- 1 - MFI Handout PP C253 – ARE C253 Elisabeth Sadoulet Fall 2007 Handout 7 Access to Financial Services in Development I. The lending problem PotentialborrowersLoan contractInvestRiskSuccessUnwilling to payRepayFailureMH in repaymentLimited liabilityMH in project choiceAS:Borrowers typeEnforcementMonitoringSelection Insurancetime Moral hazard (MH): There is moral hazard behavior when someone does not do what he is supposed to do (such as repaying its loan or using the funds in a productive way) using the fact that this cannot be known or cannot be punished. Adverse selection (AS): There is an adverse selection problem when one cannot know the quality of the partner (borrower), and thus properly select only good borrowers. • Loans are transactions over time, with risk Need for insurance MH problems Risk: Borrower needs insurance (limited liability), as even loans for good projects cannot be repaid in bad years. But lender cannot provide insurance as he cannot monitor genuine failures from false claims Problem of enforcement. (Moral Hazard (MH) in repayment). Limited liability induces risk taking behavior - need for monitoring (MH in project choice) • Screening: lender cannot screen risky from safe borrower ex-ante due to lack of information (Adverse selection (AS)). If one knew which borrowers are risky or safe, one could give them each a contract with high interest rate for risky borrowers that pay less often and low interest rate for safe borrowers that pay more often. With a unique contract at an average interest, safe borrowers are subsidizing risky borrowers. This is not efficient Solutions? - Intense information collection for screening and monitoring, and punishment mechanism for enforcement - Design a contract that makes borrowers reveal who they are (truth-telling) and that satisfies their best interest (incentive compatibility) II. The banks’ solution: Why the poor are excluded from formal financial institutions • Require collateral to overcome problems of MH. Access to credit restricted to those with collateral: wealth-constrained market. Collateral solves the problem of AS, although it is not the optimal solution. There are better contracts with a menu of combinations for collateral and interest at different levels No provision of insurance Poor may not want to put their collateral at risk. They are “risk constrained”.- 2 - MFI Handout • Efficiency cost: many good projects are not funded (allocation of credit is unrelated to the marginal productivity of capital). Equity cost: poor are excluded. Allocation of credit to wealthy reinforces inequality. III. The traditional sources 3.1. Local moneylenders • They have access to local information about borrowers: can avoid AS and give insurance. They can put pressure on borrowers to repay: e.g., take forms of collateral that bank could not use: animals, house, use of the land, reputation. Control of MH • But high cost of credit: High correlation between outcomes of borrowers’ projects (high covariation of project outcomes, money lender cannot diversify risk). Need keep high liquidity position to give immediately emergency loans. May have monopoly power. Very high cost of loans limits their use to insurance, short run needs, high return operations (buy-sell animals, merchants), and small amounts. 3.2. Local sources of credit based on interlinkages • Traders of products, providers of inputs: credit to clients Landlords, employers: credit to tenants, workers. Types of interlinkages: Borrower who sells output to merchant-lender. Borrower who purchases inputs from merchant-lender. Borrower who provides rent in labor services to landlord-lender. Borrower who transfers usufruct rights of land to farmer-lender (land pawning). • Information: control of AS and eventually provision of insurance Interlinkage is used to pressure to repay: borrower would be cut-off from other parts of the transaction if does not repay while he could creating incentive to repay. Control of MH • Disadvantage: highly segmented market. IV. Microfinance institutions (MFI) Group lending: solidarity groups A technique to channel loans to borrowers without collateral (Grameen Bank in Bangladesh, Acción Internacional, Banco Sol in Bolivia). • Rules: Self-selected groups. Use local information. Solve AS problem. Individual loans but joint liability: Each member is responsible for repaying the loans of those who default. Whole group loses access to future loans if any loan is not repaid. Loans are small and increasing: dynamic incentives to induce borrowers to pay (MH in repayment) • Group’s control of AS, MH and provision of insurance: Dynamic incentives should be sufficient to insure willingness to repay for the group, and selection by members insure that borrowers with no future plans (and hence unwilling to pay back their loan) do not creep in- 3 - MFI Handout groups of willing borrowers. Note that large heterogeneous groups are more effective for risk diversification Group members have an incentive to mutually insure against idiosyncratic risks (but not against global shocks): Repay loan for member with true failure (advance his payment). This could create MH in repayment and risk taking within group. Members can and want to monitor/help each other’s projects using local information: Note that small homogeneous groups are more effective for monitoring. In addition, group exercises pressure on each member to repay if he can, based on social capital (ostracization in community), interlinkages among members, and seizure of collateral (e.g., personal belongings). How large a group? Trade-off between control of MH in choice of project and insurance. Grameen: minimum 5. • Advantages: Access to loans for poor people with no collateral. Lower transactions costs than individual loans from the bank: Group self-select in types: bank only needs verify 1 or 2 members. Can use intermediary NGO: Genesis (Guatemala) charges 7 percentage points on loans from commercial bank. Hence, unlimited expansion possible. Banks seek good financial NGOs to reach large potential market of borrowers among the poor (small loans, but very large number of people). Link modern/global institutions (bank with access to broad financial and insurance market) with traditional/local institutions (solidarity group with access to local information and social capital). •
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