Topic 4: Microfinance and Digital money
29/10 and 5/11
Introduction
Because of transactions costs (screening, monitoring and enforcement) credit markets are
imperfect, and these imperfections are more severe in developing countries.
The standard solution, in the absence of non-monetary punishments, is to use collateral but
there are two problems:
1. A large fraction of the population in developing countries is poor & do not own any assets
to provide collaterals - poverty trap. Policy implications that could be a solution: credit
subsidy was misused and redistribution is not politically feasible.
2. Even those who own assets, do not necessarily have formal titles, and also foreclosing on
collateral is costly because of inefficient judicial system. Policy implications that could be a
solution: titling, rewriting bankruptcy codes, legal reform, but this wasn’t widespread and
the gains were marginal.
The evidence on subsidized lending is not very encouraging. It was provided by public sector
banks and there were really low repayment rates: 30% in Pakistan, 41% in India (IRDP), 51%
in Bangladesh.
The evidence on titling is mixed, it had large effects on credit supply (see Feder and Feeny,
World Bank Economic Review 1991 for land titling programme in Thailand) while Fields and
Torrero (2005) found moderate effects in urban housing titles in Peru Asset redistribution,
titling involves significant political and administrative costs. The easier way out became to
convert “social capital” that existed in social networks in close-knit societies into “invisible”
collateral.
Social capital
In rural societies, members of a community know more about one another than an outside
institution such as a bank. While a bank cannot apply financial or non-financial sanctions
against poor people who default on a loan, their neighbours may be able to impose
powerful non-financial sanctions at low cost.
An institution that gives poor people the proper incentives to use information on their
neighbours & to apply non-financial sanctions to delinquent borrowers can out-perform a
conventional bank. They can achieve goals of both efficiency & equity (conventional lending
programs being merely redistributive)
Microfinance
The Grameen Bank of Bangladesh lends to about two million people, most of whom are
rural, landless women, operates in 36,000 villages, or about half of all villages in the country.
Worldwide, 13 ml clients were served in 2000 with other major MF organizations being
FINCA, BANCOSOL, BRI, BKD, ACCION, and BRAC. These are situated mainly in Latin America
and Africa.
Most of these loans are small loans for self-employment projects mainly woman based or
with loads of women participants (e.g., poultry, paddy husking, handloom weaving, grocery
or tea shops, dairy farming).
, The difference from standard banking is that no collateral is charged, interest rates are high
but they are lower than those charged by moneylenders – from 40% to around 22%.
Borrowers organize themselves into self-selected groups of five people from the same
village then loans are given for individual projects, but the group is jointly liable for each
other’s loans - if any member of a group defaults, all members are ineligible for credit in the
future this is called joint liability. At the group formation stage what is likely to happen is
that trustworthy people and the most likely to succeed will be able to find people who to
create groups with.
This approach stands out compared to conventional lending approaches in terms of
reaching target groups - compared to bank credit subsidized loans - and loan repayment –
all microfinance banks have less than 5% default rates.
Joint liability induces: peer monitoring, peer pressure and peer selection which all reduces
loan costs.
Theory (solving adverse selection)
All parties (borrowers and lender) are risk-neutral. Borrowers need capital to start a project,
but have no money. The bank can only collect the money owed when output is high (limited
liability) therefore the project returns of borrowers have to be uncorrelated. It is important
for all the individuals in the group to have different business/projects.
Focusing on groups of size 2. A standard (individual) debt contract: If you are able to repay,
pay r. A joint liability contract: If you are able to repay, pay r for yourself AND in addition c if
your partner fails or only r if your partner succeeds
In the population there are 2 types of borrowers, safe & risky. Safe borrowers’ projects are
more likely to succeed. Output can be high or low (0) with some probabilities. Bank/lender
can’t tell who is who, but borrowers know each other’s types this is due to strong social
links. So all good borrowers will form groups with each other and the bad borrowers will be
left aside, as no one wants to take the risk of having to repay someone else’s loan.
Joint Liability: Ask borrowers to select their own partner. The expected payoff of each
borrower has two components – expected payoff when borrower does not have to pay for
partner and expected payoff when borrowers payoff have to be covered. Naturally,
everyone would like to have a safe borrower as a partner. If someone fails, they don’t care
what their partner’s type is, but if they succeed, there is positive expected gain from having
a safe partner. This is true for both safe and risky borrowers. Safe borrowers value safe
partners more than risky borrowers do. Given that they have risky partners, risky borrowers
dislike joint liability more than safe borrowers.
By offering two contracts one individual liability & the other joint liability, safe borrowers
will select the latter & risky ones the former so repayment rates will improve, & welfare will
go up.
Solving moral hazard
Moral Hazard in a standard debt contract can be reduced due to the monitoring of social
links. It’s in a group members interest to put in more effort, if the other members of the
group put in more effort (like in a public good game) the borrowers will choose endowment
so as to maximize his private payoffs. So the harder you work the more your project will
succeed, people want to work hard as they believe people will also be putting a high amount
29/10 and 5/11
Introduction
Because of transactions costs (screening, monitoring and enforcement) credit markets are
imperfect, and these imperfections are more severe in developing countries.
The standard solution, in the absence of non-monetary punishments, is to use collateral but
there are two problems:
1. A large fraction of the population in developing countries is poor & do not own any assets
to provide collaterals - poverty trap. Policy implications that could be a solution: credit
subsidy was misused and redistribution is not politically feasible.
2. Even those who own assets, do not necessarily have formal titles, and also foreclosing on
collateral is costly because of inefficient judicial system. Policy implications that could be a
solution: titling, rewriting bankruptcy codes, legal reform, but this wasn’t widespread and
the gains were marginal.
The evidence on subsidized lending is not very encouraging. It was provided by public sector
banks and there were really low repayment rates: 30% in Pakistan, 41% in India (IRDP), 51%
in Bangladesh.
The evidence on titling is mixed, it had large effects on credit supply (see Feder and Feeny,
World Bank Economic Review 1991 for land titling programme in Thailand) while Fields and
Torrero (2005) found moderate effects in urban housing titles in Peru Asset redistribution,
titling involves significant political and administrative costs. The easier way out became to
convert “social capital” that existed in social networks in close-knit societies into “invisible”
collateral.
Social capital
In rural societies, members of a community know more about one another than an outside
institution such as a bank. While a bank cannot apply financial or non-financial sanctions
against poor people who default on a loan, their neighbours may be able to impose
powerful non-financial sanctions at low cost.
An institution that gives poor people the proper incentives to use information on their
neighbours & to apply non-financial sanctions to delinquent borrowers can out-perform a
conventional bank. They can achieve goals of both efficiency & equity (conventional lending
programs being merely redistributive)
Microfinance
The Grameen Bank of Bangladesh lends to about two million people, most of whom are
rural, landless women, operates in 36,000 villages, or about half of all villages in the country.
Worldwide, 13 ml clients were served in 2000 with other major MF organizations being
FINCA, BANCOSOL, BRI, BKD, ACCION, and BRAC. These are situated mainly in Latin America
and Africa.
Most of these loans are small loans for self-employment projects mainly woman based or
with loads of women participants (e.g., poultry, paddy husking, handloom weaving, grocery
or tea shops, dairy farming).
, The difference from standard banking is that no collateral is charged, interest rates are high
but they are lower than those charged by moneylenders – from 40% to around 22%.
Borrowers organize themselves into self-selected groups of five people from the same
village then loans are given for individual projects, but the group is jointly liable for each
other’s loans - if any member of a group defaults, all members are ineligible for credit in the
future this is called joint liability. At the group formation stage what is likely to happen is
that trustworthy people and the most likely to succeed will be able to find people who to
create groups with.
This approach stands out compared to conventional lending approaches in terms of
reaching target groups - compared to bank credit subsidized loans - and loan repayment –
all microfinance banks have less than 5% default rates.
Joint liability induces: peer monitoring, peer pressure and peer selection which all reduces
loan costs.
Theory (solving adverse selection)
All parties (borrowers and lender) are risk-neutral. Borrowers need capital to start a project,
but have no money. The bank can only collect the money owed when output is high (limited
liability) therefore the project returns of borrowers have to be uncorrelated. It is important
for all the individuals in the group to have different business/projects.
Focusing on groups of size 2. A standard (individual) debt contract: If you are able to repay,
pay r. A joint liability contract: If you are able to repay, pay r for yourself AND in addition c if
your partner fails or only r if your partner succeeds
In the population there are 2 types of borrowers, safe & risky. Safe borrowers’ projects are
more likely to succeed. Output can be high or low (0) with some probabilities. Bank/lender
can’t tell who is who, but borrowers know each other’s types this is due to strong social
links. So all good borrowers will form groups with each other and the bad borrowers will be
left aside, as no one wants to take the risk of having to repay someone else’s loan.
Joint Liability: Ask borrowers to select their own partner. The expected payoff of each
borrower has two components – expected payoff when borrower does not have to pay for
partner and expected payoff when borrowers payoff have to be covered. Naturally,
everyone would like to have a safe borrower as a partner. If someone fails, they don’t care
what their partner’s type is, but if they succeed, there is positive expected gain from having
a safe partner. This is true for both safe and risky borrowers. Safe borrowers value safe
partners more than risky borrowers do. Given that they have risky partners, risky borrowers
dislike joint liability more than safe borrowers.
By offering two contracts one individual liability & the other joint liability, safe borrowers
will select the latter & risky ones the former so repayment rates will improve, & welfare will
go up.
Solving moral hazard
Moral Hazard in a standard debt contract can be reduced due to the monitoring of social
links. It’s in a group members interest to put in more effort, if the other members of the
group put in more effort (like in a public good game) the borrowers will choose endowment
so as to maximize his private payoffs. So the harder you work the more your project will
succeed, people want to work hard as they believe people will also be putting a high amount
