Financial Services for the Poor: Addressing the Generic Lender Problem

University of New England

Week 8

LO.1 LO.2 LO.3 LO.4 LO.5 LO.6 LO.7 LO.8 LO.9 LO.10 LO.11 Financial Services for the Poor Week 8 Prescribed Reading: de Janvry and Sadoulet, ch. 13 ECON390/590 Economics of Developmentune

University of New England Learning Objectives

Week 8

1. The generic lender problem
2. Commercial banks
3. Local moneylenders
4. Local sources of credit based on interlinkages in value chains
5. Informal institutions
6. Village banks and self-help groups
7. The microfinance revolution: group lending
8. Microfinance lending
9. Increasing savings: offering saving opportunities and incentives
10. Can the poor be insured? The promise of index-based weather insurance
11. How useful are MFIs for poverty reduction?une

University of New England The Generic Lender Problem

Week 8

LO.1 LO.2 LO.3 LO.4 LO.5 LO.6 LO.Z LO.8 LO.9 LO.10 LO.11 Financial transactions are complex because they involve a delay between the two sides of the transaction. Asymmetric information: Adverse selection (AS) and moral hazard (MH) AS corresponds to hidden information of a person or product that gives room for opportunism. Consequently, in a market with products of uncertain quality, bad products will be driving out good products until the market eventually disappears => ex-ante, e.g. health insurance. MH corresponds to asymmetrical information allowing opportunism under the form of hidden actions. Consequently, it creates market failures by reducing transactional opportunities, and the market eventually disappears => ex-post, e.g. car insurance.une

University of New England The Generic Lender Problem (cont.)

Week 8

LO.1 LO.2 LO.3 LO.4 LO.5 LO.6 LO.7 LO.8 LO.9 LO.10 LO.11 Why do financial markets fail for the poor? A lender must overcome the following problems:

1. Selection problem: Avoid AS of borrower
2. Monitoring problem: Avoid MH in project implementation
3. Insurance problem: Provide insurance and avoid MH in insurance claims
4. Enforcement problem: Avoid MH in loan repayment

Events Potential borrower applies Loan made Borrower invests: failure/success Risk: unexpected shocks Project outcome: failure/success Time to repay the loan Loan repayment: willing/unwilling Timeline Four problems to be solved by lender for success Selection: Avoid AS of borrower Monitoring: Avoid MH in project implementation Insurance: Avoid MH in insurance claims Enforcement: Avoid MH in loan repayment A formal lender can overcome the selection, monitoring, and enforcement problems by demanding collateral from the borrower.une

University of New England Commercial Banks

Commercial banks often only grant loans to borrowers with collateral, creating a market failure as credit is provided in a wealth-constrained market. This has two costs:

1. An efficiency cost: The allocation of credit is unrelated to the marginal productivity of capital. This can be solved by allowing the borrower to self-insure or access other sources of insurance to take a loan.
2. An equity cost: The poor with no collateral are excluded, creating sharp inequalities across potential borrowers. Exclusion of the poor contributes to reproducing poverty => Poverty is inherited from one generation to the next. The lack of collateral has excluded most of the poor from the commercial banking sector. This is problematic if entrepreneurship is a pathway out of poverty.

Week 8

LO.1 LO.2 LO.3 LO.4 LO.5 LO.6 LO.Z LO.8 LO.9 LO.10 LO.11the

University of New England Local Moneylenders

Week 8

LO.1 LO.2 LO.3 LO.4 LO.5 LO.6 LO.Z LO.8 LO.9 LO.10 LO.11 The comparative advantage of moneylenders: Moneylenders have information about potential borrowers. Moneylenders have social capital to ostracise someone who does not repay. Moneylenders can take various forms of collateral. Moneylenders play repeated games with a clientele. However, moneylenders often charge high interest rates, limiting their effectiveness to cope with unexpected or covariate shocks.une

University of New England Local Credit Sources Based on Interlinkages in Value Chains

Week 8

LO.1 LO.2 LO.3 LO.4 LO.5 LO.6 LO.Z LO.8 LO.9 LO.10 LO.11 The theory of interlinked transactions: When there are market failures, interlinkages between two transactions often allow each transaction to perform better than it would alone. Interlinkages can solve the AS, MH and insurance problems. A local merchant gives credit to a farmer and will buy his products at harvest time under favourable conditions. A local landlord gives credit to a worker and also regularly rents land to him when there is a lot of competition among potential tenants to get access to land. A local moneylender gives credit and also provides insurance to his client when hit by a shock with no other insurance option for the client. The other transaction serves as collateral for the credit transaction. However, it can lead to exploitation. This is a.k.a. supply chain finance.une

University of New England Informal Institutions: ROSCAS

Week 8

LO.1 LO.2 LO.3 LO.4 LO.5 LO.6 LO.Z LO.8 LO.9 LO.10 LO.11 Rotating savings and credit associations (ROSCAs) are useful for planned expenditures. They promote savings and to gain access to lump sums of cash (often goes to the highest bidder in terms of interest rate). A group of people who trust each other form a ROSCA. It has N member, each contributing an equal deposit d on a regular basis. One member then takes home the lump sum Nd at one meeting. Different ROSCAs have different rules of attributions. ROSCAS members are self-select and tied by some form of social capital. ROSCAs are popular among women, who participate as a strategy to protect their savings against claims by their husband for immediate consumption. However, ROSCAs are rigid in the timing and the amount of momey, making them ineffective for insurance.the

University of New England Village Banks and Self-Help Groups

A village bank has 200-400 members. It mobilises savings from members and receives loans and grants from outsiders. This equity is then lent to members in the form of individual or group loans. Loans are relatively safe due to proximity lending, overcoming AS and MH based on local information and social capital. However, the members may not have sufficient capacity to self manage. A self-help group is usually composed on 10-20 local women. Members make small regular savings contributions over a few months until there is enough capital accumulated in the group's bank account to begin lending. The group can use its equity to access commercial bank loans. This has emerged as one of the world's largest microfinance networks.

Week 8

LO.1 LO.2 LO.3 LO.4 LO.5 LO.6 LO.Z LO.8 LO.9 LO.10 LO.11une

University of New England The Microfinance Revolution: Group Lending

Week 8

LO.1 LO.2 LO.3 LO.4 LO.5 LO.6 LO.Z LO.8 LO.9 LO.10 LO.11 The microfinance revolution consists of replacing the use of assets as collateral, which the poor do not have, by social collateral, which the poor can provide. How does group lending help solve the lender problem: Self-selection by group members solves AS by providing social capital as the collateral. A smaller group overcomes MH as group members monitor each other. A large heterogeneous group can be an insurance mechanism against covariate risks. However, the interest rates remain excessively high, and the whole group could default.the

University of New England The Microfinance Revolution: Group Lending (cont.)

Week 8

LO.1 LO.2 LO.3 LO.4 LO.5 LO.6 LO.Z LO.8 LO.9 LO.10 LO.11 Group lending is the core innovation in microfinance lending:

• joint liability
• self-selection
• frequent instalments
• dynamic incentives

These designed features induces the following behavioural responses:

• assortative matching
• peer monitoring
• mutual insurance
• social capital and interlinkages

The overall effectiveness of microfinance on development remains inconclusive.ine

University of New England Issues in Microfinance Lending

Week 8

LO.1 LO.2 LO.3 LO.4 LO.5 LO.6 LO.Z LO.8 LO.9 LO.10 LO.11 Charity versus business Access to financial markets for sustainability Internet-based microlenders Information sharing through credit bureaus under rising competition Mission driftune

University of New England Increasing Savings

Week 8

LO.1 LO.2 LO.3 LO.4 LO.5 LO.6 LO.Z LO.8 LO.9 LO.10 LO.11 To accumulate savings, the poor need options to increase savings and options to restrict dis-saving Offering options to induce savings Offering options to restrict dis-saving Trade-offs between inducing savings and restricting dis-savingune

University of New England The Cost of Exposure to Uninsured Risks

Week 8

LO.1 LO.2 LO.3 LO.4 LO.5 LO.6 LO.Z LO.8 LO.9 LO.10 LO.11 Lack of access to insurance reduces the ability of the poor to take on risks that would be rewarded by higher expected incomes. Risk exposure requires the poor to engage in costly behaviour of two types:

1. Risk management strategies
2. Risk coping strategies

Lack of insurance acts as a major constraint on the development of financial markets. Traditional forms of insurance, which indemnify the insured based on verifiable individual losses have largely failed the poor because of AS and MH.une

University of New England Index-Based Weather Insurance

Week 8

LO.1 LO.2 LO.3 LO.4 LO.5 LO.6 LO.Z LO.8 LO.9 LO.10 LO.11 Under an index-based insurance scheme, insurance contacts are issued to farmers for a premium, and indemnity payments are determined by the level of the single selected index. It overcomes AS and MH (premium and indemnity payments are unrelated to behaviour of the insured) and costly assessment of individual assessment that have made traditional insurance markets fail for small farmers. The index-based insurance scheme is imperfect because:

1. Not all farmers are affected equally by local weather events.
2. The link between weather and yield is complex.
3. Only one single trigger is included in the scheme.

Nevertheless, the scheme achieves more effective shock coping and less costly risk management, resulting in more growth and less poverty.