Credit

Let's solve a numerical example using the model above. Suppose that D=1.1, c=.1, h=.2 and w=3. Where D is the deposit rate or cost of capital, c is the fixed fee, h is the escape cost, and w is wealth. What is the gap between the deposit rate and gross interest rate? (Please round to the nearest 0.01. In other words, your answer should be of the format x.xx)

0.18.

Let's solve a numerical example using the model above. Suppose that D=1.1, c=.1, h=.2 and w=3. What is R? (Round to the nearest 0.01. In other words, your answer should be of the format x.xx)

1.28.

What could be a source of conflict between the social role of microcredit and its commercial side? Check all that apply. a) A commercial organization will want to set the highest interest rate the market can bear in order to make a profit, rather than keep interest rates low and break even b) If the aim of microfinance becomes profitability rather than improving access to financial mechanisms, then organizations will stop lending to the poorest populations c) They will have a more difficult time gaining the trust of the people if they approach microcredit from a commercial standpoint d) There will be no source of conflict between the social role and its commercial side

A and B are correct. A and B are reasonable concerns regarding whether microfinance becomes commercialized and focuses too heavily on for-profit gain instead of maintaining its original mission to provide affordable loans to the poor. The existence of the concerns present in A and B proves that D is wrong. C might be correct, however, there is no evidence from the lectures that it would be more difficult to gain trust when one takes a more commercial-centered approach.

What were some of the problems faced in the Spandana evaluation discussed in the lecture? (Check all that apply.) a) Loan officers entered control areas and offered loans b) The treatment group was only 8 percent more likely to have a loan than the control group c) The sample size was too small

A and B are correct. A and B were both significant problems faced by the study. Although Spandana agreed that they would not enter the control group areas, many of their loan officers did enter control areas because they looked like nice neighborhoods for lending. The study did not make any agreements with other microfinance institutions, and thus they were free to enter the control group and give out loans. Therefore, in order to determine the effect of the Spandana loan, they could not just find the difference in outcomes between the treatment and control groups since those within the control groups may have also received a loan. Instead, the researchers had to analyze the "intention to treat". For more on "intention to treat" and "treatment on the treated," see the ITT/TOT video lesson.

What is an advantage of lending to groups rather than lending to individual borrowers? (Check all that apply.) a) Lending to groups reduces administrative costs for lenders b) Lending to groups reduces the cost of enforcement for lenders c) Lending to groups increases interest rates, and therefore microfinance organizations profit more

A and B are correct. Group lending can reduce administrative costs for lenders: loan officers have to make fewer appointments for collecting loans, and one group member can pay for another if he or she cannot make the repayment appointment. Moreover, group lending lowers the cost of enforcement for the lender, since all group members are liable if one group member defaults on his or her loan. Since the cost of enforcement and administrative costs decrease, this effectively lowers the interest rate that the microfinance needs to charge in order to recoup their loses. Therefore, A and B are correct, while C is incorrect.

In the Spandana evaluation, what did most respondents say was their primary reason for wanting to take out a loan? (Check all that apply.) a) To repay an old loan b) To start a new business c) To pay for their children's education

A and B are correct. In the study, many respondents said they wanted a loan to repay their old loans or start a new business. (A third common reason, not discussed in lecture, was to pay for captial investments for an existing business. Thus, this shows that those in the Spandana study mostly used microfinance to support their business. C is incorrect since respondents rarely mentioned paying for their children's education as their primary reason for wanting to take out a loan. You can read more about the Spandana evaluation here.

The authors of the assigned readings Microcredit is Not the Enemy (Financial Times) and Sacrificing Microcredit for Megaprofits (New York Times) offer differing opinions on several points related to microcredit. On which of the following points do the authors seem to disagree with one another? (Check all that apply.) a) Whether large mark-ups are required for commercialized microfinance institutions to ensure profitability b) Whether microfinance plays an important role in providing financial services to poor people who lack access to formal banking c) Whether microfinance institutions should increase collateral requirements in order to reduce interest rates d) Whether the recent increase in microfinance loan default is primarily the result of legislation in the state of Andhra Pradesh that implicitly encouraged borrowers to default on loans

A and D are correct. Regarding A, the authors of the Financial Times article argue that microfinance profits, at least in South Asia, "come mainly from large volumes rather than large mark-ups." In contrast, the author of the New York Times article claims that, in order to ensure profitability, microfinance institutions "needed to raise interest rates and engage in aggressive marketing and loan collection." D is correct since the authors of the Financial Times article argue that the legislation is to blame for increased default, while the author of the New York Times article claims that default increased after borrowers became convinced that lenders were taking advantage of them. B is incorrect since neither article suggests that microfinance does not play an important role in providing financial services to the poor. C is incorrect since increasing collateral requirements is not proposed in either article.

Why do microfinance organizations specifically target loans to women? Check all that apply. a) They believe women are more reliable at paying back loans b) They believe women are less likely to work as migrant workers or in the city, and therefore are better at showing up to meetings c) They believe women are easier to scare into repaying back their loans d) They believe women will use the loan for purposes that will benefit their families more

A, B, and D are correct. Microfinance organizations often lend to women because they believe that women are intrinsically better at paying back loans, are less likely to be mobile, and more likely to use the money to benefit their families. In the lecture series titled "What drives fertility decisions" under the topic of Family, we discussed the study by Prof. Duflo that showed that in South Africa, when the grandmother received the pension instead of the grandfather, the grandchildren were more likely to benefit. Thus, there seems to be credibility to the last argument. Whether or not women are "intrinsically" better at paying back loans is debatable, yet it is an argument used by microfinance institutions, which tend to provide loans only to women. While in many of the countries in which microfinance organizations work are dominated by patriarchal societies in which women have less power and therefore may be easier to scare, this is not an answer that we discussed in the lecture or that is used by microfinance organizations. Thus, it is incorrect. Based on these three key assumptions, microfinance institutions tend to target their loans to women. Note: You can read more about the study by Prof. Duflo regarding pensions in South Africa here.

Which of the following were findings of the Spandana evaluation? Check all that apply. a) Significant increase in new businesses b) Significant increase in consumption c) Purchase of more durable goods d) Purchase of more general business goods

A, C, and D are correct. While the results show a significant increase in the number of new businesses, it does not show an increase in profits or revenues. While overall consumption did not change, what people were consuming did change. There was an increase in the purchase of durable goods and general businesses goods, while the purchase of temptation goods decreased. The evaluation also found that there was no effect on women's empowerment in the household. This shows that the gender effect that microfinance institutions insist upon, which is that by giving money to women it will increase their intrahousehold bargaining power, did not hold. Also, the outcome that children were not healthier suggests that women were unable to invest the extra money into the family or into the wellbeing of their children.

In the lecture slides, we derived the following expression while building a model of lending to the poor: Which of the following facts can be explained by this model? Recall that h= escape cost, w = wealth, D=cost of capital,c=fixed cost, and R= gross interest rate. (Check all that apply.) a) Default rates are low b) Interest rates vary within a community based on individuals' wealth c) Lenders are not willing to lend if the fixed monitoring cost is too high d) Interest rates on loans are higher than interest rates on deposits

All answers are correct. A-D can all be explained by the model. The default rate is 0 in the model because there is no uncertainty; the lender chooses the loan amount such that there will be no default (i.e. escape). From the expression, we can see that interest rates will be lower for individuals with more wealth so the answer to B is "Yes." C is "Yes" since, for instance, if hw is less than c (the fixed cost of monitoring) the lender prefers not to lend at all (the fixed monitoring cost is too high relative to wealth). The fixed monitoring cost ensures that lending interest rates must be higher than deposit interest rates so that lenders can afford to pay this cost, since deposits do not have a monitoring cost.

For microcredit to be both beneficial and sustainable, what are ways that borrowers can use a microloan? Check all that apply. a) Refinancing old debt b) Smoothing consumption by borrowing against future income c) Investing in a profitable business

All answers are correct. Microcredit need not lift people out of poverty through entrepreneurship to be both beneficial and sustainable. If borrowers have another outstanding loan at a higher interest rate (say, from a moneylender), a microloan can help them pay down their old debt and save the money they would have paid on interest. Also, if borrowers know that they will earn more income in the future, they can use a loan to smooth their consumption. Therefore, all three of the answer choices are correct. A case in which microcredit could be harmful is if the borrower keeps taking out loans simply to pay back loans from other microcredit organizations for which the loans have the same interest rate. Unlike in the case for which the borrower uses microfinance to pay back another outstanding loan that has a higher interest rate, in this case, the borrower is likely to enter a cycle of debt in which he or she cannot escape.

Which of the following is a way that microfinance institutions (MFIs) are able to mitigate issues in credit markets in developing countries? Check all that apply. a) MFIs lend to groups b) MFIs typically offer a single, standardized loan product c) MFIs offer lower interest rates than most informal sources

All answers are correct. The high interest rates faced by the poor may be attributed in part to the large amount of monitoring that must be done by lenders to ensure that borrowers do not default on their loans. By lending to groups whose members are jointly responsible for one another, MFIs have been able to reduce the amount of monitoring they have to do. MFIs also typically offer a single loan product with a standardized repayment schedule. This lowers the administrative (fixed) costs of lending. Both group lending and a standardized product thus allow MFIs to offer poor people lower and less variable interest rates than they would otherwise face if they went to an informal source such as a moneylender. Therefore, all answer choices are correct.

Access to microcredit can help mitigate which of the following problems in the lives of the poor? (Check all that apply.) a) The poor are often unable to pay for years of schooling since the increased earnings associated with higher educational attainment are not available for many years b) Poor shopkeepers often have knowledge of profitable short-term investments (for instance, additional inventory), but are unable to make these investments because they do not have sufficient savings c) Given that the poor have low incomes and that prospects for higher-paying, stable jobs are limited, credit can allow borrowers to increase consumption in both the short term and the long term d) Lacking sufficient access to formal savings, the poor may use credit to finance the purchase of durable goods, with loans paid off using future income

B and D are correct. B and D are correct, since relaxing credit constraints allows households to make profitable investments in business assets B or to overcome lack of access to savings (or lack of commitment to saving) in order to purchase households goods D. A is incorrect, since microloans do not typically have a sufficiently long loan term to allow for education financing, and C is incorrect given that microloans cannot finance consumption indefinitely if income is not increasing.

Assuming zero borrowing from MFIs (microfinance institutions) at baseline, the graphs below suggest which of the following most likely occurred? (Check all that apply.) a) Only borrowers in slums where Spandana opened were able to borrow from Spandana b) Other MFIs chose to begin operations almost exclusively in Spandana slums during the period of the study c) Some Spandana borrowers in treatment areas would likely have borrowed from another MFI absent the intervention d) Borrowing from Spandana was more than three times greater in areas that Spandana entered than it was in areas that Spandana did not enter

C and D are correct. 5.3% of respondents in control slums borrowed from Spandana, so A is incorrect. 18.6% of control respondents borrowed from "Any MFI" (and only 5.3% borrowed from Spandana), suggesting that B is incorrect and that other MFIs expanded significantly into control areas as well. C is correct. The fact that the difference in Spandana borrowing is larger than the difference in "Any MFI loan" suggests that some treatment respondents borrowed from Spandana, but would have borrowed from another MFI if Spandana loans were not available. The graph on the left shows that Spandana borrowing was more than three times greater in treated areas, so D is also correct. You can read more about the Spandana study by Banerjee et al. here.

Which of the following are among the most commonly claimed problems associated with microfinance, according to its opponents? (Check all that apply) a) Loans are too small b) There is too much screening of potential loan recipients c) Interest rates are too high d) Overly aggressive lenders are responsible for a wave of borrower suicides

C and D are correct. Opponents of microfinance have focused on C and D. Microfinance skeptics have at times argued that lenders offer loans to borrowers who are unable to repay them and this could be remedied by increased screening (so B is incorrect). A is also incorrect since opponents of microfinance typically focus on concerns regarding excessive lending than about the actual size of loans themselves. Microfinance loans are typically small. Additionally, microfinance lenders tend to initially give borrowers small loans and increase the size of the loan that can be borrowed only after the borrower has paid back their previous loan.

Which of the following is true? a) Informal interest rates in poor countries tend to be fairly low b) Informal interest rates in poor countries are positively correlated with loan size: people who borrow more tend to pay a higher interest rate c) Informal interest rates in poor countries tend to be high and variable d) Informal interest rates in poor countries can be explained by high rates of default by poor people.

C is true. Informal interest rates in developing countries tend to be quite high; annual interest rates for example are typically in the range of 40% to 200%. Rates of default on these loans, however, tend to be quite low, so we cannot explain the high interest rate directly by the existence of high default rates. Informal interest rates do tend to be highly variable, even within the same village: a study in Pakistan by Aleem (1990) found that the standard deviation of interest rates was as high as 38.3%!

TRUE or FALSE. Economists have always claimed that it would be possible to lend to the poor.

False. Before the microfinance boom, there were government lending programs for the poor for which repayment rates were often only 35 percent - much lower than the 98 percent repayment rates experienced by microfinance institutions today. As a result, in the 1970s, expert economists argued that the poor were not reliable borrowers and therefore it was not possible to lend to the poor.

True or False: Default rates tend to be high among the poor, which leads to higher and more variable interest rates.

False. Default rates tend to be low among the poor, and therefore do not explain the reason why the poor face higher and more variable interest rates for the money they borrow. One explanation for why the poor face such high interest rates is that the fixed cost of lending to the poor is high compared to the amount that they are borrowing. This is because the poor are extremely difficult to monitor and therefore have high monitoring cost relative to the rich. As monitoring costs increase, the fixed cost of giving the loan increase, which results in a higher interest rate for the poor.

True or False. The poor can only borrow from a bank or from a credit union.

False. Most of the poor do not have access to any kind of formal credit, excluding microfinance, and therefore most of the poor do not borrow from a bank or from a credit union. The poor instead tend to borrow from a moneylender, shopkeeper, landlord, family member or someone else they know.

True or False: Poor people in developing countries are generally unable to borrow money.

False. Poor people in developing countries actually borrow quite a bit. For example, according to the household survey used in Poor Economics, 93% of rural Pakistani households living on less than a dollar a day typically have at least one loan at any given time. That said, it's also true that poor people are generally unable to borrow from formal institutions: only 1.5% of those same Pakistani households had a loan from a bank.

True or False: To test the impact of microcredit, we can compare the incomes of those who received a loan with the incomes of those who didn't receive a loan.

False. Those who apply for and receive a loan may differ from those who do not in some important ways. For example, they may be more entrepreneurial or more future-oriented. Consequently, we would be comparing two different types of people. In testing the impact of microcredit, what we are really interested in is comparing the incomes of people who received a loan and the incomes of the same group of people if they had never received a loan. This is called the "counterfactual."

Although there are usually several moneylenders in a single village, it is still possible that they exercise some monopoly power in setting interest rates. Which of the following is a reason why this could still be the case? a) People do not frequently change moneylenders because it is extremely costly b) Moneylenders are protected by laws which regulate lending c) Moneylenders often know more about individuals' borrowing habits than the individuals themselves.

a) People do not frequently change moneylenders because it is extremely costly. People who borrow from moneylenders usually borrow repeatedly from the same lender. One explanation for this is that it is very costly for borrowers to switch to a new lender. First, the new lender will have to spend more time and effort monitoring the new borrower because he will not know whether the new borrower is likely to default on the loan or not. Second, the fact that the new borrower is switching may signal to the new lender that something has gone wrong with the borrower's previous loan and that the borrower may be likely to default. Both of these would drive up the interest rate that lenders would charge to new borrowers which would make switching very difficult. If switching among moneylenders is difficult, individual moneylenders would then be able to exert some monopoly power over their customers, and therefore would be able to keep interest rates higher.

Why were only households with at least one woman between the ages of 18 and 55 selected to be surveyed in the Spandana study? a) These are the individuals most likely to become microfinance clients b) These are the respondents most likely to increase business profits given a loan c) These are the individuals who are easiest to survey d) In order to increase gender balance in the sample

a) These are the individuals most likely to become microfinance clients. Women aged 18-55 have high rates of microfinance borrowing relative to other groups. Since the authors were interested in estimating the impact of microcredit access on potential borrowers, households with members who were likely to become microfinance clients (that is, women aged 18-55) were targeted for the household surveys. You can read more about the study by Banerjee et al. here.

Based on the expression above, does an increase in the escape cost (h) lead to a decrease, increase, or ambiguous change in the gross interest rate (R)? a) Ambiguous change b) Decrease c) Increase

b) Decrease. As h rises, lending can be increased such that the fixed cost C again represents a smaller relative cost to the lender and so the interest rate falls. In the above equation, we can see that as h increases, the numerator (top) of the equation will become smaller, while the denominator (bottom) of the equation will become larger. Thus, the fraction will become smaller, which means that R decreases.

In the lecture slides, we derived the following expression while building a model of lending to the poor: Note: If you have not already watched the video in the "Review: Modeling Credit" section, you may find that video helpful for the next couple of questions. Based on this expression, does an increase in wealth (w) lead to an increase, decrease, or ambiguous change in the gross interest rate (R)? a) Ambigious change b) Decrease c) Increase

b) Decrease. As wealth rises, borrowing increases and the fixed cost C represents a smaller relative cost to the lender; thus, the interest rate falls. In the above equation we can see that as w increases, the denominator (bottom) of the fraction will increase while the numerator (top) remains the same. The fraction will become smaller as w increases, which means that R decreases while w increases.

What does the acronym IPO mentioned in the lecture refer to? a) Initial Purchase Order b) Initial Public Offering c) International Purchasing Offer d) Initial Public Order

b) Initial Public Offering. An IPO refers to an Initial Public offering. In the lecture it is mentioned that in 2009 in Mexico an organization called Compartamos had an IPO, or initial public offering. At an IPO, shares of the company stock are sold to the general public. Comparatamos made a significant amount of money from as a result of their IPO. An organization in India called SKS also had an IPO and also made hundreds of millions from their IPO. This caused uproar among many in the field of microfinance, who argued that becoming very profitable by lending to the poor goes against the spirit of microfinance. However, the organizations argued that the IPO would allow them to expand their lending and reach more borrowers, and therefore was in keeping with the principles of microfinance, which is to expand access to credit and loans among the poor. The key takeaway is that the use of IPO's in microfinance sparked a significant debate about how much one should profit from helping the poor.

The rich typically take out larger loans, and pay ____________ interest rates. a) Higher b) Lower

b) Lower. The size of the loan is inversely related to the interest rate. Since the rich tend to take out larger loans, they pay lower interest rates and face less variation in interest rates available. The range of interest rates for the landless in India is between 28 and 125 percent, while for the people who have land, interest rates range from 21 to 40 percent. This is due to the fact that lenders perceive those who own land as less risky than those who do not have land. This is because they have an asset (their land) which in some sense backs the loan if they were to default they could potentially sell some of their land to pay the debt. The landless do not have this option.

As the classroom discussion indicates, the documentary "Small Fortunes" makes the claim that poor people are inherently trustworthy borrowers, and simply lack access to credit in the absence of microlending. Why might we be skeptical of this claim? a) Studies have shown that microlending programs have extremely high rates of default b) The fact that poor people are seen as trustworthy is a direct result of the design of microlending programs, which are set up to minimize the chance that borrowers will default c) In the absence of microlending, poor people generally have very good access to formal loans

b) The fact that poor people are seen as trustworthy is a direct result of the design of microlending programs, which are set up to minimize the chance that borrowers will default. It is true that poor participants in microlending programs rarely default on their loans. However, this could be because microlending programs are designed precisely to ensure that their clients will repay their loans. For example, microlending programs usually offer a simple loan product with a standardized schedule of repayment in small installments and make use of group lending to lower the costs of monitoring and enforcing repayment.

How do microfinance institutions typically incentivize people to continue to repay? a) Interest rates are reduced each time a borrower pays back his or her loan b) The size of the loan an individual can take out increases each time he or she pays back his or her loan c) Microfinance institutions punish those who do not pay back their loan

b) The size of the loan an individual can take out increases each time he or she pays back his or her loan. Typically, microfinance institutions start with a small first loan. Once a borrower repays the first loan, they are able to take out a larger second loan. Over time, as borrowers continue to repay previous loans, the size of the next loan they can take out increases. This provides borrowers with an incentive to continue to repay.

Based on the expression above, does an increase in the cost of capital D lead to a decrease, increase, or ambiguous change in the gross interest rate (R)? a) Ambiguous change b) Decrease c) Increase

c) Increase. As the cost of capital D rises, lenders must charge a higher interest rate to recoup costs. In the above equation, we can see that as D rises, the numerator (top) of the fraction will increase while the denominator (bottom) of the fraction remains the same. Therefore, the fraction becomes larger, which means that R is increasing.

The Spandana evaluation found that the treatment group experienced an increase in _____ but no change in ______. a) Women's empowerment; spending on business durables b) Health expenditures; educational enrollment c) Spending on business durables; women's empowerment

c) Spending on business durables; women's empowerment. In the study, households in the treatment areas spent significantly more on business durable goods than households in the control area. On the other hand, the study found no difference in measures of either child welfare (such as health expenditures and school enrollment) or women's empowerment (such as their decision-making power within the household). This result calls into question the claims that have been made that microfinance is beneficial not only because it empowers women but also because it benefits their children.

Does the Economist blog post mentioned in the lecture series primarily blame the government or microfinance lenders for the default crisis in Andhra Pradesh? a) Neither b) Microlenders c) The government

c) The government. The Economist argues that the government is primarily to blame for increased default: "Before the government made it impossible for MFIs to collect their dues, repayment rates remained as high as ever, and default rates were not on the rise." You can read the entire blog post here.

Which of the following questions was the Spandana study designed to answer? a) Which are the types of borrowers with the lowest default rates? b) Is the repayment period for the typical microfinance loan too short? c) What is the impact of increased access to microcredit for potential borrowers? d) Do high interest rates offered by microfinance institutions constrain borrowing?

c) What is the impact of increased access to microcredit for potential borrowers? The Spandana study examined the random phase-in of Spandana (a microfinance institution) in Hyderabad, India. Households with members likely to become microfinance clients were surveyed in order for the authors to estimate the impact of Spandana's entrance on potential borrowers. "What is the impact of increased access to microcredit for potential borrowers" is the correct answer. The remaining options were not motivations for this particular study. You can read more about the study by Banerjee et al. here.

In order to put social pressure on individuals to repay their loans, many microfinance institutions have a rule that if one person in a group does not repay, ... a) everyone else must cover the cost of that person's loan b) everyone else must go nag the person to repay c) nobody can receive a new loan until that person repays d) interest rates for the entire group will increase.

c) nobody can receive a new loan until that person repays. Group lending is emphasized in microcredit because it places social pressure on individuals to repay. If everyone else in the group puts in their money, you might feel a social pressure to also pay back your loan. One way in which microfinance institutions increase the amount of social pressure is by establishing the rule that if one person in a group does not repay, the rest of the group cannot get a new loan until that person repays.

In what state of India did a number of people commit suicide in 2009 and 2010 due to their inability to pay back their microfinance loans? a) Assam b) Arunachal Pradesh c) Madhya Pradesh d) Andhra Pradesh

d) Andhra Pradesh. In Andhra Pradesh, hundreds of people committed suicide because their loan burden was too high. Many of those who committed suicide had borrowed from six or seven microfinance institutions and could not repay their outstanding loans.

The data suggests that in order to pay back loans, the poor who open up a new business cut back on ___________. a) health expenditures b) purchase of durable goods c) borrowing from other lenders d) purchasing temptation goods

d) purchasing temptation goods. Temptation goods refer to any goods that the poor say that they do not want to purchase, but end up spending money on anyway. Some examples include: tea, coffee, snacks, betel nuts, cigarettes and alcohol. The findings of the study showed that those who open up a new business after receiving the loan are more likely to cut back on temptation goods and purchase durable goods for their business. This suggests that they expand their consumption of durable goods, but pay back the loan by cutting back on temptation goods. For the group that will never start a business, however, you see an increase in the purchase of temptation goods following the loan and so this change in spending behavior does not hold across all groups.