P.V. Viswanath
What is microfinance?
Is it the granting of small loans?
If so, what’s different about small loans?
Do we have different theories of capital structure according to
firm size? No.
Do we have different theories of payout according to firm size?
Size can be a factor in a firm’s dividend payout and size can
be a factor in a firm’s capital structure, but usually it is a proxy
for other underlying factors, sometimes less known, sometimes
less known.
But we do not have a different treatment of a firm’s financial
decisions according to firm size.
So why microfinance – if, indeed, it is the making of small
Microfinance as a small loan business
Loans are small
Lending is risky – clients have very little collateral
Very costly to ensure that loans are used for the
purpose for which they have been lent.
Too costly to evaluate loan applications
Too costly to administer
Too costly to disburse
Too costly to collect repayments
What can we do?
What is special about loans?
Why do borrowers need loans?
 Smooth
out consumption
 Investment in small business
 Deal with unexpected emergencies, e.g. health, tuition
payments, burial fees.
 Anything else?
How might you (the mf borrower) deal with such
contingencies if there are no microfinance
Indigenous Solutions and Intervention
Indigenous Solutions
Ask (extended) family members
 Save ahead of time so as to have enough money when
funds are needed
 Go to money-lender
Externalities or why we might need microfinance
Insufficiency of local capital
 Scale problems – cost of capital is too high because of small
scale of local operations
 Inability to save because of low and volatile incomes
 Behavioral and social issues
Diminishing Returns to Capital
Capital should flow to the poor
Diminishing Marginal Returns to Capital implies:
 Enterprises
with little capital should earn higher returns
to their investments than enterprises with a lot of capital.
 Poorer enterprises should be able to pay banks higher
interest rates than richer enterprises.
 Hence capital should flow from rich depositors to poor
 Capital should flow from rich countries to poor countries.
 Capital should flow rich to poor borrowers within a given
Why resources don’t flow to poorer
countries: One answer
 Investing
in India, Kenya or Bolivia is much riskier,
especially for global investors without the time and
resources to keep up-to-date on shifting local conditions
 Lending to cobblers and flower-sellers is, again, riskier
for the same reasons that lending to large, regulated
 But why can’t cobblers and flower-sellers offer higher
risk-adjusted rates of return to lenders?
Why resources don’t flow to poorer
countries: Another answer
Perhaps poor borrowers can pay high interest rates,
but government-imposed interest rate restrictions
prevent banks from charging the interest rates
required to draw capital from developed to
developing countries and from cities to villages.
If so, then the answer is political. Advocates should
convince governments to remove usury laws and
other restrictions on banks, thus allowing capital to
flow where it is needed.
However, usury laws have their supporters (Who?)
Is there capital rationing?
Paula and Townsend (2004) surveyed 2880 rural and
semi-urban households in central and northeastern
One-third of the households in their survey stated that
they would like to change occupations. Of these, most
would like to open a business. Many of these
households report that they don’t start a business
because of non-availability of funds.
54% of entrepreneurial families want to expand their
business; but most of them report that they don’t have
enough money to do this.
Is there capital rationing?
The average annual income of business owners in the sample
is three times higher than that of non-business owners.
What can we infer from this? Can we infer that starting a
business increases family income? Perhaps..
Or, perhaps, the more entrepreneurial families have
already started businesses and the higher income is due to
their greater entrepreneurial ability.
Paula and Townsend do find that, even after accounting for
entrepreneurial ability (using several measures of talent),
poorer households are less likely to start new businesses.
This suggests that credit rationing is an impediment to higher
Causes of Capital Rationing
Adverse Selection
 Lenders
do not have enough information to be able to
easily determine which customers are likely to be more
risky than others.
 Banks would like to charge riskier customers more than
safer customers to compensate for the higher
probability of default.
 But they don’t have this information.
 Hence they have to charge higher rates for everybody.
 This drives safer customers out of the credit market.
Causes of Capital Rationing
Moral Hazard:
 Banks
are unable to ensure that customers are making
the full effort required for their investment projects to
be successful.
 Sometimes borrowers abscond with the bank’s money;
banks are not able to monitor such possibilities cheaply.
 Judicial systems in developing countries are often weak,
thus making it difficult for lenders to retrieve their funds.
Would interest rates be too high?
The reasons given above mean that break-even
interest rates can be high.
But if the principle of diminishing marginal returns
holds, this may not be a big problem.
On the other hand, this principle might not hold
because production functions might include scale
Hence, poorer entrepreneurs operating at smaller
scales might have lower returns to scale compared
to richer entrepreneurs operating at larger scales.
Production functions with scale economies
Are subsidized loans the answer?
The reasons discussed above means that some
deserving borrowers will not obtain loans. Could
this be resolved through subsidized loans?
Often, subsidized loans do not work for two
One, subsidized banks push out informal credit
Two, once market rates are not used, the rationing
mechanism used by the pricing system is no longer
Are subsidized loans the answer?
Credit is no longer allocated to the most productive
recipients, but rather on the basis of political or social
Good projects, thus, still continue to go unfunded.
Bankers’ incentives to collect savings deposits were
diminished by the flow of capital from the government,
which subsidized the loans. Hence poor households did
not have convenient access to banking services, either.
State banks were pressured to forgive loans just before
elections and to provide the powerful, rather than the
poor, with access to cheap funds.
Banks had no incentive to build tight, efficient institutions.
Are moneylenders monopolists?
It has been argued that moneylenders have local monopolies
because they have access to information about local conditions
as well as the creditworthiness of local borrowers. Hence
potential competitors cannot break into local markets.
Since monopolists will lend, as long as the return on the
marginal loan is greater than the marginal cost, they will earn
positive profits on infra-marginal loans.
In competitive markets, average profits will be zero. Hence
interest rates will be lower and more borrowers will get loans.
Monopoly is, thus, inefficient.
Furthermore, it has been argued that moneylenders prevent
the use of innovative technologies that would reduce the
demand for moneylenders’ services.
Competition as a rationale for intervention
Why don’t moneylenders have more competition?
Are initial investment needs too high/too risky? Or is there
no better alternative to money-lending?
If moneylending is characterized by monopolistic
competition, banks might be able to operate more
efficiently by operating on a larger scale and using better
lending technologies.
This could bring more financial resources into local markets,
thus pushing down interest rates and increasing efficiency.
Expanding the reach of the market for loans might also
reduce discrimination on the basis of race, gender, ethnicity,
social class and religion.
Is microfinance simply microcredit?
As we mentioned before, one of the reasons that
people borrow is that, at times, because of cashflow
volatility, their cashflows are insufficient for their
needs at that time.
Borrowing means a large inflow at the time of
need, followed by periodic outflows that represent
However, there are two other potential solutions to
this problem.
Microfinance as access to banking
One solution proceeds as follows:
Whereas in borrowing, the inflow precedes the
outflows, what if the outflows precede the inflows?
This is saving. In saving, the individual sets aside small
amounts of money to create a pool of money that can
be used when needed.
With borrowing, there are moral hazard and adverse
selection costs; with saving, these costs are avoided
because the individual is lending to him/herself.
Transactions costs are also avoided.
Microfinance as Microinsurance
The second potential solution is to reduce the
volatility of cashflows.
This can be done through insurance. For farmers,
crop insurance could be used to smooth out inflows.
Shepherds/cowherds could have their animals
Health insurance could be used to smooth out
unexpected cash outflow requirements.
The rest of the course
In this course, we will talk about the adverse selection and
moral hazard problems and see how group lending may
provide a solution.
We will talk about the inadequacy of group lending by
itself and talk about other techniques that have been
adopted by mfis.
We will talk about whether mf is effective – in reducing
poverty, in empowering women and in achieving other social
We will talk about how mfis source funds.
We will look at mf from the viewpoint of the investor.
We will look at new developments in microfinance.
And WE means YOU because you will be doing the work!

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