MFI Handout - 1 -PP C253 – ARE C253 Elisabeth SadouletFall 2003Handout ππππ8Access to Financial Services in DevelopmentI. The lending problemPotentialborrowersLoan contractInvestRiskSuccessUnwilling to payRepayFailureMH in repaymentLimited liabilityMH in project choiceAS:Borrowers typeEnforcementMonitoringSelection Insurancetime∑ Loans are transactions over time, with risk fi Need for insurance fi MH problemsRisk: Borrower needs insurance (limited liability), as even loans for good projectscannot be repaid in bad years.But lender cannot provide insurance as he cannot monitor genuine failures from falseclaims ∫ Problem of enforcement. (Moral Hazard (MH) in repayment).Limited liability induces risk taking behavior - need for monitoring (MH in projectchoice)∑ Screening: lender cannot screen risky from safe borrower ex-ante due to lack ofinformation (Adverse selection (AS)).If one knew which borrowers are risky or safe, one could give them each a contractwith high interest rate for risky borrowers that pay less often and low interestrate for safe borrowers that pay more often. With a unique contract at anaverage interest, safe borrowers are subsidizing risky borrowers. This is notefficientSolutions?- Intense information collection for screening and monitoring, and punishmentmechanism for enforcement- Design a contract that makes borrowers reveal who they are (truth-telling) and thatsatisfies their best interest (incentive compatibility)MFI Handout - 2 -II. The banks’ solution: Why the poor are excluded from formal financialinstitutions∑ Require collateral to overcome problems of MH. Access to credit restricted to thosewith collateral: wealth-constrained market.Collateral solves the problem of AS, although it is not the optimal solution. Thereare better contracts with a menu of combinations for collateral and interest atdifferent levelsNo provision of insurance fi Poor may not want to put their collateral at risk. Theyare “risk constrained”.∑ fi Efficiency cost: many good projects are not funded (allocation of credit isunrelated to the marginal productivity of capital).Equity cost: poor are excluded. Allocation of credit to wealthy reinforces inequality.III. The traditional sources3.1. Local moneylenders∑ They have access to local information about borrowers: can avoid AS and giveinsurance.They can put pressure on borrowers to repay: e.g., take forms of collateral that bankcould 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 ofproject 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 returnoperations (buy-sell animals, merchants), and small amounts.3.2. Local sources of credit based on interlinkages∑ Traders of products, providers of inputs: credit to clientsLandlords, 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 insuranceInterlinkage is used to pressure to repay: borrower would be cut-off from other partsof the transaction if does not repay, creating incentive to repay. Control of MH∑ Disadvantage: highly segmented market.MFI Handout - 3 -IV. Microfinance institutions (MFI)4.1. ROSCAS (Rotating Savings and Credit Associations)∑ Rules:N members.Equal deposits d at regular intervals.One member takes all contributions at one meeting: gets Nd.Different rules of attribution: random draw, bidding on order of turns (createsinterest revenue for others).Example: 10 members that put $10/week.1st winner: gets $100 interest free. Repays weekly at zero interest.10th winner: gets $100 having lost interest on all previous deposits.However: Repeated game: random distribution of gainers and losers.Loss is zero if money has zero opportunity cost.∑ Advantages:No AS and MH: members self-select and know each other well.Insurance: some in the bidding ROSCAS, but weak.No management costs.Self-imposed forced saving: would have consumed the $100 otherwise.Social function: information sharing within club, other deals, women away fromhome.∑ Disadvantages:Rigid and limited access to credit:Timing not effective for insurance.Fixed quantity Nd.No external injection of funds.No long run savings: only serves for small investment with indivisibilities (durablegoods and small equipment)4.2. Group lending: solidarity groupsA technique to channel loans to borrowers without collateral (Grameen Bank inBangladesh, 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 of 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 (MHin 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 henceunwilling to pay back their loan) do not creep in groups of willing borrowers.Note that large heterogeneous groups are more effective for risk diversificationMFI Handout - 4 -Group members have an incentive to mutually insure against idiosyncratic risks (butnot against global shocks): Repay loan for member with true failure (advance hispayment). This could create MH in repayment and risk taking within group.Members can and want to monitor/help each others’ projects using local information:hence. Note that small homogeneous groups are more effective for monitoring.In addition, group exercises pressure on each member to repay if he can, based onsocial capital (ostracization in community), interlinkages among members, andseizure of collateral (e.g., personal belongings).How large a group? Trade-off between control of MH in choice of project andinsurance. Grameen: minimum 5.∑ Advantages:Access to loans for poor people with no collateral.Lower
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