Lecture 17

What is a microfinance institution and what are the characteristics of MFIs?

- *Microfinance* institutions provide financial services, including credit, supplied in small allotments to people who might otherwise have no access to them. - The characteristics of MFIs: + Includes microcredit, microsavings, and microinsurance + Primary focus: very small loans for microenterprises +Microcredit often uses *group lending schemes* (joint liability) (a formal arrangement among a group of potential borrowers to borrow money from commercial or government banks and other sources as a single entity and then allocate funds and repay loans as a group, thereby lowering borrowing costs) * Provides *"collateral of peer pressure"* to jointly repay (Before qualifying for a loan, each member is required to identify several other members or potential members willing to cosign loans with the,. Often, once a member of a cosigning group receives a loan, no other member may borrow until the first borrower has established a regular repayment record; and in any case, no repeat loans are approved until all members' accounts are satisfactorily settled. Progressively larger loans are approved as borrowers gain experience and a credit history and identify productive uses for larger loans. Members know the characters of the cosigning group members they select and may be expected to join groups with members whom they believe are likely to repay their loans. Banks make use of this information "embedded" in the village or neighborhood abut who is a reliable and capable borrower and induce villagers to reveal this info. At the same time, *an implicit collateral is created by the pressure that members would be expected to exert ion each member in the group to repay funds.* * An alternative without joint liability: *"dynamic incentives,"* in which loan sizes steadily increase when loans are repaid (start with repaying current smaller loan, and then eligible for larger loan in the future)

What are the current policy debates concerning MFIs?

- *Microfinance schism i.e Are subsidies on loans to the poor appropriate?* (CGAP argues that one can reach more borrowers by requiring sustainability so that available dollars go further. This argument is reasonable as far as it goes, but there is no reason to believe that the poorest borrowers can afford the high interest rates that this would require with the business opportunities they realistically face and the poor generally lack opportunities to invest in high-return projects. Thus some subsidy is generally required to truly reach the poorest current and potential microentrepreneurs. But even subsidized credit is no guarantee of higher productivity and incomes. Some studies have suggested that the poorest of the poor may not be made better off and indeed may be worse off if they take on additional debt that is for them unproductive but for which they must pay interest.) - *Should credit be integrated with education, health, or other programs?* (Proponents argue that it may be useful to tie credit to social services that are demanded only by the poor and inherently require time for participation for at least 3 reasons: 1. could act as a screening mechanism; 2. The Poor generally cannot make adequate use of credit without better health and education; 3. many of the poor appear not to recognize the importance of human capital, and the availability of credit may act as a "hook" to get them enrolled in health and education programs.) - *Should MFIs undergo commercialization, whereby an NGO providing microfinance is converted into a for-profit bank?* (*Commercialization*: A process whereby an NGO providing microfinance is converted into a for-profit bank) (*Advantages* include the fact that the MFI becomes regulated as a bank, and so cal legally accept savings deposits as well as disburse loans; and the MFI acquires the discipline of the market and an added incentive to cut costs and expand its scale. Could be used as a vehicle to develop the overall financial system.) (*Disadvantages* include the problem that people living in poverty become considered in some cases too expensive to serve; or, that if they are served, very high interest rates will be charged and aggressive tactics may be used to collect funds.)

Financial Policy and the role of the state: Stiglitz - What are the several financial market failures?

- *The "public good" nature of monitoring financial institutions* (Like other forms of information, monitoring is a public good - everyone who places savings in a particular financial institution would benefit from knowing that the institution was prospering or close to insolvency. Like other public goods, there is an undersupply of monitoring information, and consequently, risk-averse savers withhold their funds.) - *Externalities of financial disruption* (In the absence of government insurance - whether or not an explicit policy has been issued - the failure of one major financial institution can cause a run on the entire banking system and lead to LT disruptions of the overall financial system - *Missing and incomplete markets* (In most developing countries, markets for insurance against a variety of financial or physical risks are missing. The basic problem is that info is imperfect and costly to obtain, so a developing country government has an important role in reducing these risks - i.e. mandating insurance) - *Imperfect competition* (Competition in the banking sector of most developing countries is extremely limited, meaning that potential borrowers usually face only a small number of suppliers of loanable funds, many of which are unwilling or unable to accommodate new and unknown customers) - *Inefficiency of competitive markets in the financial sector* (Theoretically, for perfectly competitive markets to function efficiently, financial markets must be complete - without uninsured risks - and info must be exogenous - given free to all and not influenced. As a result, unfettered financial markets may not allocate capital to its most profitable uses, and there can be deviations between social and private returns. Government intervention may offset these balances) - *Uninformed investors* (Many investors in developing countries lack both the info and the appropriate means to acquire it in order to make rational investment decisions. Governments can impose financial disclosure requirements on firms, etc)

Informal Finance and the Rise of Microfinance

- A developed and well-functioning financial market is not a typical scenario in developing countries - Households and businesses in developing countries also need finance. - Amount required is typically small to be catered for by formal financial institutions. - What are the alternatives? + Finance from family members and friends + Rotating Savings and Credit Associations (ROSCAs) (a group formed by formal agreement among 40 to 50 individuals to pool their savings and allocate loans on a rotating basis to each member) + Co-operative unions + Moneylenders

Why are most rural businesses constrained financially?

- Most rural businesses are constrained financially because of the following: + *Microentrepreneurs often have little or no collateral.* + *It is difficult for conventional lenders to determine borrower quality.* + *Small loans are more costly to process per dollar lent.* - The emergence of microfinance seek to solve all of these problem

What are the potential limitations of microfinance as a development strategy?

- People seem to be mostly interested in payed employment instead of being entrepreneurs (Although systematic evidence is lacking, interviews with factory workers in developing countries such as Peru and Bangladesh suggest that many are former microentrepreneurs who gave up their enterprises in favor of a regular job - more of a stable salary) - Mircofinance is the not the only way to reduce poverty among the poor (the poor face many problems, some of which cannot be solved solely by relaxing credit constraints. The money going to microfinance is being diverted from other funds. More cost effective strategies: Improved systems for regulation and oversight, upgrading the financial system safety net training of government financial officials, etc.) - It may result in increased household debt Conclusion? - Microfinance is a powerful tool, but it needs to be complemented with other development and poverty policies

Financial Liberalization, Real Interest Rates, Savings and Investment: What was the 1980s financial system of most developing countries?

- Real interest rates on savings deposits in the negatives - Continued inflation - Substantial capital flight - Lending restrictions and mandatory interest-rate (IR ceilings on loanable funds)

Formal Financial Systems and Reforms: Regulation in the credit market

- look at graph (The ceilings were often set by governments seeking to finance their budget deficits through the sale of low-interest bonds to private commercial banks) - this leads to: + Rationing (A situation where lenders restrict the supply of additional credit to borrowers, even if the latter are willing to pay higher interest rates) (because of the ceiling, supply is less than demand) + Financial Repression: (Constraints on investment resulting from the rationing of credit, usually to a few large borrowers) (Investment is limited or "repressed" by a shortage of savings,which in turn results from administered real interest rates below what would occur in a market setting) (In the absence of outright corruption in the allocation of loanable funds, most commercial banks choose to allocate the available credit to a few large borrowers so as to minimize the admin overhead costs as a proportion of the total costs of lending) -Solution: liberalize the financial sector by allowing nominal interest rates to rise to market-clearing levels - higher real rates should also generate more domestic saving and investment and permit some borrowers to shift form the unorganized to the organized credit market.