GS-III: What ails the existing microcredit model

Context

Microcredit has gained much traction as a tool for ensuring the welfare of the most impoverished in society and boosting development alongside.

What is Microcredit?

• Microcredit refers to the granting of very small loans to impoverished borrowers, with the aim of enabling the borrowers to use that capital to become self-employed and strengthen their businesses.
• Loans given as microcredit are often given to people who may lack collateral, and credit history.
• Microcredit agreements frequently do not require any sort of collateral, and sometimes may not even involve a written agreement, as many recipients of microcredit are often illiterate.

Part of Microfinance

• Microcredit falls under the larger umbrella of microfinance, financial services for individuals who don’t have access to traditional services of this kind.
• Microfinance activities usually target low-income individuals, with the goal of helping them to become self-sufficient. In this way, microfinance activities have an aim of poverty alleviation as well.
• An example of a microcredit institution is the Grameen Bank in Bangladesh, founded in 1976 by Mohammed Yunus.

Why?

• The primary reason for the lackadaisical effects of microcredit is the stringent repayment schedule offered by most microcredit institutions.
• Since most borrowers to whom microcredit is given have little to no credit history as a result of their exclusion from traditional systems of credit.
• Hence institutions offering microcredit are unable to judge the risk associated with lending to certain borrowers, and cannot be sure what the risk of them defaulting will be.
• To lower the risk of defaulting, microcredit lenders, therefore, resort to repayment schedules that demand an initial repayment that is almost immediate, to which borrowers must adhere.

What are the other applications of microcredit?

• Conventionally, microcredit has been used mainly for entrepreneurs to begin production and attain self-sufficiency.
• Small microcredit loans can allow rural labourers –those who are employees, as opposed to entrepreneurs, who are employers to migrate to urban areas to find work during the lean season, when there is no work to be found on farms.
• Those who migrated temporarily during this season experienced increased spending in both food and non-food areas and increased their calories consumed.
• Microcredit can be used in situations where seasonal factors cause drops in income to overcome these “seasonal credit crunches” and avoid taking decisions which cause people long-term negative impacts.

Conclusion

• Microcredit has a vast range of applications for poverty alleviation and general development, but existing systems require reform in multiple areas to allow for unfettered benefits that last.
• In areas where the application of microcredit is relatively new, microcredit systems must be carefully evaluated before they are put into place, so as to enable the greatest benefit from such institutions.