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Small Scale Lending as Both Costly Activity - Essay Example

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From the paper "Small Scale Lending as Both Costly Activity" it is clear that microfinance institutions target the rural poor by proving them with financial services to run their businesses, pay school fees for their children, and perform other functions…
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Small Scale Lending as Both Costly Activity
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Microfinance Most of the businesses, whether large enterprises or small scale businesses, require some form offinancial support in order to carry out day-to-day operations and be able to create revenue (Collins et al. 160). Banking industries and most of the other financial institutions have stringent requirements that borrowers must meet before they can access finances for their business. Banks have always perceived small scale lending as a both costly and precarious activity; hence, they have focused their services on medium and large scale clients who can afford to give a collateral and acquire large sums of money from the banks (Yunus 134). Due to these stringent measures, small scale businesses and private entrepreneurs are locked from assessing bank finances to support their businesses. The service of lending finances to small scale businesses and private entrepreneurs who cannot access such services from banking and other financial institutions is referred to as microfinance. Banking institutions consider such borrowers as lacking ability to repay loans and the interest (Collins et al. 135). However, microfinance institutions have successfully advanced finances to such borrowers for a long time and have managed to get them out of poverty. Conventionally, banks have ignored small scale clients by failing to grant them loans or accept deposits from them. Providing financial services to small scale customers is an expensive activity because it takes a lot of time to processes numerous but small value loans involving many clients (Collins et al. 155). This is because the same processes undertaken when processing small amount transaction is similar to that which is taken to process a large amount belonging to one large client. Since the same interest rate is charged for both large and small scale clients, banks prefer dealing with large clients in order to save costs involved when dealing with many small scale clients (Yunus 135). The operation cost of processing transactions in the bank remains unchanged regardless of the amount of funds the bank is handling. This is the reason why banks prefer large scale clients who are making large transactions so that they can maximize their revenues. According to Collins et al. (165), handling many accounts is costly in terms of data base management. This has discouraged banks from inviting membership from small scale clients so that they can maintain the cost of data base management as small as possible. According to Yunus (137), banks consider lending their finances to small scale borrowers as hazardous due to uncertainty of their existence. Banks prefer borrowers with a collateral, which they can pledge as security for the loans advanced to them (Collins et al. 163). The collateral has to be tangible assets such as title deeds, log books, share certificates and other tangible assets. Unfortunately, small scale borrowers do not have such a collateral for security against bank loans; hence, they cannot access financial benefits from the banks. This is because most of the small scale businesses and private entrepreneurship are started from scratch without any established resources. In case of default or repayment of the loan by the borrower, the lender may not have anything to compensate for the advanced finances. Failure of banks to grant loans to small scale borrowers has detrimental effects on the economy and borrowers. According to Yunus (141), small scale businesses and private entrepreneurs offer employment opportunities to very many people across the globe, as compared to large incorporated organizations. Inadequate funding of small scale businesses results into slowed growth of those businesses, hence affecting the employment opportunities. Furthermore, the borrowers have resulted into sourcing funds from expensive lenders such as individuals’ lenders, local money lenders, or relatives and friends, hence increasing the cost of operating businesses. Many poor rural dwellers have continued to lack access to formal banking services. This has enhanced the growth of microfinance, mainly in the rural areas, and helped such dwellers take care of their financial needs (Collins et al. 165). This has resulted in tremendous growth of microfinance across the world with an estimated microfinance capital requirement of $250 billion. Following this tremendous growth in microfinance, there is an increasing concern about the efficiency with which these finances will be utilized. There is an increasing fear that lending such an enormous amount of unsecured funds to unsecured borrowers may result in massive default rate by the borrowers (Yunus 143). In most cases, small scale borrowers fail to channel the borrowed funds into the right activities which the funds were borrowed for. These borrowers are mainly inexperienced in financial matters; hence, they may end up misusing the borrowed funds (Collier 79). Furthermore, the very nature of the small scale businesses is prone to immense risk of failure due to diseconomies of scale, lack of diversified market for their products, unqualified staff, and so on. Therefore, as microfinance sector continues to grow, the lenders should apply strategies to minimize the risk of evading payment of the loans and interest which may have accumulated. Rural dwellers, especially in the developing countries, have shortage of funds for various activities which require funds (Collins et al. 170). These include construction of shelter, mitigation of risks, food, paying of fees for education of their children, paying of hospital bills, and so on. Due to these immense needs among poor rural people, the money advanced to poor people for development is diverted to solve the other needs. Furthermore, poor people cannot afford to finance these activities directly from their meager income. As a result, they have to accumulate their funds by saving the little income they earn until it is enough to solve their problems. In order for the poor people to accumulate significant amount that can solve their needs, they require some form of training on how to make savings and use their savings effectively (Yunus 165). Microfinance institutions offer both credit and saving facilities to their clients in order for them to solve their needs. Many poor people obtain wealth by obtaining loans from microfinance institutions and other small scale lenders. They utilize these savings by investing in small business enterprises which continue to generate income for repaying their loans and interest (Collins et al. 168). However, the lenders should focus on assisting the borrowers to mitigate risks associated in this form of borrowing and lending to ensure that all funds are utilized efficiently and effectively. According to Yunus (185), microfinance institutions are facing the same high cost of executing numerous small value transactions. This has made the lending institutions maintain the interest charges exceptionally huge. However, for microfinance institutions to survive in their activities, the owners should be business oriented and focus on their profitability (Collins et al. 170). This will require the managers to employ appropriate measures to ensure low cost of operation and increase their revenue. One of such strategies is that microfinance institutions should mobilize the borrowers into clusters. This will enable the lenders to reduce the transaction expenses by reducing the number of transactions they process without interfering with the total value of the loan portfolio. Furthermore, they should teach the members of each cluster to encourage their colleagues to repay the assigned amount before they can manage to get another loan. Therefore, since repayment by each member in the cluster will affect future borrowings by the other members, this will reduce the risk of failure in loan repayment and hence increase the profitability of the institutions. The other major problem facing microfinance lenders is misuse of funds by the borrowers. Sometimes, due to ignorance or lack of knowledge of how to manage their borrowings, borrowers end up spending the borrowed funds for other purposes rather than the purpose for which it was acquired (Collins et al. 172). This results in a situation where borrowers have difficulties repaying the loans, hence causing huge losses to the institutions. For the microfinance institutions to mitigate this loss, they should educate their clients on significance of using borrowed fund for the right purpose (Yunus 197). This will enable the borrowers to invest the loans in profitable means, which will enable them to generate revenue for repaying the loan. They should offer training to the borrowers on efficient financial management and entrepreneurial skills, enabling them to run profitable businesses (Collier 68). This will enable the lenders to expand their lending capacity and ensure increase in revenues for the institutions. After all, as small scale businesses expand their capacity, they will also be able to apply for greater loan portfolios and hence reduce the transaction cost and improve lenders profitability. According to Yunus (213), there is no clear distinct between microfinance lenders and formal lenders of finances. The borrowers of microfinance acquire finances from informal lenders and invest the same in informal sectors. This keeps the gains circulating within the informal sector. Microentrepreneurs also obtain insurance shield for their businesses from the formal institutions (Collier 74). It is now apparent that some of the state owned institutions are advancing microfinance services to the poor people. Both government and nongovernmental organization institutions are issuing financial aids and grants for poor people in order to promote economic development. Therefore, these activities have resulted in an interaction of formal and informal sectors in advancing financial support to the local poor (Collins et al. 174). This has caused difficulties in distinguishing between formal and informal financial lenders to the rural poor. The effects of microfinance services are reflected through various means in the society, especially in developing countries (Collins et al. 179). Women are mainly considered poor since majority of them do not own collateral for formal bank loans. However, they have turned out to be the most beneficiaries of the microfinance, which has supported businesses, hence making them more self-reliant. Also, microfinance services have increased income for the poor rural dwellers. This has resulted in improved dietary and food accessibility among the poor people (Collier 69). Furthermore, most loans are acquired for paying school fees. With microfinance activities in the rural areas, there is an increased enrollment of children in the learning institutions, which enhances the significance of lending to the poor. With most people gaining access to business through finances obtained from the microfinance lenders, this has resulted in tremendous growth of small scale businesses. Consequently, this has created job opportunities for many people across the world (Yunus 209). This has resulted in improved living standards among the people of the worlds, who were poor majority before the advent of microfinance lending. Microfinance institutions targets the rural poor by proving them with financial services to run their businesses, pay school fees for their children, and perform other functions. There is a lot of risk associated with lending finances to the poor. They may not use the funds for the purpose it was intended for. Lenders may offer them advice on how to use the funds effectively. They may also encourage lending to a group of clients rather than dealing with an individual so that they can reduce transactions costs. Lenders should make a follow-up to ensure that clients who were granted loans have really made use of them. Microfinance institutions have fostered development in the rural areas by improving diets, empowering women in businesses, and other economic activities, and have promoted wealth of the local dwellers by supporting their economic activities. Works Cited. Collier, Paul. The Bottom Billion: Why the Poorest Countries Are Failing and What Can Be Done About It. New York: Oxford University Press, 2007. Print. 64-99. Collins, Daryl., Morduch, Jonathan., Rutherford, Stuart. & Ruthven, Orlanda., Portfolios of the Poor: How the World’s poor Live on $2 a Day. United Kingdom: Princeton University Press, 2009. Print. 102-206. Yunus,Muhammad, Banker to the Poor: Micro-Lending and the Battle Against World Poverty. USA: Public Affairs, 1999. Print. 131-237. Read More
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