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3. Sources of microfinance
for forest-based enterprises

Microfinance is the supply of basic financial services to poor and low-income households and their micro-enterprises. Microfinance comprises several financial tools such as savings, credit, leasing, insurance and cash transfers. These services are provided by a variety of institutions, which can be broadly divided into banks, NGOs, credit and savings cooperatives and associations, and non-financial and informal sources.

Providing financial services for small-scale enterprises is a powerful tool for poverty reduction, enabling poorer households to build assets, increase incomes and reduce their vulnerability to economic stress and external shocks. Microfinance helps rural households to plan and manage consumption and investments, cope with risks and improve their living conditions, health and education by smoothing household cash flow and increasing disposable family income. Box 6 is an example of provision of microfinance to small-scale enterprises in Guyana.

To help reduce poverty effectively in the long term, microfinance services must be sustainable and have a wide outreach, and provide services and products that address and suit the needs of poor people and their enterprises. This chapter looks at different microfinance services and their characteristics, as well as microfinance outreach, highlighting wherever relevant the specificities of servicing small-scale enterprises. It goes on to consider microfinance sustainability and the impact that financing small-scale enterprises could have on the environment.

Microfinance services

The rural poor and their forest-based enterprises need a variety of financial services, not only microcredit but also savings, credit, leasing, insurance and cash transfers. To successfully address these needs, microfinance services must be convenient, flexible, of easy and rapid access, and reasonably priced. Box 7 outlines the need for financial products in Uganda.

The provision of microfinance services can be facilitated by business development services. These services can help build financial and business management capacity of rural households, improve their technical skills, provide local support services for enterprises with emphasis on marketing, and establish linkages between forest communities and microfinance services. Business development services should grow with the development of small-scale enterprises and cater to their evolving needs. Examples of useful business development services for improving access to microfinance are: training of rural households in funds management, loan application, bookkeeping and accounting; preliminary loan appraisal of small-scale enterprise financial planning; consolidation of small individual proposals into a bankable portfolio of forest-based enterprise plans; and support to microfinance institutions for monitoring and supervising the implementation of small-scale enterprise activities. Business development services can also help microfinance institutions to assess risks related to small-scale enterprises. Embedded services such as training to producers and quality control, provided by buyers of commodities, can also positively improve access to microfinance services by increasing micro-entrepreneurs' skills and the marketability of their products.


As worldwide microfinance experience has shown, access to safe and flexible savings services can play a critical role in poor people's strategies for minimizing risks, mitigating income fluctuations, facing unexpected expenditures and emergencies, and building a small asset base over time. In particular, the very poor living in rural areas, who may lack investment opportunities and safe ways of keeping their savings, greatly value access to safe savings services.

Most poor families do save and often in a non-financial form, for example, small gold items or stockpiling goods, because they frequently lack access to good formal savings facilities. In-kind savings are suboptimal options, because they are subject to fluctuations in commodity prices, and destruction by pests, fire and theft.

While microfinance institutions offer both good loan services and good voluntary savings services, worldwide experience shows that there is usually more demand for savings than for loans. Better availability of safe savings facilities increases self-financing capacity and thus reduces the need to borrow, with its inherent risks. When a poor household needs a relatively large amount of money for an investment purpose, saving is a less risky way to obtain it than taking on a debt with a fixed repayment obligation.

Traditionally, microfinance mobilization of savings has taken place in the form of compulsory savings under group or individual lending methodologies. Often a percentage of the loan amount is required as mandatory savings and is meant to guarantee group loan repayment. Compulsory savings were also seen as a way to instil savings habits in poorer households.

Experience has shown, however, that compulsory saving is not conducive to encouraging clients' saving habits, but rather is considered as one of the requirements for accessing loans. It is the mobilization of voluntary savings, ensuring safety, flexibility and accessibility, which can have the strongest impact on poor people's lives. With the right products and incentives, microfinance institutions can rapidly mobilize very significant resources (see Box 8).

Rural households and their enterprises are likely to have difficult access to microfinance institutions, which tend to avoid areas of sparse population and remote access due to the higher costs involved. Given the importance of seasonality and deferred income for small rural enterprises, savings are very important not only to build an asset capital, but also for smoothing consumption, affording continued access to health and education services, and as an insurance against emergencies.

Ensuring the existence of safe and accessible savings services for forest-based small-scale enterprises should be a priority for any microfinance development programme. Possible ways for microfinance institutions to make the service available at lower costs include mobile banking, microfinance officers visiting rural communities on market days, and facilitating groups in collecting and depositing individual voluntary savings.

Mobilizing the savings of small-scale enterprises implies risk, however, and microfinance institutions allowed to do so should clearly show their capacity to mobilize savings safely. Accordingly, they should demonstrate strong governance and professional management, strength and reliability, adequate internal controls, financial management and information systems, the guarantee that deposits and savings are not used to cover their operating expenses and records of strong loan portfolio quality management. In most countries, mobilization of public savings is restricted to banks, where regulations should be in place for effective supervision.

Credit cooperatives are also a very important instrument for mobilizing savings, although generally limited to cooperative members. It is important that sound provisions regulating and supervising cooperatives' operations are in place to prevent governance weaknesses that would ultimately damage depositing members.


Microcredit consists of small loans provided to poor households or micro-enterprises. Microcredit is normally characterized by standardized loan products with short maturities, limited amounts, fixed repayment schedules and high interest rates. Most microfinance institutions require potential borrowers to save before applying for a loan in order to demonstrate their intention to develop a long-term banking relationship. When the amount saved reaches a specific level, the lender will consider granting a certain amount as a loan. Although forced savings might be effective in helping to control moral hazard risks, they increase the effective interest rate and restrict potential borrowing.

One of the most characteristic microcredit innovations is the use of group lending techniques. Group lending reduces information asymmetries common to most lending situations, drawing on borrowers' superior knowledge of each other. Since a group member is far more likely to understand the creditworthiness of an individual in a village than a non-local loan officer, group techniques can be gainfully used to screen members, monitor repayments, and exert peer pressure. Groups utilize the networks of trust and relationships in the village, mutual guarantees, and shared knowledge about eligibility and performance to help ensure repayment of the loans given to the group. Group incentives and dynamics to avoid moral hazard are reinforced through regular group meetings, often required under the terms of the group loan.

Group and village credit and savings associations or village banks are usually formed following the loan from a sponsoring agency to a group or village association, which then makes individual loans to its members. The sponsoring agency can be an NGO or a bank. "Village banking" normally refers to a group of 10 to 30 individuals, while in "group lending", the group consists of 3 to 9 individuals. However, here the term "group lending" is used generically for both, as the key features are essentially the same.

Among key rationales for group banking methodology are the reduced operating costs for the microfinance institution, which provides a single loan to many small borrowers at once instead of a much greater number of individual loans, and the opportunity to substitute individual collateral with social solidarity to guarantee the loans (in the case of a solidarity group). Pooling compulsory with voluntary savings helps overcome minimum deposits and low balance fees and reduces transaction costs for the savers with representatives making the trip for many. The disadvantage is that loan officers must travel to and attend all group meetings, and that time must be spent organizing and training new groups.

Groups can be used in two ways: simply as delivery mechanisms, receiving the loan payments from the microfinance institution and collecting savings and repayments on behalf of the members, while maintaining individual responsibility; or as solidarity groups, where the group as a whole is responsible for the individual members' subloans and if one member fails to repay, the repayment will be covered by the others. The solidarity group guarantees these subloans and relies on peer pressure and peer support among members to ensure repayment. In addition to providing a group guarantee for the loan, the advantage of all group members being responsible for loan repayment is that it creates incentives to admit only responsible individuals, and to make sure that each individual borrows within his/her repayment capacity.

As a complement to the co-liability for the existing loans of fellow group members, a group guarantee fund is often established. A small fee is added to each member's loan and deposited in a fund. The money can be used in emergencies to cover the loan instalments of group members who experience temporary difficulties in making timely loan payments. The fund reduces the need for group members to use their own resources to make these payments, but raises the effective interest rate on their loans.

Group banking can offer small-scale enterprises and rural families several important services in addition to credit and savings: groups often also receive non-financial services, and establish internal accounts. As part of their establishment and functioning, groups normally adopt bylaws, strengthen their financial literacy and learn how to keep records of financial transactions with the assistance of the sponsoring microfinance institution. Regular meetings, which are the vehicle for delivery of credit and savings services, also provide benefits such as networking, informal technical assistance on production and processing aspects, empowerment, and strengthening of social group capital. The group internal account, under which money is collected from several sources (forced and voluntary savings, interest income earned, fees and fines levied) and then used to make loans to group members, is practised by some groups as a supplementary source of credit and savings among its members.

All of these advantages make group lending particularly useful when trying to reach forest-based small-scale enterprises and poor rural households (see Box 9). However, a limitation is that group loans are rather inflexible compared to individual loans; each member receives a loan that starts on the same date and has the same term and repayment frequency, and the size of the single individual subloan is generally capped, in view of the group's solidarity. It may therefore be better suited to small-scale enterprises engaged in activities requiring limited capital and with regular and shorter-term yields.

Social capital is a prerequisite for the success of group lending. When social cohesion is weak, groups are not homogeneous and peer screening and monitoring are inadequate, putting the group's repayment at risk. Solidarity group lending however has the disadvantage of making group members responsible for co-borrowers' possible default, over which they may feel they lack control. This can hinder group participation and borrowing, or cause the failure of group lending initiatives.

As clients develop economically and become more acquainted with microfinance services, and as competition in the sector strengthens, small-scale enterprises are likely to have greater demand for more diversified products, such as flexible repayment schedules, individual loans and loans with different term structures and different purposes. An example of the move towards more flexible systems is that adopted by the Grameen Bank since the end of 2002. Under the new Grameen Generalized System, flexible loan terms and repayments and new deposit products have been introduced and group liability has been discarded. Other microfinance institutions are also shedding the traditional Grameen model, or making more flexible products available together with traditional standardized group ones.

Small-scale enterprises, especially when engaged in wood forest production, may need financing for larger investments that have prolonged amortization periods. Due to the gestation period, there is normally a significant time lag between the initial expenditures and the time when investment creates a positive cash flow and the enterprise can repay the loan. While presenting the advantage of reducing transaction costs and credit risks, the traditional standardized microcredit and group lending may not match their cash flow, and may not suit their investment requirements. Small-scale enterprises with intensive capital needs to finance fixed-term investments and that are engaged in higher risk activities are likely to face difficulties in accessing microcredit that matches their demand, given its shorter maturities, limited amounts and fixed repayment schedules.

Innovative lending practices and financial products can be adapted to suit small forest-based enterprises and household cash flows. Innovations that can facilitate access to credit include the use of collateral substitutes and the graduation of clients to larger loans and longer maturities. Equipment loans or leases with maturities of two or more years are other examples of new loan products that have emerged from the increasingly competitive microfinance sector and that would allow small forest-based enterprises to overcome the constraint of short-term working capital loans.

A critical constraint for these enterprises and poor forest households in accessing credit is often the lack of fixed assets and collateral. Appropriate land tenure policies and property rights can have a major role in helping overcome the constraint, as in the case of the project in Nepal shown in Box 10.

Microfinance institutions can also play an important role in enhancing smaller enterprises' ability to finance tree crop investments by offering them a mix of short- and medium-term loans, which enable them to bridge critical periods in their cash flows during the establishment and gestation periods. Such an approach is most feasible in the case of short gestation crops such as tea or coffee, and for enterprises that have also other sources of income. The promotion of practices such as intercropping, staggered planting of tree crops and planting of species with different gestation periods can ease cash flow constraints and make it possible to use other income sources for loan repayment.

Even the simple expansion of microfinance institution outreach, where possible, may not be sufficient to ensure that rural and especially poorer households can take advantage of the available microfinance services and in particular access microcredit. Small-scale enterprises often lack financial management and business planning skills, and this hinders their development into bankable customers of microfinance services. The availability of non-financial government support services such as input and equipment supply, output marketing, extension and business development can play a major role in facilitating their access to longer-term finance, because they reduce the high risks and transaction costs, and increase the profitability of the investments.


A lease is a transaction in which an owner (the lessor) of a productive asset allows another party (the lessee) to use an asset for a predefined period against a rent (lease payment). The lease payment is calculated to cover all costs incurred by the lessor, including depreciation interest on capital invested, insurance, administrative costs and profit margin. During the lease period, the lessee is responsible for all operational costs including the maintenance and repairs of the asset. The leased asset is assumed to generate the main source of income for the lease payment.

The main types of leasing are:

The main advantage with leasing compared to traditional loans is the elimination or reduction of collateral requirements, because the leased item itself stands as security. As the lessor remains the legal owner of the asset, repossession is easier. In addition, the lessor has greater control over the disbursement of the funds, avoiding the risk of diversion. The possibility of becoming owner of an asset also provides a strong incentive for the lessee to make timely payments. There might also be tax advantages related to the fiscal depreciation of the asset.

Leasing can be provided by banks, non-bank financial institutions such as leasing companies and other financial institutions. It can also be used by equipment suppliers as an alternative to supplier credit. Close collaboration with equipment suppliers facilitates technical training and after-sales service.

The selection of the asset is crucial for success because it constitutes the main source of payment and the security of the transaction. Suitable lease equipment should:

Due to its characteristics, leasing is particularly suitable for small enterprises engaged in wood and non-wood products processing, intending to finance the purchase of equipment. Although the selection of clients takes into account the experience of the customers and their skills in handling the asset, their credit history and their ability to make a down payment or deposit, a client can qualify for a leasing contract based on generated cash flow. This makes it particularly attractive to forest-based small-scale enterprises without extensive credit history, assets or capital base.

By financing the acquisition of fixed assets, this alternative to credit circumvents one of the greatest bottlenecks that forest-based small-scale enterprises face in expanding their production and productivity possibilities, and gives those with scarce financial resources the opportunity to start businesses or make new capital investments even in the absence of collateral. At the same time it lowers portfolio risks for microfinance institutions.

In spite of its advantages, leasing is not fully developed as a financial instrument for small-scale enterprises in developing countries. Leasing is sometimes unavailable for them due to the high risks and transaction costs in dealing with small clients, especially in a rural context, limited access to long-term funding sources at a reasonable cost, and the lack of awareness of the technology and specific skills to adapt it to the requirements of the target market. However, leasing can be an effective instrument to finance forest-based small-scale enterprises, helping reduce lending risks and the need for collateral. Microfinance institutions should take full opportunity of its advantages. The case of ANED (Box 11) shows that this can be done successfully in rural areas.

1 Based on Bamako, 2000

Equity finance/venture capital 2

Equity finance means the provision of external capital to an existing enterprise for investment purposes. As opposed to loans, the investor does not receive a fixed return such as interest payments, but has a residual claim on the company profits. Venture capital means the use of equity finance for capitalizing extremely risky investments such as start-ups, which might not be able to attract traditional microfinance and may not provide sufficient collateral.

Equity finance often involves high transaction costs related to screening and evaluating investment opportunities, developing feasibility studies, business plans and exit strategies, and monitoring and supervising enterprise management. Equity finance has not traditionally been part of microfinance services, therefore, and is normally confined to medium and large enterprises. However, there is a renewed interest in using equity finance and venture capital approaches for the financing of small-scale enterprises. Some funds and programmes have been created for capitalizing joint ventures between small-scale enterprises and the investors. The equity investor buys shares on behalf of a target group and then gradually divests by selling the shares to this group.

There are two key advantages for the investors providing equity finance. Firstly, it can be adjusted more flexibly to volatile conditions and changing profitability and liquidity positions. Secondly, the investor participates in the management of the enterprise, which reduces moral hazard problems caused by asymmetric information and helps provide additional management inputs.

Equity finance and venture capital are valuable tools to finance long-term risk investments because they do not involve fixed financial charges for small-scale enterprises and provide a means for sharing risk. They are a suitable mechanism, acting as an alternative to matching grants, and are more appropriate than subsidized interest rates for governments or NGOs that are willing to support particular environmental practices while developing small forest-based enterprises.

In the case of forest-based small-scale enterprises, however, there can be several difficulties in using equity finance and venture capital. The profitability in forest-related activities often does not compare favourably with many other economic sectors when adjusted for the risks. Knowledge of forest production and its risks may not be readily available. Therefore, traditional microfinance institutions are often reluctant to engage with such enterprises.

2 Based on FAO, 2003

Micro-insurance 3

Micro-insurance is a risk management tool for poor people. Insurance protects people and businesses against financial loss by spreading the risks among large numbers. The contract indicates the amount of a specific potential loss covered by the insurer and the insured person or enterprise pays a premium that is directly related to the likelihood and the cost of the particular risk.

Micro-insurance traditionally started as loan insurance, but is now expanding to address the needs of the low-income market and to cover a variety of insurance products such as:

Micro-insurance provides a safety mechanism against negative events: it is therefore particularly useful for rural and poor families, and for forest-based small-scale enterprises where the nature of the activity and the return periods expose the enterprises to greater risks. Since it is costly to create new distribution channels, micro-insurance has greater chances of reaching these enterprises viably when it is integrated into existing microfinance institutions, using the existing delivery mechanisms and clientele. If provided at a reasonable cost, micro-insurance can be a powerful poverty reduction mechanism with great expansion potential, and at the same time, can significantly contribute to microfinance institution profitability.

3 Based on CGAP, 2003

Remittances 4

In many disadvantaged areas, migrant remittances are a major source of income for households. The transfer of money back home from seasonal and long-term migrants is a very valuable financial service and can add up to a large volume and number of transactions. In 2003, migrant workers' remittances to developing countries were estimated at more than US$90 billion. If the informal, unrecorded ways of transferring money on which many immigrants rely were taken into account, the estimated total value would probably be considerably higher. In-country transfers of funds are also important, especially for rural families living in poorer regions, often supported by a member working in the city.

The remittances are mainly used to cover household expenses of migrants' families in developing countries, such as food, housing and education. Immigrants from Latin America send an average of US$300 to their families up to eight times a year, while workers from Southeast Asia transfer about US$800, but less often. Although the amounts are often small, in many cases they constitute the main source of disposable income for the poor families of the migrants, and can therefore be fundamental for rural households. In the district of Parbat, Nepal, remittances amount to 38 percent of the total district GDP. Remittances can also play an important role in building financial assets and facilitating kick-starting of small livelihood activities such as forest-based enterprises.

Up to 15 to 20 percent of the value of remittances can be lost in transfer because of the high financial and transaction costs. Supporting greater competition among banks and money transfer agencies can reduce inefficiencies and fees, and give a wider choice of alternative services, with an impact on the cost of sending money. This would particularly benefit rural households, since they are more likely to depend on migrant remittances and to have limited alternatives of service providers.

4 Based on IFAD, 2004b

Microfinance providers

Formal and semi-formal microfinance institutions fall into three categories:

Formal and semi-formal microfinance institutions present different advantages and disadvantages, linked to their outreach and social focus, on the one hand, and to the extent of effective regulation and corporate governance, on the other. Their comparative advantages or weaknesses are outlined in Table 1.

Government and donor programmes in support of rural microfinance expansion usually avail themselves of these formal and semi-formal institutions in order to reach out to rural households, depending on specific local constraints and the prevailing situation. At times, development projects provide money or establish revolving funds for microcredit initiatives, usually managed by a selected microfinance institution. In some cases, the revolving funds may be directly administered by one administration agency, which may be assimilated to the provision of microfinance services by NGOs, or devolved to specifically created savings and credit associations or credit unions, which are the least formal type of credit cooperatives. Provision of microfinance services under government projects is therefore not treated separately here, but is looked at from the point of view of the institution used.

Experience shows that the performance of microfinance government and donor projects is usually better, and the sustainability prospect higher when existing and efficient microfinance institutions are utilized and possibly strengthened through specific technical assistance. When new credit associations are established, or government agencies used for credit provision for project purposes, the lack of specific financial management skills is likely to endanger the soundness and performance of the initiative.

In addition to the formal and semi-formal microfinance institutions, pawnshops and other non-financial and informal sources of microcredit such as money lenders, traders, relatives and neighbours also play a very important microfinance role, especially in areas little penetrated by more formal institutions.

Table 1
Advantages and disadvantages of different categories of microfinance institutionsa




Credit cooperatives





Microfinance services


Public mobilization of savings

Provision of financial professional management and management information system

Access to commercial funds, greater linkages with financial system provided

More equipped to potentially provide services such as leasing and micro-insurance

More socially and environmentally focused

Tradition of operating on the basis of social capital and with groups

Experience of providing non-financial support

Potential interest in providing equity finance

Close to customers/members

Easy access to internal funds







Focus on sustainability

Extensive network of branches (for national state-owned or commercial banks)

Greater flexibility for expansion

Wider outreach, mission of maximizing coverage of disadvantaged communities

Low operating costs

Social capital





Regulation and supervision ensures prudential operations


Member-based ownership

Democratic, participatory






Microfinance services


Profitability focus, less attention to social and environmental goals

More formal loan application and procedures, mostly collateral-based

Insufficient professional management, inadequate management information system

Lack of financial management skills and inadequate management information system

Practices and standards often underdeveloped







Constraints in expansion due to prudential regulations (e.g. capital requirements for branching)

Reluctance to enter microfinance, or service disadvantaged communities

Financial constraints to expansion (limited sources of funds, donor dependence)

Viability concerns

Outreach limited to membership

Viability concerns







Possible governance and ownership weaknesses

Weak supervision and governance

aActual situations will vary according to the specific microfinance institution and national financial regulatory framework.


A variety of banks may provide microfinance services, such as state-owned banks, commercial banks, savings banks, postal banks, regional banks, rural banks and thrift banks. With microfinance proving to be a profitable business (e.g. Robinson, 2002), many banks have been expanding the scope of their operations into microfinance by downscaling and establishing linkage programmes with semi-formal sources of different types.

Depending on the size and network of the institution, banks may follow a strategy of direct provision of microfinance services, or act as wholesaler providing apex services and refinancing to smaller local microfinance institutions. Bank downscaling into microfinance can either take place directly by launching a microfinance service, by creating a division within the bank to deal with microfinance services, or by creating independent specialized subsidiaries (as seen in Chile where the Banco del Desarrollo created Bandesarrollo Microempresa Asesoria Financiera de Interes Social).

Through their often large rural networks, fund transfer systems, access to multiple funding sources, trained staff and modern administrative accounting and management systems, banks often have a comparative advantage in reaching large numbers of poor people in a cost-effective manner. If regulated and supervised, banks are generally also a reliable means for the public mobilization of savings, which in many countries is actually limited by law to licensed banks.

The postal infrastructure is also used in many countries to provide financial services, taking advantage of the fact that staff time may not be fully occupied by handling mail. Postal banks usually do not make loans; their services are limited to savings and payments/transfers, with accounts and transactions sizes tending to be quite small.

Given the low-density population, difficult access and poor infrastructure that usually characterizes rural areas, banks may be reluctant to adequately service small-scale forest-based enterprises and answer their financial needs. Credit products offered by banks are seldom adapted to the longer productive cycles of rural and forest activities, and most banks only provide credit against collateral, which may not be available to poorer households. Other major weaknesses of banks entering the microfinance market have been identified as: a potential lack of institutional commitment, organizational and administrative structure that are inadequate for microfinance services, the need to adapt personnel and financial methodologies, and the lack of knowledge about the microfinance market and best practices.

The outreach expansion of sustainable microfinance institutions to service large segments of the population, especially remote communities and poor households, requires substantial and effective social intermediation support. Banks, or more generally, private sector microfinance institutions, are not likely to invest in social intermediation (including awareness and record-keeping of basic financial services), given the externalities associated with such investments. Unless coupled with parallel government social intermediation interventions or business development services, banks may therefore be unable to reach the desired level of coverage.

Although banks may be seen as a second best option for providing microfinance services to forest-based small-scale enterprises due to lesser social focus and expertise, the advantages of their greater supervision, public mobilization of savings, more financially sound operations and customer confidence should not be overlooked. As a result of such advantages, a microbanking approach has been adopted in Papua New Guinea to expand the provision of microfinance services (see Box 12). A similar approach has been followed in Timor-Leste. The conflict following the independence referendum in 1999 caused all Indonesian banks to be closed, and only two foreign banks established offices in the capital, providing limited banking services. Faced with the need to support the development of microfinance in rural areas, in 2002 the new government established a microfinance bank, at the same time developing a policy and legal framework within which it could operate.

Non-governmental organizations

NGOs widely comprise institutions that are not regulated by banking laws and provisions, and which usually have a developmental or social objective in addition to a financial objective. Most often, a solid financial performance is a means and not an end in itself. The primary objective is non-financial; extending outreach in areas or to families not normally served by banks and bank microfinance institutions. Such institutions tend to be focused on poor people and low-income households, and not only those without access to banks.

Given their social objectives, expansion of outreach among poor people is often rapid, limited only by the availability of resources. NGOs may have several other advantages: they are grassroots-based and therefore have an information advantage and network benefits; they have expertise in forming groups, introducing disciplines, transferring know-how and skills; and they can undertake vocational training activities at the same time.

NGOs may also offer the advantage of greater attention to environmental concerns. Banks are in general not equipped for supporting or monitoring the use of microfinance services for economic development through the sustainable exploitation of natural resources. NGOs may have greater experience and expertise in ensuring environmental protection, while supporting economic development through microfinance services.

As worldwide microfinance experience has shown, NGOs are a powerful tool to provide microfinance services for poor people living in remote rural areas, maximizing outreach by using successful, innovative techniques for providing such services, and in particular, making and recovering tiny uncollateralized loans. Box 13 presents an example of a successful NGO microfinance institution in Bangladesh.

Because of their social and environmental focus, NGO microfinance institutions are often better suited to cater to the needs of forest-based small-scale enterprises. They may have the expertise to build and strengthen groups and to help such enterprises adopt profitable economic activities that do not have negative impacts on the forests. In rural areas characterized by very high costs of delivery of microfinance services and where smaller forest-based enterprises are engaged in sector-specific production activities that are unfamiliar to more formal microfinance institutions, NGOs may be the only institutions equipped for the sustainable delivery of these services.

NGO microfinance institutions' dependence on grants, their financial viability, management and monitoring capacity, and their repayment performance may occasionally pose problems. Their internal governance may also be a concern. A strong independent apex institution capable of exercising financial discipline, with good training capacity, which would help link the NGO to the formal financial network may help NGO microfinance institutions to overcome such weaknesses. In Nepal, for example, the Rural Microfinance Development Centre was established as an apex organization in order to support the many NGO microfinance institutions in the country.

To ensure sound and sustainable operations, it is important that NGOs strengthen internal controls, risk management, transparency and disclosure of financial information, while at the same time paying more attention to the cost side of providing the services, and particularly to their sustainability.

Most of the NGO microfinance institutions are credit-focused, with deposits often limited to obligatory cash collateral for loans. Their inability to publicly mobilize deposits and their limited links to financial markets make it difficult for them to expand without continued access to wholesale funds from governments and international donors. Legal restrictions on the scope of services provided by NGOs may also limit the effectiveness in addressing heterogeneous needs of poor people. Some of the more successful NGO microfinance institutions manage to obtain funding from commercial banks, but rarely in amounts exceeding their own equity. At some point, therefore, growth-oriented NGO microfinance institutions find themselves constrained by lack of funding. A debt to equity ratio of 1:1 is fairly typical for NGOs, while banks and other regulated financial institutions operate with leverage ratios of about 10:1.

The need to overcome their dependence on funds from international donors or governments for their lending, which restrict their growth, is a fundamental reason behind the transformation of many NGO microfinance institutions into bank microfinance institutions. By becoming licensed and supervised by governmental financial authorities over time, NGO microfinance institutions can fund themselves with savings accounts and term deposits captured from the public, and use the capital to provide financial services to far greater numbers of poor people over longer periods of time. Upgrading into regulated banking institutions also allows NGOs to seek other commercial funding from bank loans and increasingly through capital markets in the form of bond issues (see Box 14).

Financial cooperatives and credit unions

Credit unions and cooperative financial institutions collect savings and provide loans to their members. In many rural areas credit unions are still the only source of deposit and credit services, apart from the informal financial market. Because membership is usually based on some common bond, such as living in the same village or common employment, credit unions tend to be relatively small. Groups with longer traditions of mutual trust and close-knit communities that enable resource users to reciprocate in behaviour are more likely than others to succeed in devising and sustaining successful credit unions. At the same time, successful cooperatives are likely to strengthen the social capital of their members.

Credit unions start with shared capital or shared savings and do not normally take saving deposits from the public, but only from members. The main purpose of credit unions is to make attractively priced loans to members, achieve affinity to overcome asymmetric information, and develop group dynamics to provide an incentive to repay.

Governance is usually based on a one-member-one-vote principle, with no board of directors representing ownership interests, and the annual assembly of all members democratically deciding on key issues. A potential risk is that strong managers with broad authority can be inefficient and lead credit unions into abuse, fraud and failure, while individual members have limited ownership incentive and power to prevent such an eventuality.

Credit unions often face outreach constraints, because the demand for loans often exceeds the supply of savings, so member loans are typically limited. Opening membership of credit unions may be a way to expand outreach, but it risks weakening credit unions by diluting the members' social capital and information. Credit unions may also suffer from lack of financial training and management skills, and a varying quality of supervision and governance, which may expose them to potential risks. Two other possible weaknesses are a permissive attitude towards loan delinquency rooted in misinterpreting cooperativism and the concentration of loans since small, single community-based credit unions may not be able to diversify their portfolios adequately.

These potential weaknesses mean that credit unions risk providing uncompetitive products and services, and confusing financial information, as well as undertaking undisciplined financial operations. Loan analysis may be based more on membership considerations, and the credit provided on a pro rata basis rather than on revenue prospects.

To address weaknesses and potential risks and to ensure sound and sustainable credit union microfinance institutions, it is important that the financial system ensure tight operational standards for financial cooperatives, effective off- and on-site supervision, improved accounting and reporting standards, and enforcement of capital adequacy ratio requirements and external borrowing limits. Box 15 shows an example from the United Republic of Tanzania where credit and saving cooperatives have been successfully supported.

For forest-based small-scale enterprises, local credit cooperatives and local forest NGOs may have the advantage of having detailed knowledge of the characteristics and constraints of their activities, technical as well as economic and social. This may help them to identify the most suitable financial services and develop the most effective guarantee systems. Credit cooperatives also assist in overcoming the constraint of high transaction costs to service such enterprises.

There are examples of more informal cooperative arrangements among forest communities, such as the cash box system in the Gambia (outlined in Box 16), where common funds are successfully used for small-scale enterprises.

Microfinance institutions that fund exclusively forest or agricultural portfolios are extremely vulnerable to external shocks. Given the greater needs of small-scale enterprises for investment financing at the beginning of tree planting activities, credit cooperatives focused on forest production activities may often find their funds becoming quickly insufficient to finance the local credit demand.

Non-financial or informal sources

Pawnshops. Pawnshops can be a very important source of microcredit for low-income and poor households. The major reasons for their success among poorer families are their easy access - no loan application forms to fill in but only an identification card and the item to be pawned - and the very quick processing of the loan. For rural households, especially those engaged in non-wood forest product activities with little access to assets and collateral, small pawn loans can be a valuable means to address emergency shortages in family cash flows, being less expensive and more reliable than money lenders. Strengthening sound and efficient pawning institutions, and supporting the development of products targeted to poor people, can therefore be an effective means of expanding microcredit outreach and serving rural households (see Box 17).

Agreements with non-financial institutions. Equipment suppliers, processors and traders are among the non-financial institutions that might be interested in providing finance and who are able to do so. They might have advantages compared to financial institutions in terms of reducing risks and transaction costs, namely:

In comparison to most microfinance institutions, suppliers, traders and processors have a greater knowledge of small-scale enterprises and their economic activities and products because they are their regular customers. Therefore, they are in a better position to assess their economic potential and financing risk. They may also face fewer transaction costs than most microfinance institutions, because of the already existing regular business contacts. From the point of view of the credit delivery, non-financial institutions can therefore be a cost-effective mechanism.

There are different types of company-community partnerships:

Outgrower schemes occur where companies contract communities or individual landowners within their concessions or in nearby areas to plant trees and to supply a given amount of timber to the company for an agreed price. The details of outgrower schemes and the balance of rights and duties vary. In some instances, the company is not obliged to purchase the landowners' timber, but has the first right to do so. In others, the landowners can choose to sell to a third party if the company does not match the market price. Box 18 outlines an example of one of the first outgrower schemes employed by Sappi in South Africa.

The primary benefit to the company or licensed concession holder is the increased supply of naturally grown timber. The schemes also reduce the company's plantation supervision costs, for example, in preventing forest fires, since the local people have a vested interest in protecting the plantations.

Research findings show that the most successful collaborations occur when companies negotiate transparently with communities to achieve a win-win situation. This helps secure a long-term commitment from outgrowers. Local groups also need secure land ownership, which would result in little competition for the use of land. The company needs to deliver clear information on the potential risks and consequences to the tree growers as well as planning reinvestment mechanisms well. They must be able to offer a fair price for the timber, because the long-term viability of the schemes will depend on tree growers making a good profit from the first harvest.

Joint ventures are basically partnership arrangements. In general, the company and community participants share equity and split the profits in proportion to their respective shares. Communities in joint ventures may be involved in the operations' management.

Other arrangements between companies and communities vary from simple contracts where communities are paid to protect trees in lands already allocated to the company, to arrangements whereby companies deliver contributions to local development (e.g. schools and health care) in return for community cooperation. Informal agreements vary considerably.

Agreements with non-financial institutions may involve high costs for setting up and managing the loan administration and monitoring system, and a lack of transparency in account management. Because of the greater bargaining power enjoyed by informal suppliers in general, the lack of alternative sources of credit and the often limited literacy and financial skills of their customers, the terms and conditions under which services are provided may not enable the clients to fully harness economic opportunities, and interest rates charged are often considerable. Limited funds can also pose a problem and limit outreach, often to better off and more promising forest-based small-scale enterprises. An advantage with regulated and supervised financial institutions is their ability to offer additional financial services such as savings, a greater variety of typologies of loans, and payment services.

Informal financial arrangements. For most poor and low-income households in rural areas, microfinance services are supplied mainly by informal sources, such as self-financing through family and relatives, friends and neighbours, or borrowing from money lenders and traders. Poor people tend to be too wary of risks to borrow for promotional measures (that is, investment in the future). They prefer gathering their own resources or resources from family and close friends first in order to finance most rural investments.

Self-financing is investment within a particular household or enterprise of savings accumulated in that household or enterprise. Among poor people, most investments are made through self-financing, which has the advantage that no external information, collateral, contract or form is required. However, self-financed resources may not match those required by the investment opportunity and therefore may limit the scale of activity. This may be a particular constraint in the case of indivisible investments (such as buying cattle, equipment, or a bag of fertilizer), and considerably reduce the possibility of introducing productive innovations and technologies.

Informal suppliers of credit, such as money lenders and middlemen providing credit, are often the only available source of credit in remote areas, supplying mainly short-term credit and charging higher interest rates than semi-formal and formal sources. Their contribution to financial intermediation and the improvement of resource allocation is also limited because they operate mostly in limited localized areas and seldom allow movements of funds over larger distances and beyond well-known clients.

Microfinance outreach

Despite the substantial worldwide expansion of microfinance in the last two decades, an overwhelming number of poor people continue to lack access to basic financial services. This expansion has reached mainly urban households and micro-enterprises with regular income flows. With activities that may require comparatively larger loan amounts, forest-based small-scale enterprises and rural households have less frequent revenue flows, need longer repayment terms and are still largely unserviced. Even rural microfinance institutions still focus mainly on trading and other non-agricultural activities that have a shorter turnover.

Successful outreach expansion can be achieved through the entry of financial intermediaries not previously serving micro-clients, or through the broadening and deepening of the coverage of services by already existing microfinance institutions.

In rural and remote access regions, strengthening and expanding operations of existing microfinance institutions may work better than trying to lure urban commercial banks to rural areas. The lack of rural lending experience of these banks may constitute a formidable barrier to their entry in rural markets. Microfinance experience shows that the forced expansion of lending operations under supply-led regimes typically leads to poor microfinance institution performance, with declining repayment rates as the quality of the borrowers and the loan portfolio are sacrificed in favour of quantity. In the forest sector, due to the peculiarities of the investments, microfinance institutions without experience in the sector or without support from government specialized agencies will likely lack the necessary expertise to understand and assess small-scale enterprise investments.

Limited branch networks are a bottleneck to the outreach extension of already operating microfinance institutions. This is often a greater constraint for banks when restrictive banking legislation imposes high capital requirements for opening new branches, and for limited funds, especially NGO microfinance institutions that are excessively dependent on government and donor financing. Establishing a network of partnerships among microfinance institutions, and between them and other financial institutions can help overcome both constraints, and allow for the necessary growth and expansion. For integration to take place, microfinance institutions must adhere to financial best practice standards and transparency in their financial and operational performance. The increasing availability of microfinance institutions' appraisal mechanisms and rating institutions should facilitate the establishment of such partner networks. Examples of specialized microfinance rating agencies are Microcredit Ratings International Ltd. and Credit Rating Information Services of India Ltd. for Asia, MicroRate for Latin America and Africa, and Microfinanza Ltd. and Planet Rating worldwide. The Consultative Group to Assist the Poor (CGAP) and the Inter-American Development Bank (IDB) have launched the pilot phase of a joint initiative called the Microfinance Rating and Assessment Fund, aimed at improving the quality, reliability and availability of information on the risk and performance of microfinance institutions in all developing countries.

Simple systems and procedures are often key to increasing the outreach of microfinance institutions, especially in rural environments such as those of forest-based small-scale enterprises where costs of providing microfinance services are high (see Box 19).

When viable, for example through mobile branches or visiting loan officers, doorstep services enhance accessibility to microfinance institutions and support outreach expansion for remote areas, especially for low-income and illiterate households. Information communication technology has also a very high potential for breaking geographical and other barriers to outreach expansion, and may therefore represent a great opportunity for forest communities.

In forest areas, where communal ties are likely to be stronger, social mobilization and shared and respected cultural values can be drawn upon to minimize costs and accelerate microfinance outreach. Traditional informal organizations, collaborative practices, cultural values such as honour, solidarity, integrity and serving others are social assets that can be profitably tapped to both expand the coverage and reduce the costs of microfinance services.

Gender outreach5

Microfinance programmes have generally targeted poor women. This is because experience has shown that targeting poorer households through women is more effective, as they are more risk-averse, look for more productive loan utilization, are better credit risks and ensure higher repayment rates than men. Women are reputed to possess more unrealized entrepreneurial capacity, to have higher savings propensity, and to be more inclined to use income that they control for improving children's nutrition and education. The small credit amounts used in microfinance seem to suit women better than men, and women can also be used as vehicles for credit delivery. Microfinance is generally viewed as a powerful tool for empowering women and improving their livelihoods.

Addressing gender issues in microfinance interventions, however, means more than targeting a programme towards women, or counting the number of loans made to women. A gender-sensitive approach would imply examining both women's and men's economic and social position in the family and the community. It also implies analysing how their position is reinforced through the institutions that they deal with and how it is governed by national laws and customs.

Government programmes that help women to overcome the constraints of accessing credit and other financial services through specific policies, programmes, and/or legislation can improve microfinance outreach, building on their general repayment performance and underused economic potential.

5 Based on FAO, 2002

Outreach through groups

Most microfinance institutions provide savings and loan facilities and other microfinance services to groups, thereby reducing the number of individual transactions. Through group outreach microfinance institutions can also avail themselves of the groups and their representatives for a number of activities such as the disbursement of individual loans, the collection of individual savings and repayments, peer monitoring, and repayment pressure.

Transaction costs may be too high to provide microfinance services individually, both sustainably and often enough, especially in areas of difficult access and sparse population such as forest regions. Although bigger and stronger forest-based small-scale enterprises may afford to visit the microfinance institution branches when needed, group outreach can be a successful mechanism for microfinance institutions to expand their outreach with limited increases in costs.

Financial sustainability

Financial sustainability is necessary to reach significant numbers of poor people in a stable and durable manner. Sustainability is the ability of the microfinance provider to cover all of its costs, and is therefore the only way to reach significant scale and impact beyond what donor and government agencies can fund. Sound, efficient and sustainable microfinance institutions should ensure high loan recovery rates, charge appropriate interest rates, increase productivity and the number of borrowers, and reduce operating costs with efficient delivery systems. Sustainability is closely linked to outreach since most poor people are not able to access financial services due to the lack of strong financial intermediaries, which are the only way to guarantee continued provision of microfinance services for poor people.

To achieve the viability and good financial performance necessary to service small-scale enterprises reliably and continuously, microfinance institutions should be able to charge cost-recovering rates and at the same time ensure transparency in pricing to protect consumers. Viable and sustainable microfinance institutions, focusing on reducing transaction costs and developing new products and services, will be able to better provide microfinance services to poor people. Promoting competition and institutional efficiency will facilitate the reduction of interest rates over time.

Several microfinance indicators, benchmarks and rating systems have been developed to assess microfinance institutions' performance and their sustainability (Table 2). Transaction costs, including credit and economic risks, and interest rates are the main financial factors, together with the cost of funding, affecting the viability and sustainability of the institution.

The adjusted return on assets (ROA) and the portfolio at risk (PAR) are among the most significant indicators of overall financial performance. The adjusted ROA shows the profitability of the microfinance institution, after discounting possible grants and subsidies from government or donors, and therefore its sustainability. The PAR tells how well the microfinance institution achieves its basic goal of lending money and receiving it back. More detailed indicators are provided in CGAP (1999). Detailed microfinance benchmarks, for example, by lending method, by region, by target market, are provided in the MicroBanking Bulletin (

Table 2
Microfinance institution financial indicators and performance benchmarks

Performance criterion


Performance benchmark

Capital adequacy


Capital adequacy ratio

Minimum 20% (however, it depends on the size and typology of microfinance institution: the ratio may be lower in bigger and more regulated microfinance institutions)


Loan loss reserve adequacy






Portfolio quality

Portfolio at risk (PAR)

Maximum 10% (applied to 31 or 91 days PAR)


Loan loss ratio

Maximum 4%





Return on assets (ROA) (subsidy adjusted)

Minimum 2%





Operating self-sufficiency ratio

Minimum 120%




Financial self-sustainability

Financial self-sufficiency ratio

Minimum 100%


Subsidy dependency index

Maximum 0%






Average number of daily transactions/teller

No standard benchmark


Number of active clients/operational officer

No standard benchmark






Number of delivery units (branches, sub-branches, mobile units)

No standard benchmark


Number of savers or savings accounts

No standard benchmark


Average savings balance

No standard benchmark


Number of borrowers or loan accounts

No standard benchmark


Average loan size

No standard benchmark

Source: IFAD, 2004c

Transaction costs and credit risks

Transaction costs are those connected with the provision of microfinance services, such as the collection of savings, disbursement of loans, collection of repayments and provision of other services such as insurance and transfers other than the cost of funding.

Provision of microfinance services to small-scale enterprises is likely to entail greater transaction costs than the already costly provision of traditional microfinance, because the population density is generally low and households generally live in remote access areas. The higher transaction costs of microfinance institutions are largely a result of the need to travel long distances to reach a dispersed rural clientele, the poorly developed rural transport and communication infrastructure, and poor knowledge of heterogeneous rural households, their economic activities and their financial needs. Normally, labour and transportation costs represent more than 60 percent of the total administrative costs of the microfinance institutions. It should be noted that for the clients, in addition to the costs of borrowing, there are other high additional costs: opportunity costs (working time), transport costs, fees and unofficial payments, delays, excessive paperwork and collateral documentation.

The delivery mechanism for microfinance services also has important consequences on transaction costs; in order to achieve greater outreach, some microfinance institutions provide doorstep services to the client, whereby their staff visit households instead of requiring clients to come to the branch. This reduces the costs for the clients and facilitates access to services, but entails greater transaction costs for the microfinance institution.

Although most investments in forest-based small-scale enterprises are expected to yield benefits in the medium and long term, forest activities are perceived to be subject to uncertainties. The larger the size and the longer the term of the loan, as is the case for initial fixed investments such as tree planting and purchase of equipment, the more important are frequent contacts with and supervision of the borrower. This should control the risk of loan default, which is costly and time-consuming. Microfinance institutions will therefore tend to incur greater costs and require higher collateral when servicing forest communities than in the case of other clients.

Providing microfinance to poor individuals is deemed to involve high risks. The management of these risks contributes to the transaction costs, both in acquiring information on the borrowers and their economic activities, and in making the necessary provisions against possible non-repayment. Credit risks relate to moral hazard, which is the possibility that borrowers may skip the repayment, while external economic risks relate to the future economic and financial viability of the investment financed. Lenders must carefully screen and select borrowers in order to reduce moral hazard risks, and to ensure that the entrepreneur has sufficient management skills and that the economic activity will generate enough profits to repay the loan.

Credit risks are normally assessed by creating a client profile including track records, range of experience, existing assets and labour force. Credit risk is normally higher for a client that the microfinance institution has no previous experience of, so usually new borrowers receive smaller loans with shorter repayment periods, while borrowers with good loan repayment can gradually receive larger amounts for longer terms. Frequent payments in small instalments are a strong tool for maintaining contact with the borrower and the lender, thus controlling this risk, although they increase transaction costs. If repayment is based on the projected cash flow generated by the investment, supervision should ensure that the disbursed loan is used for the purpose stated in the loan contract. Mobilization of savings is an alternative way to build additional ties between borrowers and lenders, reducing credit risk and providing for partial loss coverage in case of non-repayment.

Collateral. To a certain extent, risks and information-related problems and costs can be reduced by the use of collateral. Collateral serves two important functions: it acts as a screening device to reduce wilful defaults on loans, and it reduces lending risk by providing the lenders with an additional source for repayment. Due to costs and risks involved in liquidating the collateral, the lenders tend to require collateral valued at 1.5 to 2 times the loan amount. The collateral requirement has a negative impact on poor people because it tends to limit loans to wealthier individuals.

Forest-based small-scale enterprises are likely to face greater requests for collateral because of greater uncertainty about their ability to repay given the longer-term nature of the investment being financed and the higher probability that some negative unexpected event will occur during that time. This is a problem in many developing countries, and in particular for enterprises and households living from forest activities, given that forest land is in many cases government-owned, and households often lack formalized ownership titles and registers for real estate assets. Examples of external risks that can affect forestry activities are: natural disasters such as storms and fires; technical production failures such as tree crops damaged during the immaturity period or equipment breaking down; and changes in economic conditions, for example, a lower demand leading to a lower price for the product.

Investments for immobile assets such as land and buildings are generally less risky for the lender because the assets (along with the borrower) cannot easily disappear and can be used as collateral. Semi-immobile assets such as tree crops share many of these characteristics but need more supervision. In order to reduce financing risks, mobile assets such as certain types of machinery may require either additional collateral or a proper registration system and a legal framework that facilitates repossession.

Interest rates

To achieve sustainability, interest rates of microfinance institutions should cover all costs including costs of funds, administrative costs and provision for loan losses and inflation. Microfinance institutions often charge interest rates of 2 to 3 percent per month or even more; these rates are mainly a result of high transaction costs and risks in financial intermediation. Loan administration costs in terms of personnel and resources are approximately the same irrespective of the loan size, and thus have a higher impact when dealing with small loans. To cover these costs and allow for their growth, microfinance institutions should therefore be allowed to charge interest rates that are above the average bank loan rates. When servicing forest-based small-scale enterprises they may have to charge interest rates even higher than average microfinance rates, given the higher transaction costs involved in rural areas. For most rural people the alternatives to sustainable microcredit are money lenders, input suppliers, inflexible and risky local savings circles, or nothing at all. Although the rates of interest charged by microfinance institutions to cover the costs of microcredit are relatively high, they are still below what poor people usually pay to money lenders and middlemen. Ensuring transparency and competition among microfinance institutions will, on the other hand, help prevent those excessive rates and other fees from being passed on to the clients to cover operational inefficiencies.

The interest rate directly affects the financial costs of loans for small-scale enterprises and therefore the viability of the investments. High interest rates have a significant impact on profitability, particularly that of longer-term investments such as tree crops, given the large loan amounts to be repaid over a long period. If high interest rates are applied to larger loans with longer maturities, then the resulting financing costs may exceed the profitability of the specific term investment opportunities. On the other hand, longer-term loans have the primary advantage of spreading amortization payments over a longer period, making these loans more affordable.

Although high interest rates may be a disincentive for forest-based small-scale enterprises in investment and economic development, in order not to compromise the sustainability of microfinance institutions, more favourable interest rates should be pursued by increasing efficiency, strengthening financial performance, ensuring high productivity of staff, introducing innovations that reduce transaction costs, facilitating access to cheaper commercial sources of funds and promoting greater competition.

Microfinance institutions that offer savings facilities, generally banks, have a cheap source of funds for further lending. Since poor clients are usually not very sensitive to interest rate incentives, especially where alternative savings services are unavailable, but rather to savings flexibility and accessibility, savings have the advantage of usually being an inexpensive source of funds. Mobilization of savings is therefore an important means to reduce microfinance institution costs, leading to more sustainable operations while charging lower interest rates. Efficient wholesaling or apex institutions, and a developed network of linkages among the various layers of financial institutions are also important to reduce provisioning costs for microfinance institutions that rely on commercial sources of funds.

To allow efficient microfinance institutions to reach sustainability and facilitate their growth it is important that governments do not impose interest rate ceilings or provide unsustainable, subsidized credit programmes. Such programmes distort the markets and are often plagued by very poor repayment records, undermining the operations of sound microfinance institutions. Past experiences with subsidized targeted credit have generally been unsatisfactory, with low repayment rates, and have shown that it is difficult to target subsidized credit due to rent-seeking behaviour of larger or better-off customers, political patronage, and an easy diversion of loan funds for other purposes. A problem with subsidized credit is that borrowers tend to feel less compelled to repay government-subsidized loans. Default rates of over 50 percent are common worldwide in subsidized rural credit programmes. If loan defaults are tolerated, borrowers may confuse loans with grants, which will undermine their future credit discipline.

Microfinance institutions administering government lending programmes with low interest rates or facing interest rate ceilings will never recover their costs and will therefore always require government or donor subsidies (with fiscal implications). While benefiting borrowers who manage to obtain loans, interest rate ceilings will negatively affect a larger number of potential borrowers. This is because microfinance institutions will often retreat from the market, grow more slowly and reduce their operations in rural areas where they cannot recover their transaction costs, leading to a general limited access to credit.

Many microfinance institutions started with international donor funds, local government money, or a combination thereof. In order to encourage microfinance institutions to become sustainable, any resources provided in the form of subsides from donors should be momentary and transparent, and should not be linked with lending, but instead support institution and capacity building.

Impact on the environment

In addition to its economic impact, microfinance may have an impact on the environment. Changes in the physical, human and social assets that arise from microfinance activities will affect a community's production, consumption, and management of resources. The net effect of increased demands on forests and on the quality of forest resources - possibly including physical capital and production effects, income and income diversification effects, and social and human capital effects - may be negative or positive. Microfinance and in particular microcredit can influence forest resources through the direct, intentional efforts of lenders, or indirectly through changing the constraints faced by forest communities and enterprises.

Examples of direct links between microcredit and environmental goals are microfinance institutions (normally NGOs) that tie environmental management explicitly to lending or that include environmental practices among the conditions for lending. Conservation or development NGOs may also use microcredit to promote their environmental agendas.

The indirect environmental consequences of extending microcredit to poor people generally include economic effects brought on by the availability of credit. Such consequences include increase in physical capital, income growth and diversification. There are also soocial effects (greater empowerment of women, building and strengthening social capital through group lending), which generally improve the use of common forest resources. The combined net impact of all these factors on deforestation rates and on the use of environmental resources is ambiguous, depending on borrowers' responses to the set changed opportunities, their adopted behaviour, the local condition, and how the composition and not simply the level of activities change.

Although much needs to be understood about the connection between microfinance, the environment and the use of natural resources, it is clear that the nature of the microfinance institution and the extent to which the provision of services is linked to environmental goals may differently affect forest resources.

Microcredit incentives linked to the sustainable use of natural resources, supported by appropriate education and training for environmental protection by the government or sensitized microfinance institutions, will help minimize negative impact and ensure sustainable forest management. Careful attention should be paid in ensuring that environmental objectives and safeguards do not compromise the viability of the microfinance institution. Mechanisms such as government matching grants or subsidized provision of inputs to forest-based enterprises committing to environmentally sustainable practices may be preferable to the provision of targeted credit with subsidized interest rates, which have often proved inefficient and undermine the long-term sustainability of the microfinance institutions.

Box 6
Microfinance providers for small-scale enterprises in Guyana

Small-scale enterprises in the forest sector rely on both formal and informal mechanisms to meet their financing needs. There are a few formal microfinance institutions in Guyana, even though none is specific to the forest sector.

The Institute of Private Enterprise Development (IPED) is a privately-owned non-profit organization established in 1986 to provide credit to micro-, small- and medium-scale enterprises, and technical and managerial support services to its loan beneficiaries. Its micro-enterprise programme was launched in 1993. The forest sector is a beneficiary of loans from IPED. Between 1986 and 1999, IPED provided 73 loans, or 0.4 percent of its loan portfolio, to logging, sawmilling and charcoal-producing groups/individuals, and 11 loans for the production of wooden toys. It has been noted, however, that there has been a reduction in borrowing from this institution by logging and sawmilling companies.

The seasonality of forest harvesting operations generates cash flow problems that are particularly acute for smaller-scale operations. Apart from some dedicated private microcredit schemes, there are few specific incentives for smaller enterprises. The scale of operation and lack of capital often excludes such operators from initiatives that might improve sustainability, such as membership of representative bodies, training courses and certification schemes.

Source: Thomas et al., 2003

Box 7
Financial situation for small-scale enterprises in Uganda

For small-scale enterprises in Uganda (within and outside the forest sector), finances and financial management represent one of the greatest constraints to effective operations. Few financial products are available to Ugandans other than bank loans. There are many problems accessing finance in Uganda, due to its relatively underdeveloped financial sector, and this particularly affects sustained investment in long-term ventures such as forestry.

For many small-scale enterprises it is extremely difficult to get a loan, since it involves undertaking effective budgeting and cash flow projections, preparing business plans, maintaining solvency and liquidity, providing collateral, managing accounts and providing accurate financial records for external investors or tax authorities. Furthermore, many of these enterprises operate as one of many parallel business ventures, and their finances tend to flow between them, sometimes causing problems of cash flow and liquidity. Small-scale enterprises that cannot get a loan must resort to informal lending at very high interest rates or rely on personal connections.

Microfinance institutions typically provide short-term loans for small amounts of capital, while small-scale enterprises often need longer-term and larger loans. There is often a lack of cooperation between banks and forest sector. A better appreciation of the specific and long-term nature of forestry investment is necessary for banks to understand operating requirements for small-scale enterprises. While there may be interest in investing in tree planting, for example, there is generally insufficient widespread ability to invest in a sector that yields only long-term benefits.

A saw log production fund is being established, overcoming the problem of access to long-term finance for small- to medium-scale plantation development. The fund will be operated as an independent entity through a management agent or bank, and will provide a mix of grants and credits targeting small to medium-sized private investors and organized groups.

In a modern financial sector there are products such as asset leasing and venture capital. In Uganda, no such services yet exist, and government regulations do not allow or recognize the modern concept of leasing. If leasing were clarified and made more available, it would provide opportunities for small-scale enterprises to commence or expand operations. However, a Financial Institutions Bill (2003) is being discussed that further clarifies taxation and obligations of all parties under leasing agreements.

Equity facilities provide much-needed finance to small- and medium-scale enterprises worldwide. In Uganda, equity financing is limited, largely due to the loss of social capital stemming from years of civil unrest, which has resulted in general mistrust between lenders and receivers of credit beyond close family ties.

Source: Auren and Krassowska, 2004

Box 8
Mobilization of microsavings: the Workers Bank in Jamaica

In 1993 the Workers Bank of Jamaica was looking at ways to encourage and boost savings deposits in its banking network. Competition at the high end of the marketplace drove the bank to introduce new and innovative ways to mobilize savings, motivating small savers to deposit increasingly large amounts in the bank. A new product, the Partner Savings Plan, was inspired by an analysis of the Jamaican Rotating Savings and Credit Association (ROSCA), which was created to provide an attractive form of saving for low-income Jamaicans, particularly women.

The analysis identified a number of successful factors, which were replicated in the Bank's Partner Savings Plan. These included easy access for conducting both savings and credit transactions, informality in business transactions (no taxes, no complicated forms), flexibility of informal savings arrangements and low minimum opening balances, geographical convenience, low transaction costs, and familiarity with people involved in the Partner Savings Plan.

By marketing itself as a more secure option than the traditional partner ROSCA, adding an interest that was called "bonus", and offering the chance to win big prizes, the Bank was able to mobilize 17 292 partner accounts for a total value of deposits of US$3.36 million, between May 1994 and September 1997.

Source: Owens, 2003

Box 9
Group lending in Latin America

In Latin America, group lending has a greater rural concentration than individual lending: 29 percent of village banking clients (ten borrowers or more) and 17 percent of solidarity groups (three to nine borrowers) in the region are rural, versus only 8 percent for the individual clients. Group lending also has greater penetration among poorer households: the average loan balance of group loans, commonly used as a proxy for clients' status under the assumption that poorer households will be able to borrow smaller amounts, is far smaller than individual ones - US$150 for village banks and US$329 for groups, compared to US$980 for individual loans.

Group banking needs to become more flexible and client-oriented over time, however, in order to increase client satisfaction, retention and impact. In the case of four leading Latin American village bank institutions, client retention rates are low compared to those achieved by individual lenders.

Source: Westley, 2004

Box 10
Leasehold forestry for small-scale enterprises in Nepal

In Nepal, a government project, the Hills Leasehold Forestry and Forage Development Project, with support from the International Fund for Agriculture Development (IFAD) and the Government of the Netherlands, has addressed poverty reduction and restoration of degraded land by leasing small blocks of degraded public forest land to the poorest households for 40 years.

The long-term lease provides poor people with long-term security of tenure and the incentive to invest in order to regenerate, protect and manage the degraded forest areas. At the same time, land tenure facilitates access to microfinance services and credit.

Source: IFAD, 2004a

Box 11
Microleasing: ANED in Bolivia

The Financial Leasing Programme of the Asociación Nacional Ecuménica de Desarrollo (ANED) is an innovative microleasing mechanism for the small producers of Bolivia's rural areas to finance investment capital, which emerged in 1997 as a response to the needs of many rural producers to have fixed assets to enable them to significantly increase their productivity and income.

The Programme faced several difficulties in its beginning. First, it needed to develop a methodology through which the products could be used simply, considering that most of them had only basic education levels. Another difficulty was operations management since the software used by the organization had to be adapted to Bolivian financial leasing conditions. In addition, hard work was needed to identify suppliers who could provide the appropriate machinery to answer the needs of the target customers, as well as to train clients in handling the machines and equipment.

Until October 1999, in over two years of operation, equipment had been financed for over US$623 000, 95 percent of which was agricultural machinery and the remainder for traditional handicrafts, with an average contract amount of US$1 895, confirming that the financed machinery was meant for small rural producers. The Programme delinquency rate was nil in December 1998. Although it was not possible to obtain separate data on this Programme's profitability and sustainability, information available on the income, costs, disbursements and profits generated by the Programme indicate that it could generate net positive profits while operating in market conditions.

Source: Alvarado and Galarza, 2003

Box 12
Microbanking: Papua New Guinea

In Papua New Guinea, a country with a large rural population, scarce population density, difficult access to remote areas, a forest-dependent economy and customary land tenure, the approach adopted by the Government in the past, building on savings and loans credit societies, has proved unsuccessful. This is because the poor governance and management of these institutions resulted in a loss of confidence on the part of the people. The Government has therefore decided to pilot a microbanking scheme for the sustainable delivery of demand-driven microfinance services, starting with the establishment in 2004 of Wau Microbank, with funding from the Government and international donors. A microbanking approach is felt to present several benefits: greater sustainability prospects, better governance, and more effective adoption of financial technology, systems and procedures.

Wau Microbank has the advantage of being regulated and supervised by the central bank, managed by a qualified staff team, open to the general public, and allowed to collect savings. Under its special licence granted by the Central Bank, Wau Microbank is exempted from the general banking regulations, and is authorized to perform limited banking functions for the public, namely, accepting savings deposits from the general public and granting small loans to its target populations.

With its adherence to established corporate standards of practice and the Central Bank supervision, Wau Microbank provides an adequate instrument to address the need for safe savings deposits, which is a priority among the local population given limited investment opportunities and the hazard of keeping money at home due to crime problems. In addition to demand and term deposits, the bank offers business and all-purpose loans, payment and payroll services, as well as limited non-financial services (business orientation to borrowers).

Upon reaching full sustainability of the delivery of microfinance services, the government plans to transfer the bank ownership to the local community and to replicate the model in other areas.

Source: Asian Development Bank, 2004

Box 13
NGO microfinance institutions: the ASA Foundation
of Bangladesh

The Association for Social Advancement (ASA) was organized as an NGO in 1978 with the vision of creating an enabling environment to establish a just society. In 1991, ASA was restructured and shed all other services to become a specialized NGO, committed to large outreach, cost-effective lending and to achieving financial self-sufficiency through efficiency.

The basis of ASA's success, which has led it to be considered one of the fastest growing, most cost-efficient, sustainable and best-managed microfinance institutions in the world, are its focus on cost-efficient and sustainable microfinance services with a large outreach, its shift from donor dependency to commercial borrowing for funding its operations and its innovative ways of providing microfinance.

ASA operations have four simple key organizational norms to achieve their central objective of sustainable outreach: standardized loan products; basic voluntary deposit services; simple, effective and rigid procedures allowing for cost-effective delivery of microcredit and limited deposit services; and zero tolerance on late repayments of loan instalments.

ASA follows a unimodel branch system based on the standardization of procedures described in a detailed operating manual, allowing for maximum delegation with minimum level of discretion; the standardization of all ASA branches (staff, buildings, furniture, etc.); and simple, uniform accounting systems, which have facilitated the rapid expansion of its branches. There is no group liability and groups are used solely to reduce operating costs. It offers its clients rapid and easy access to its standardized micro-loans (with amounts increasing with each new loan), charging cost-covering interest rates and open access to savings.

By the end of June 2004, ASA had 1 725 branches (compared to 159 branches in 1992), with over 2.3 million loans disbursed annually serving over 2.5 million active clients (more than 95 percent women), 2.8 million savers, US$345 million disbursed yearly as loans, US$48.8 million in savings, an adjusted return on assets of 11 percent in 2003, and an average of 419 active clients per loan officer and 1 654 active clients per branch in 2003, which is one of the highest of the region. On-time recovery rates have exceeded 98 percent over 1999-2003, and ASA has been financially self-sufficient since mid-1990.

The ASA model shows how tight cost control, including systematically cutting down costs and minimizing transaction costs, together with a lean administrative structure and high loan officers' productivity can efficiently deliver financial services to millions of poor clients.

Source: ASA, 2003

Box 14
NGO microfinance institution upgrading to a commercial bank: BancoSol Bolivia

In Latin America, microfinance, which had started in the 1950s with the establishment of credit unions, began rapidly expanding in the 1980s with socially-driven NGOs making loans to poor micro-entrepreneurs. The growth of these NGO microfinance institutions was largely funded by grants and soft loans from international donors and governments of the region. By the early 1990s a few leading NGO microfinance institutions had reached full sustainability. As a result, in 1992 one of the leaders among these pioneering microfinance institutions, the Bolivian NGO Fundación para la Promoción y Desarrollo de la Micro Empresa (PRODEM), converted itself into the first regulated microfinance institution in Latin America, BancoSol, a regulated commercial bank.

By transforming itself into a bank, BancoSol was allowed to mobilize savings, outgrowing donor and government funds and obtaining a cheaper source of funds than commercial borrowing from other financial intermediaries, and to respond to the demand of clients for one-stop shopping. By 1997, only five years after its commercialization, BancoSol already served over one-third of the total clients of the entire Bolivian banking system, despite charging high real interest rates, and surpassed other Bolivian banks in profitability thanks to cost-effective lending methods and its experienced and motivated staff. Interest income paid its full operating and financial expenses, and the expansion of its operations was funded by capturing commercial loans and deposits from the public, under the prudential supervision of the Bolivian authorities. At the end of 2001, more than 75 percent of its overall financing was in the form of deposits from the public and the remaining 25 percent was from other financial institutions.

To meet the financial challenges of rapid growth and compensate for the related rising costs, BancoSol started increasing loan sizes and maturities, thereby producing more interest income with little increase in operational cost per loan. This increase in portfolio efficiency allowed BancoSol to remain financially viable without having to raise its interest rates.

Following the BancoSol example, some 40 NGO microfinance institutions in the region have since upgraded to become regulated commercial microfinance institutions, relying ever less on subsidized funds and increasingly on deposits from the public.

Source: CGAP, 1997

Box 15
Credit and savings cooperatives in the United Republic of Tanzania

In the thinly populated areas of Tanzania, the country's commercial banks are unwilling and the development banks unable to serve the rural poor in a sustainable manner. To address this void, the government, with support from IFAD, has facilitated the transformation of almost 200 rural savings and credit cooperatives from credit channels into autonomous, self-financed and self-managed institutions functioning like private rural banks.

Strengthening rural savings and credit cooperatives has led to annual increases of 70 percent in savings deposits, the diversification of loan products to finance micro-enterprises, in addition to agriculture, including petty trading by women and an increase in membership of women to 40 percent. The repayment rate reaching 91 percent is still not fully satisfactory, but represents a substantial achievement. By mobilizing their own resources, lowering their transaction costs and raising repayment rates, the cooperatives have embarked on the road to sustainability.

Source: IFAD, 2004c

Box 16
The cash box system in the Gambia

Some villages in the Gambia are using the cash box system. The sources of income flowing into the community forest cash box are:

  • 85 percent of all proceeds from the community forest by the various interest groups;
  • 50 percent of the fines collected from offences committed in the community forest and violation of internal by-laws;
  • income from projects financed from the cash box, e.g. the timber and log enterprise in Berefet, which partly funded the ecotourism camp.

A community forest committee manages the cash box. Any withdrawal from the cash box must be decided by at least two-thirds of the committee members and should be used for either forestry development activities or other community development activities. The committee keeps proper records of the income and expenses of the cash box and must prepare and forward to the district forestry officer a statement of the accounts for each financial year. The community forest auditor internally audits the cash box as is the right of any forest officer designated by the Director of Forestry.

In Kafuta village, proceeds from 2003-2004 logging were deposited in the village cash box. The community forest committee unanimously agreed to use part of this money and the balance from the village development committee funds to finance the production and marketing costs for 2004-2005 for log and fuelwood enterprises. In addition, these enterprises financially supported the village water system and the construction of a mosque.

Source: Forestry Department, the Gambia, unpublished.

Box 17
Pawning financing: Perum Pegadaian in Indonesia

In 2001 Perum Pegadaian, the state-owned Indonesian pawnshop company, was the largest microcredit supplier in the country, accounting for almost half of all microfinance borrowers, with more than 15 million customers. Nonetheless, given the very small loan sizes, with its total outstanding loans of US$150 million, it represents only 7 percent of the total microcredit loan amount outstanding.

The importance of Perum Pegadaian as a provider of microcredit for poor and low-income households is confirmed by its average loan size of less than US$10 (40 percent of its customers borrow less than US$5; 88 percent of its customers borrow less than US$56), compared to an average loan size of more than US$80 for cooperatives and credit unions, and more than US$300 for banks. With a return on equity of 17 percent and a return on assets of 4.5 percent, the company is financially sound and profitable. Among its key success factors with poorer families are its simple and fast processing of micro-loans (which can be made available generally within 15 minutes); the presence of products specifically addressed to poorer customers through the acceptance as collateral of simple items such as fabric, clothes and small appliances; and its extensive outreach through its 772 branches and 14 regional offices throughout Indonesia. To strengthen its microfinance focus, Perum Pegadaian is currently developing micro-loans that do not need the actual deposit of assets as collateral, which is substituted by titling papers (for example of motorbikes) or even marriage certificates.

Source: Perum Pegadaian, 2003

Box 18
Sappi and outgrower schemes

Sappi is an international pulp and paper company and the second largest private forest owner in South Africa. It was the first company in South Africa to experiment with partnership arrangements with local communities as a way of increasing its access to forest resources.

The original scheme, "Project Grow", was initiated in Kwazulu-Natal in 1982 and has since been managed by the Lima Development Foundation, an NGO with a track record in community development. Under this scheme, local communities sign a contract with Sappi, which entitles them to free expertise, training and seedlings, advanced payment for work, and a guaranteed market for their trees at current market prices. When the trees are finally ready, Sappi pays the participants the value of the produce, deducting any advance payments.

This scheme has worked well, despite farmers not owning the land they plant. In general, individuals are granted rights to community-owned land for plots averaging less than one hectare per family. By 1999, 6 800 ha had been planted by 7 600 farmers, generating 2.4 million rands (R) (US$545 000) per year. Participants earn about US$205 per hectare per year, which compares favourably with the alternatives such as ranching or sugar production.

In 1990 Sappi introduced a second outgrower scheme for title deed holders called the Management Associated Programme (MAP). MAP offers free seedlings and technical advice, a loan of up to R1 200 (US$275) per hectare at the prime bank interest rate, and a guaranteed market price for timber. Up until 1999, 28 000 ha had been planted. The average income is US$115 per hectare per year. The grower must follow the harvesting practices prescribed by Sappi and cannot sell the timber grown to anyone else.

Source: Landell-Mills and Ford, 1999

Box 19
Outreach expansion: Center for Agriculture and Rural Development
(CARD NGO), the Philippines

After adopting the ASA methodology (see Box 13) in late 2001, CARD NGO, an NGO that had already been active in the country for more than ten years, registered a steep increase not only in client outreach and portfolio, but also in terms of savings by the end of 2003. The total number of clients increased by 134 percent, portfolio by 102 percent, savings by 110 percent, branches by 148 percent, and technical officers by 185 percent. This was accomplished while maintaining a repayment rate of 99 percent and a financial sustainability of more than 100 percent.

The factors identified by CARD NGO as key for achieving such rapid expansion in two years using the ASA methodology are: very simple bookkeeping, forms and filing systems (a typical branch has no cashier or bookkeeper and no computers); branch staff that can track loan status at any time without waiting for inputs from the microfinance institution head office, therefore enabling the staff to take immediate and appropriate action in case there is a deviation from targets; simplified staff training and recruitment procedures; promotion of flexible withdrawal savings; and strong head office monitoring through a simplified monitoring checklist.

Source: Alip and Dimaculangan, 2004

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