Microfinance: Rethinking Banking
FIN 680V/ FIN 360
Spring 2012
P.V. Viswanath
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, India
Bolivia, Mexico
Indonesia
Bosnia
Inner-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
Output
Marginal return for poorer
entrepreneur
Capital
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 collateral
Weak 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.
Incentive Problems
Adverse 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.
P.V. Viswanath
9
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.
P.V. Viswanath
10
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
P.V. Viswanath
11
Financial System Solutions
Moral 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.
P.V. Viswanath
12
State Intervention as Solution
Traditional solutions:
– Moneylenders, friends, neighbors, relatives, local traders.
Problem: insufficient funds
The 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 selfcontrol mechanisms.
Differential Marginal Returns to Capital
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.
Marginal return
for richer
entrepreneur
O
u
t
p
u
t
Marginal return
for poorer
entrepreneur
Capital
O
u
t
p
u
t
Marginal
return for
richer
entrepreneur
Marginal return
for poorer
entrepreneur
Capital
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 profitminded microfinance enterprises.
Issues for discussion
Joint Liability Groups
Dynamic Incentives
Looser definitions of collateral
The role of gender
Social Impacts of microfinance