Microfinance: Rethinking Banking

P.V. Viswanath

FIN 680V/ FIN 360Spring 2012

Primary Issues

Loans are so small that profits are difficult to obtain.Lending is risky since the borrowers are too poor to offer collateral.Potential need for subsidies.Potential large positive impact on society.

Locations

Bangladesh, IndiaBolivia, MexicoIndonesiaBosniaInner-city Los Angeles, outskirts of Paris, Queens

Diminishing Marginal Returns to Capital

The principle of Diminishing Marginal Returns to Capital says that “enterprises with relatively little capital should be able to earn higher returns on their investments than enterprises with a great deal of capital.”Implies that poorer enterprises should be able to pay banks higher rates of interest than rich entrepreneurs.Money should flow from rich depositors to poor entrepreneurs.Example of the tailor who can reap very high returns with his first investment in a sewing machine. Subsequent investments in a set of electric scissors would yield a lower return.

Marginal Returns to Capital

Marginal return for rich entrepreneur

Marginal return for poorer entrepreneur

Capital

Output

Diminishing Marginal Returns to Capital

Capital should flow from rich to poor borrowers within any given country.But this is not so in practice….Why are investments in fact far more likely to flow from poor to rich countries, and not in the other direction?Why do large corporations have an easier time obtaining financing than self-employed cobblers?

Reasons for “perverse” flow of capital

Higher risk– Investing in rural India or Kenya or Bolivia is much

riskier than investing in the US

But are the risk-adjusted returns high enough?Maybe they are, but usury laws prevent charging high rates.If so, the problem is entirely political. Or is it?

Market Frictions

Incomplete information– Adverse selection

This problem exists before the parties contract– Moral hazard

This problem is after the parties contract

Lack of collateralWeak judicial systems make contract enforcement difficult.Hence, higher rates may reduce incentives to repay loans – and this may be crucial when there’s no collateral and good legal systems for forcing payment may not exist plus monitoring may be expensive.

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Incentive ProblemsAdverse selection: One of the parties to a transaction lacks information while negotiating. – An example of adverse selection is when people who are high risk are more

likely to buy insurance, because the insurance company cannot effectively discriminate against them, usually due to lack of information about the particular individual's risk but also sometimes by force of law or other constraints.

Moral hazard: The ignorant party lacks information about performance of the agreed-upon transaction or lacks the ability to retaliate for a breach of the agreement. – An example of moral hazard is when people are more likely to behave

recklessly if insured, either because the insurer cannot observe this behavior or cannot effectively retaliate against it, for example by failing to renew the insurance.

Both issues are incentive problems and both have to do with lack of information; adverse selection manifests itself prior to the contract and moral hazard subsequent to the contract.

Moral Hazard

What moral hazard problem is induced by the Federal Reserve bailing out banks?Is there a moral hazard problem when the Federal Government helps people affected by Hurricane Katrina?Is there a moral hazard problem when the government helps people who can’t make their mortgage payments because they have lost their jobs?How would you deal with these situations?

In these cases, one party is unable to commit to taking certain actions.

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Principal-Agent Problems

Principal-Agent problem: A special case of the moral hazard problem is when one party (the agent) undertakes to act on behalf of the other (principal). However, if the agent cannot be costlessly monitored, s/he might act in his own interests and to the detriment of the principal.– An example is when managers might act too

conservatively because they don’t want to lose their jobs if the business fails – and they turn down risky, but profitable investment opportunities

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Financial System SolutionsMoral Hazard– Managers could be given shares of stock or stock options to give them

incentives to act like stockholders.– Collateralization of loans reduces the incentive for borrowers to act in a risky

fashion since they would lose their collateral.– The existence of liquid markets for collateral then allows lenders to dispose of

the collateral. Markets for collateralized assets also allow them to keep track of the value of the collateral.

Adverse Selection– Banks cultivate long-term relationships with their clients making it less risky for

clients to share sensitive information with the banks and allowing banks to price risk in a more informed fashion.

– Firms can signal using mechanisms such as dividends and capital structure to reduce the adverse selection problem in the sale of securities.

– Firms can signal quality through the offering of guarantees; this reduces the adverse selection problem in the sale of products/services.

State Intervention as Solution

Traditional solutions:– Moneylenders, friends, neighbors, relatives, local traders.

Problem: insufficient fundsThe state can provide subsidies to reduce interest rates.State intervention often politicizes the process.When interest rates are not allowed to reflect costs of financial intermediation, wealth and political power replace profitability as the basis for allocating credit.

IRDP Program in India

Improper incentives for the financing organization.According to a 1989 study, IRDP Repayment rates fell below 60 percent and just 11 percent of borrowers took out a second loan after the first.In 2000, the loan recovery rate fell to 31 percent!Subsidizing banks can make banks flabby by creating banks and removing market tests.

Problems with State Intervention

Subsidized banks drove out informal credit suppliers.Market interest rates are not available as a rationing mechanism.Bankers’ incentives to collect savings deposits from the area are diminished by the flow of government capital – poor people had no way to save.State banks were pressured to forgive loans before elections, to give loans to the politically powerful, no incentives to create efficient organizations.

Microcredit to Microfinance

Microcredit originally meant a focus on getting loans to the very poor.The focus was on poverty reduction and social change.The push to microfinance came with the recognition that households can benefit from access to financial services more broadly defined (e.g. savings and insurance) and not just credit for microenterprises.

Borrowing and Saving

Why microfinance can not simply be about microcredit:Households borrow and save simultaneously.Borrowing and Saving are complementary activities.– The ability to borrow in a pinch can be critical in keeping

saving strategies from becoming derailed.– In theory the poor can save over a period and time and use it

for microenterprises.– In practice, household and community demands often use up

saved funds; also, individuals have weak internal self-control mechanisms.

Differential Marginal Returns to Capital

Capital

Output

Marginal return for richer entrepreneur

Marginal return for poorer entrepreneur

Capital

Output Marginal return

for poorer entrepreneur

Marginal return for richer entrepreneur

There may be yet another reason for the perverse flow of capital from poor to rich countries. The production function may not be concave everywhere.

Usury?

If marginal returns to capital are high, then the poor should be able to pay higher rates of interest.However, capital may be complementary with other inputs such as business savvy, commercial contacts, education levels etc.Hence the marginal return to capital may be lower for poorer entrepreneurs.Alternatively, returns to capital may be concave over some ranges and convex over others. Thus at a certain stage, the tailor might be able to expand by buying machines that allow him to tap into more profitable markets for more sophisticated and complicated clothing.In this case, high interest rates might freeze out some entrepreneurs.

Are subsidies necessary?

Some microfinance organizations have stayed at the NGO level and have depended on subsidies.Others, like Banco Compartamos have made large bond issues and even a public stock offering.IFMR has been an innovator in procuring market financing for microfinance, in India.It is possible that more traditional NGOs cater to a different and poorer clientele than larger profit-minded microfinance enterprises.

Issues for discussion

Joint Liability GroupsDynamic IncentivesLooser definitions of collateralThe role of genderSocial Impacts of microfinance