consumption. Because poor people are generally quite vulnerable to unfavorable incidents and unexpected risks, reducing investment in education leaves the next generation poor, and the vicious circle of poverty never ends. Financially constrained people have to prepare for unexpected risks by themselves, meaning that risk management is much more important for poor people. Therefore, risk management, encompassing loans, savings, and insurance, is a crucial role of microfinance.

It has been said that poor people are too poor to save money, and, hence, there is no demand for savings. Theoretically, household members might simply be too impatient to save sufficiently (Armendáriz de Aghion and Morduch 2005). However, saving is a core principle of risk management for households.

Insurance is an effective measure for coping with risk, which has made microinsurance the focus of an important financial service. Microinsurance is defined as the protection of low-income people against specific perils in exchange for regular monetary payments (premiums) proportionate to the likelihood and cost of the risk involved (Churchill 2006). As with all insurance, risk pooling under microinsurance attempts to allow many individuals or groups to pool risks and redistribute the costs of risky events within the pool (Churchill 2006). The definition of microinsurance does not differ from conventional insurance, except for the target: low-income people. However, microinsurance is not just a scaled-down version of conventional insurance.

Microinsurance has different marketing channels: small community-based schemes, MFIs, or partnerships with large and multinational insurance companies that offer microinsurance. As the conventional, market-based distribution system has not served low-income people adequately, the establishment of a different distribution channel has been necessary. The features of microinsurance are: group pricing with links to other services, limited period and scope of coverage, limited screening on preexisting conditions, simple and easy to understand policy document, and smaller indemnity.

Although the greatest demand is for health insurance, such insurance is likely to be more difficult to market than life and property insurance because: (1) a third party is necessarily involved (e.g., a health-care provider); (2) a number of classical insurance problems apply (e.g., those more likely to get sick are more likely to sign up and those who are insured are more careless and overuse health services), which makes insurance costly for all involved; and (3) the only policies that are affordable to poor people are those that are highly restrictive in terms of the kinds of benefits offered (Helms 2006).

These difficulties of micro health insurance are examined by Ito and Kono (2010) in this issue using survey data from India. Microinsurance is at an early stage of development in India, where a uniform product is being offered to poor people. There are, however, problems: low take-up rates, high claim rates, and low renewal rates. The authors endeavor to investigate the causes of these practical but basic problems based on recent insurance literature and behavioral economics literature, along with experimental survey data. Novel and advantageous features of this article are its application of behavioral economics to microfinance and its utilization of experimental survey data to discern household characteristics that affect the purchase of health insurance.


A. Paradigm Shifts

There have been two paradigm shifts in the microfinance field. During the 1960s to 1980s microfinance focused on agri-credit or microcredit subsidized by government and/or donors to small farmers; after the 1980s the target shifted to the poor. The first paradigm shift began to emerge in the second half of the 1980s. The new paradigm recognized the problem of high transaction costs and risks because of information asymmetries (Zeller and Meyer 2002), and the focus became the building of cost-efficient MFIs (Robinson 2002).

The second paradigm shift emerged in the middle of the 2000s. This shift was from microfinance to inclusive finance, from supporting discrete MFIs and initiatives to building inclusive financial sectors (United Nations 2006). In 2004, the Consultative Group to Assist the Poor (CGAP) endorsed the “key principles of microfinance.” These principles were explained within a framework for an inclusive financial system. The framework recognized that the massive number of excluded people would gain access only if financial services for the poor were integrated into all three levels of the financial system: micro, meso, and macro (Helms 2006). Within this framework, poor and low-income people are the clients at the center of the financial system. The micro level of inclusive financial systems consists of financial service providers that offer services to poor and low-income clients. The meso level includes the financial system's basic financial infrastructure and its range of services. The macro level consists of an appropriate government legislative and policy framework. Traditional microfinance focused on the micro level of financial providers, but current microfinance focuses on a more comprehensive financial system.

The second paradigm shift can be described as a shift from a product-centered to a client-centered approach. The product-centered approach is one where microcredit organizations offer a standardized product targeted to the “average client” during “normal times.” By contrast, a client-centered approach focuses on identifying and meeting the effective demand from both current and future clients. A client-centered MFI may offer a variety of financial products and services aimed at a variety of customers (Dunn 2002). The microfinance agenda is now increasingly client or market driven. Therefore, new attention is being given to client products: focusing on how to attract and keep clients (Cohen 2002). Under increasingly competitive conditions, obtaining information on clients becomes crucial for MFIs: Who are the clients? How do the clients use the products? What new product would better serve current clients? What new products would attract new clients and expand outreach? (Dunn 2002).

In this issue, Tsukada, Higashikata, and Takahashi (2010) use household panel data from Indonesia and apply the mixed logit model to analyze the changing credit demands of clients. This analytical framework fits the client-centered approach and seeks to determine the influences of a new microcredit product on client choice behavior, which provides new insight for microfinance study.

B. Ultimate Objectives of Microfinance

Although the perspective of microfinance has widened, essential microfinance objectives remain unchanged. Outreach to the poor is one basic motive, and making a positive impact and maintaining financial sustainability remain important focuses. Zeller and Meyer (2002) explain the inherent trilemma of microfinance: outreach, impact, and financial sustainability. They present an analytical framework of the critical triangle in achieving the economic sustainability of microfinance. In their framework, many types of institutional innovations contribute to the financial sustainability of MFI, impact of microfinance, and outreach to the poor and these institutional innovations interact with the outer circle represented by the external socioeconomic environments as well as the macroeconomic and sectoral policies. A harmonization at the institutional level and improvements in the policy environment improve the performance of financial institutions. The efforts to harmonize with the two levels are equivalent to building an inclusive financial system. The framework points to the wide set of potential synergies and at the same time trade-offs among the three objectives.

1. Outreach and mission drift

Although microfinance continues to expand, many poor people still remain mired in poverty. The fact that outreach to the poorest of the poor is not being achieved has provoked criticism that microfinance has drifted from the mission. As the microfinance industry has grown, financial sustainability has been increasingly emphasized. The concern about financial sustainability has led to MFIs commercializing or scaling-up, which is suspected of interfering with further outreach and bringing on mission drift. The process of scaling-up, mainly by the involvement of large donors, may lead to an increase in the size of loans and the inclination to lend to wealthier people. However, Armendáriz de Aghion and Szafarz (2009) argue that a larger average loan size is not driven by transaction cost minimization alone. Instead, anti-poverty MFIs could potentially deviate from their mission by extending larger loans, not because of “progressive lending” or “cross-subsidization,” but because of the interplay between their own mission, the cost differentials between poor and unbanked wealthier clients, and region-specific characteristics pertaining to the heterogeneity of their clientele.

2. Anecdotal episodes and evaluation of impact

There have been a large number of microfinance success stories over the past few decades. Such anecdotal episodes may have encouraged poor people to borrow money, leading to the rapid expansion of microfinance. This expansion has been assessed mostly based on the increase in the number of borrowers and MFIs, the increase in the total amount of loans, and the high repayment rates. Recently, more rigorous efforts to evaluate the impact of microfinance have been conducted in place of only evaluating quantitative expansion. However, accurately assessing the impact of microfinance is not straightforward. To accurately gauge the effect of microcredit, it is necessary to compare a client's situation with a counterfactual situation where microfinance is not provided, which cannot be readily examined.

Takahashi, Higashikata, and Tsukada (2010) in this issue address this impact issue using data collected in Indonesia. Although Indonesia has a long history of microfinance, as will be explained below, there are few rigorous evaluations of the impact of microfinance. The authors seek to fill this gap in the literature by applying an advanced econometric method, i.e., propensity score matching with the difference-in-difference method, to adjust for possible estimation biases.

3. Financial sustainability and commercialization

The commercialization of MFIs is one solution for financial sustainability. One of the reasons that transformation or commercialization of MFIs is important is the increasing demand for savings. The focus on the importance of savings for poor people is a recent development. In general, a microcredit provider cannot be allowed to accept deposits from the public. Almost all countries require an organization to have a license for collecting savings. To obtain a license, a certain level of management skills and size as a financial intermediary is required, thus the transformation or commercialization of microfinance comes into play.

Hamada (2010) in this issue investigates the problem of the shortage of funds in commercialized formal MFIs in Indonesia.


A. Purpose and Background of This Special Issue

This section provides a summary of the findings of the individual articles in this special issue. We conducted a two-year research project titled “Role of Small-Scale Finance in Rural Development: Rural Finance and Microfinance” from 2007 to 2009, which aimed at improving our understanding of the roles and functions of microfinance and small-scale finance in India and Indonesia. This special issue is a collection of studies selected from our research.

The sphere of interests of microfinance has been expanding. In addition to savings and insurance, a much wider range of microfinance services are now under consideration, such as the necessity of long-term savings or pensions for old-aged poor people (Ratherford 2008). Depending on the integration of formal financial markets, the means of fundraising also vary: for example, IPOs, bond issuing, and investment by private equity funds. Studies cannot keep up with such dynamic movement in the practice of microfinance. Capturing the whole movement of recent developments in microfinance is beyond the scope in this issue, but our studies try to explain the new directions of microfinance. The focus of each article varies, but each one examines recent developments in microfinance and explores recent topics in order to fill the gap between academic studies and practice.

B. Focus and Findings of the Articles

Kono and Takahashi (2010) examine the existing literature to show how the microfinance revolution is truly revolutionary. Their focus is on: (1) how to conduct valid and reliable impact evaluations of microcredit, (2) what the recent empirical literature tells us about the impact of microcredit, (3) what the economic theory and empirical literature tell us about the important factors for the high repayment rates in microcredit programs, and (4) what challenges microfinance faces. They argue that the microfinance revolution is revolutionary and has achieved high repayment rates that could not be attained in the past subsidized credit programs. They also label the introduction of insurance products by microfinance as an innovation because virtually no institutions have ever tried such an introduction in developing countries. However, judging from empirical evidence, there still remains room for improving performance, especially in terms of impact on and outreach to the poor. Based on their evidence, Kono and Takahashi contend that microfinance is developing in a promising direction but has yet to reach its full promise.

In the sphere of microinsurance, there are three crucial problems: low take-up rates, high claim rates, and low renewal rates. Ito and Kono (2010) investigate the take-up problem using household data collected in Karnataka, India. This is the first attempt to examine the problem of microinsurance take-up based on two major theories of behavioral economics: the prospect theory and hyperbolic discounting. The prospect theory presumes that people behave in a risk-averse way in evaluating gains but in a risk-loving way in evaluating losses. Because insurance covers losses, Ito and Kono suspect that prospect theory can explain the low take-up rates, and they find some support for this. Those who are risk loving in evaluating losses are less likely to purchase insurance, although it is statistically significant only in some specifications. They also find that households whose heads have a hyperbolic discounting factor are more likely to purchase insurance, consistent with their theoretical prediction of demand for commitment. The authors find some evidence for the existence of adverse selection: households with a higher ratio of sick members are more likely to purchase insurance.

Three articles explore three current topics and focus on the experience in Indonesia. The three topics are: the effect of introducing new products on client credit choice, the impact of microcredit, and the financial sustainability of MFIs in Indonesia. Tsukada, Higashikata, and Takahashi (2010) and Takahashi, Higashikata, and Tsukada (2010) use panel data (for 450 households) collected in Gresik, East Java, Indonesia. They conducted surveys in 2007 and 2008 on clients and non-clients of a people's credit bank (bank perkreditan rakyat, BPR) located in East Java. The BPR under study was developed by the largest nongovernmental organization in the country, Yayasan Bina Swadawa. The panel data are useful for displaying the dynamic changes in household behavior associated with a wide variety of microfinance services in Indonesia.

Indonesia has a long history of commercial microfinance going back to the village credit boards (badan kredit desa) started in 1896. In addition, there are large numbers of microfinance programs and MFIs in the country. Microfinance programs are supported by the government and international institutions targeting the poorest of the poor, the economically active poor, and micro and small enterprises, with assistance in the form of cash transfers, scholarships, and technical business support.

Indonesia's microfinance system includes several types of institutions: commercial banks with microfinance operations, such as Bank Rakyat Indonesia (BRI), which is a world famous MFI; secondary banks known as BPR, which is a commercialized but small-scale unit bank; and cooperatives, savings, and credit associations, and self-help groups. In addition to the formal MFIs and microfinance programs, the activities of the rotating savings and credit association or arisan have long been very common and accepted as a part of daily financial activities. Many studies on microfinance have been conducted in Indonesia. In particular, the very wide network of BRI has motivated many studies, including Robinson (2002) and Yaron (1992). BRI provides a contrastive microfinance model to Grameen Bank. Features of BRI can be found in its subordinate organization, the local unit called unit desa (BRI-UD). BRI-UD has a nationwide network of 4,046 units. The success of BRI is attributable to its financial self-sufficiency, high profitability, and high repayment rates of more than 99%. BRI lends to all industries, not only to the agriculture sector, and introduced small account deposit products in the 1980s named SIMIPEDES and SIMSKOT, which are deposits without a withdrawal limit. The wide coverage of sectors and range of financial product choices has contributed to the successful expansion of BRI-UD.

Although the success of BRI has been important, our focus is on BPRs. These are commercial banks that have been expected to play a central role in small-scale lending to the productive poor and to micro, small, and medium enterprises in Indonesia. The total number of BPRs is 1,765, with each BPR being very small and a unit bank. BPRs continue to provide smaller-scale credit than BRI. Our investigation of BPRs reveals problems inherent in the commercialization and competitiveness of the microfinance market. We also succeed in setting a unique research environment, where a BPR provides small-scale, noncollateral loans to the poor. We took advantage of this opportunity to measure the actual impact of microcredit on people's welfare and choice behavior. Our targeted people were not poor enough to receive the benefits of the government microfinance program, which targets the poorest of the poor, and not rich enough to obtain credit from commercial banks easily.

Tsukada, Higashikata, and Takahashi (2010) examine the empirical determinants of how heterogeneous households demand different types of loan products in a credit market in Indonesia. A unique situation arose that allowed them to make a first-time effort to apply the mixed logit model to analyze the effect of a new loan product. This situation was a microfinance institution's launching of its micro-lending business in the survey area during this study's survey period. The results show that small-scale loans from the formal sector without collateral requirements greatly increase overall credit access. Households in self-employed businesses prefer formal credit as a stable financing source but are impeded in receiving formal credit when they are located in rural areas, probably due to high transaction costs. The poorest households cannot exploit new credit opportunities as much as middle-income households, even if the credit scale is very small. The article reveals the heterogeneity of households in their preferences for different credit attributes, which suggests the development of a diversity of loan products for further improving credit accessibility in Indonesia.

Takahashi, Higashikata, and Tsukada (2010) is one of the few studies to systematically evaluate the outreach and impact of microcredit on the welfare of clients, especially the poor, in the context of Indonesia. In doing so, they apply a rigorous impact evaluation technique, i.e., propensity score matching using the difference-in-difference method. The distinct features of the credit scheme under study are that it is collateral-free on a small scale, which is in sharp contrast to most microcredit institutions in the country that tend to lend a relatively large amount of money and demand collateral in loan applications. The authors' results show that although collateral ownership is indeed not an important determinant of participation in the microcredit scheme under study, relatively better-off families gain access to microcredit. Moreover, the impact of microcredit on various household outcomes is generally statistically insignificant, except for sales of nonfarm enterprises for the wealthy and schooling expenditures for the poor, implying that the credit scheme under study might not have an impact on poverty alleviation in Indonesia, at least in the short term.

Shifting the discussion from the small credit taker to the small credit supplier, Hamada (2010) in this issue addresses the problem of the financial self-sufficiency and sustainability of commercialized microfinance institutions. It has been argued that an advantage of commercialization is its use of market-based funds; however, securing finance sources is a crucial problem for commercialized microfinance institutions. She focuses on the problem as it affects BPR and examines the effects of a funding support program known as the “linkage program.”

The results of the regression analysis, using financial data from 1,104 BPR, reveal that bank loans from other banks have contributed to the expansion of BPR credit. Moreover, an effect of bank loans through the linkage program has been larger than that of bank loans only. Funds from saving and deposits have had the largest effect on the expansion of BPR credit. Concerning profitability, bank loans affect the returns on assets (ROA) positively, but there is no obvious effect of participation in the linkage program.

C. Future Agendas

As explored in this issue, one of the current primary interests of studies on microfinance is its impact on the poor, as it is difficult to modify the designs of microfinance business models without knowing how they affect client welfare and profits. We are still in the process of learning, and one must carefully learn from each and every study that is internally consistent to produce the externally applicable knowledge. It is important to determine the mechanisms making microfinance “successful” in the eyes of the layman, and how such mechanisms change with the exogenous conditions prevailing in different parts of the world.

However, microfinance has continued to expand its scope of interests and operations on the ground before researchers have been able to get a clear and good understand of its nature. But the many directions in which microfinance has expanded indicate to researchers the topics for future studies. We will briefly discuss some of these topics below.

The expected trend is for financial services to the poor to become more comprehensive. This trend might help to reduce the risks that the poor face and should protect them more effectively than when each service is provided separately. Accordingly, the role of commercial MFIs will become increasingly important. This reliance on commercial MFIs is necessary for expanding the scope of services. However, caution is warranted because commercial MFIs face different problems from nonprofit MFIs. For-profit MFIs face the question of whether they can develop innovations that reach poorer households than they currently do without compromising their profits. In contrast, nonprofit MFIs face the question of whether their social and economic impacts are large enough to justify and ensure receiving continuing support (Cull, Demirgüç-Kunt, and Morduch 2009). In addition to wider scope, quality of service is essential. A client-centered approach requires financial products with conditions flexible enough to suit the demands of the poor, because their incomes are small and can be insecure. This will put an additional burden on much needed cost reduction, which is already an issue for MFIs as it requires them to prepare flexible payment schedules, to accept broader purposes for loan use, and to allow longer repayment periods.

Progress in technology may be the key to reducing transaction costs in microfinance. We have already witnessed the rapid expansion of the market for mobile phones in poor countries. The expansion of mobile phone networks affords various opportunities to the poor, and it has benefited the microfinance industry in particular. Grameen Bank Village Phone and Kenya's M-PESA are good examples.

Microfinance will continue to change, but its original purpose is to provide comprehensive financial services to the poor and low-income people in a sustainable way. To achieve this objective, continued evaluation of microfinance from the standpoint of sustainability, outreach, and impact will be essential to its further development.