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Editorial Notes

[Editorial Notes] What ails the existing microcredit model

Microcredit has been seen as an effective tool to improve the lives of people who do not have sufficient financial option to enter into a mainstream economy. However, the existing systems of microcredit have a limited impact on the long term wellbeing of an individual.
By IASToppers
August 26, 2019

Content

  • What is microcredit?
  • What is the benefit of providing small loans?
  • Why microcredit failing to deliver long term benefits?
  • How the microcredit system is reformed for greater benefits of borrowers?
  • What are the other applications of microcredit?
  • Conclusion

What ails the existing microcredit model

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What is microcredit?

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  • It refers to the granting of small loans to the people who lack collateral, do not have credit history and a steady source of income,
  • It aims to unable such people self-employed as well as aid in strengthening their businesses.
  • The very core idea behind this system is to bring in the people, into the mainstream economy, who are outside of the formal financial system or do not have access to a larger economy.
  • Microcredit agreement does not require (often) any sort of collateral and sometimes may not even include a written document, as many of the borrowers are often illiterate.
  • It falls under the larger scope of Microfinance, which targets the low-income individuals and an aim of poverty alleviation.
  • A fine example of microcredit includes Grameen bank of Bangladesh which has 8.4 million followers and 97 per cent of whom are women.
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Grameen bank of Bangladesh

What is the benefit of providing small loans?

  • It gives people the initial boost required to enter into an industry.
  • The small loans provide the capital to start a productive business which will not only help an individual to get self-employed but improves the overall life too.
  • It also helps to sustain the production of an existing business with which the loan can be gradually repaid.

Why microcredit failing to deliver long term benefits?

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  • These institutions are unable to judge the risk associated with lending to borrowers as borrowers lack a credit history (due to their exclusion from traditional systems of credit).
  • To lower the risk of defaulting, microcredit lenders therefore uses the repayment schedules that demand an immediate initial repayment, after which borrowers must adhere to an inflexible weekly schedule for repayments.
  • Due to the above schedule, the borrowers are unable to use loans on investments and instead are forced to use the loans on short term investments which could boost their production to an extent only leading to meagre growth.

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How the microcredit system is reformed for greater benefits of borrowers?

Using a monthly repayment schedule

  • As per a study, borrowers who received the grace period (of 2 months), compared to those who started to repay immediately (after 2 weeks), were more likely to have started a new business and also reported higher profits and household incomes.
  • The monthly repayment borrower faces low financial stress and involves the income more than double in comparison to borrowers under the weekly repayment schedule.
  • However, some study claimed that there was also an increased rate of defaulting in monthly repayment group, while other found increased incomes without the increased rate of defaulting.

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Using a community information system

  • The biggest reason for the strict repayment system by the institutions is lack of credit history, which can be mitigated through community information.
  • The community can be an accurate source of information about credit risk for microcredit institutions.
  • According to a study, when local traders or shopkeepers made lending decisions, the recipients of the loans were notably successful in increasing production, and their incomes increased.
  • The implementation of such processes would require the elimination of bias and incentivising accurate information.

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What are the other applications of microcredit?

  • Conventionally, microcredit has been used mainly for entrepreneurs to begin production and attain self-sufficiency.
  • But it can be applied to more unexplored and new paths for poverty alleviation and productivity-boosting measures.
  • Microcredit can allow rural labourers to migrate to urban areas to find work during the lean season when there is no work to be found on farms.
  • It can also be used to dampen the effects of shocks like floods by providing people with a form of insurance that both increases production before the shock and provides a safety net thereafter.

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Conclusion

  • Microcredit has a vast range of applications for poverty alleviation and general development, but the existing system requires reform in multiple areas to allow for benefits that last for a longer time.
  • In the new areas of application, the microcredit system should be evaluated carefully to enable the greatest benefits from such institutions.

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