Microfinance

How does group lending help reduce adverse selection and moral hazard?

-Adverse Selection because if a bunch of risky people get together for a group loan they are facing a higher effective interest rate because not only do they have to pay the regular interest to the bank, but they also have to cover the loans of their fellow group members more often. The high effective interest rate will discourage them from applying for loans. -Moral Hazard because it uses social collateral which consist of losing your social status and relationships instead of money because you don't make a profit (social peer pressure)

Group lending (what is it/ how it works)

-Offering joint liability group loans -Groups form to go in on a loan together and all members are jointly responsible for paying back the loan

What happens in a raise in interest rate (banks)

-direct = high interest rates means more money per loan (interest rate effect) -indirect = high interest rates mean riskier portfolio (adverse selection effect) -banks will raise interest rate if direct effects are stronger than indirect

Criticisms of microfinance

-if the poor can't repay loans there could be debt traps -many institutions do not earn enough to cover operating costs and maintain capital holdings -success could be due to selection bias

How can banks combat moral hazard?

-interest rate -collateral (shift risk to the borrower instead of the bank) -monitoring -dynamic incentives (not repaying your loan means you won't get a loan in the future) -credit reporting (acting risky increases credit score and could prevent you from getting loans)

How can banks combat adverse selection?

-interest rates (lower them so that the portfolio is less risky) -ask for more information (credit scores) -collateral -information -loan sizes (provides an incentive by offering higher loans as borrowers pay back their loans) -group lending

Collateral

Amount (percent of loan) that borrower must put away (like in a savings account) in case the loan defaults (c) -ex = collateral of mortgage is the house

Revenue

Amount that the borrower earns from his or her business (theta)

Moral Hazard

Arises when people behave recklessly because they know they will be saved if things go wrong -act riskier because you have insurance -action based (you change your behavior after you receive the loan)

Why are microfinance interest rates so high?

Because the loans are so much smaller

Why are so many people in developing countries without loans?

Essentially - because of problems with moral hazard and adverse selection in lending market and developing countries don't have the tools to deal with this like they do in the developed countries so those in developing countries do not have the same access -mechanisms aren't available for those in developing countries to have combating strategies in place (not many people have collateral or credit scores) -interest rates are very high and borrowers have no collateral

Grameen Bank

Founded by Muhammad Yunus in Bangladesh to provide very small loans to poor individuals, particularly women -pioneered microfinance and microcredit

Lending strategy of the Grameen Bank

Gives around $400 average loan size with an average interest rate of 20% -requires recipients to accept certain social disciplines like cleanliness and family planning -provides services like cleaning, etc.

How to define the quality of a loan

If it is paid back or not (high quality if it gets paid back)

Why do banks lend to women?

In general women have had higher repayment rates and they tend to be more conservative investors and less likely to use the money for their own personal consumption -also loans for women have greater impacts for them to have opportunities the generally haven't had in the past -greater impact on child health -increasing income causes lower fertility rates

Interest Rate

Percent of the loan amount that must be repaid to the bank (r)

Principal

The amount borrowed (p)

Profit / Payoff

The amount that the borrower or bank is left with after all expenses and loans are repaid (pi) -equals the revenues - the cost

Adverse Selection

The quality of a product decreases when sellers raise the price or when buyers lower the price -different types of people that all have different levels of risk -typically people who are riskier will take the loan ex = more risky people are likely to apply for loans when interest rates are high -asymmetric information occurs which causes the quality of the loan to change based on the interest rate

Credit agencies

Traditional banking system and way that people get conventional loans

Why is loan market different than other markets

adverse selection and moral hazard -defined as the quality changes based on the price change -as interest rates go up loan quality goes down -asymmetric information causes change in quality based on price

Dynamic incentives

borrow has incentive to take a lot of risk and bank has incentive to accept lowest amount of risk

What is microfinance?

provision of small loans and other financial services to individuals and small businesses in developing countries that are unable to obtain loans from traditional/commercial banks -bottom-up approach (people helping themselves) -designed to break poverty trap

Poverty traps

the constant cycle of being stuck in poverty and unable to support yourself/family enough to reach the threshold out of poverty -getting people out of poverty traps can push people into an upward spiral out of poverty -can be done through microfinance loans