INTRODUCTION TO MICROFINANCE 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? No. 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 loans.. 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 Solutions 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 institutions? 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 Output Diminishing Returns to Capital 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 entrepreneurs. Capital should flow from rich countries to poor countries. Capital should flow rich to poor borrowers within a given country. Why resources don’t flow to poorer countries: One answer Risk: 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 corporations. 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 Thailand. 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 incomes. 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 economies. Hence, poorer entrepreneurs operating at smaller scales might have lower returns to scale compared to richer entrepreneurs operating at larger scales. Output Production functions with scale economies Capital 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 reasons. One, subsidized banks push out informal credit suppliers. Two, once market rates are not used, the rationing mechanism used by the pricing system is no longer available. Are subsidized loans the answer? Credit is no longer allocated to the most productive recipients, but rather on the basis of political or social concerns. 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 repayment. 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 insured. 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 goals. 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!