Microfinance: Theory and Practice

1. Microfinance: Theory and Practice Beatriz Armendariz Littauer 323 Lecture 1: Overview

2. Microfinance: “formal” financial institutions delivering credit & other financial services to poor individuals without collateral Salient features: • Technology credit delivery often attributed to Muhammad Yunus (Peace Nobel Prize 2006) • Main idea: group lending under joint responsibility (GLJR)  High repayment rates at “affordable interest rates) • Idea has been widely analyzed theoretically: GLJR circumvents: adverse Selection, moral hazard, and enforcement  lower than usurious interest rates

3. GLJR rooted in: • ROSCAs Informal credit arrangements among individuals acting both as lenders and borrowers. Defaults averted under the threat of social sanctions • 19th Century Credit Unions Villagers that are linked by a “common bond” and where the threat of stigma or social sanctions prevents individuals from defaulting

4. Main innovations introduced by Yunus in 1977 and parallel efforts in Latin America • 1) Foreign savings mobilized a) via donations from charities and multilateral organizations, b) via private entrepreneurs in recent trends pertaining for-profit microfinance institutions, and c) via “social business” or “socially responsible” investments

5. 2) Strong biased in favor of women for two reasons: a) Donors’ standpoint: women are the main brokers of health and education; empowerment concerns, and gender equity concerns (in line with the millennium development goals (MDGs). (Pitt and Khandker (1998 JPE article in your syllabus) have helped to reinforce this view: “Consumption increases by 18 taka for every 100 taka lent to women; and only 11 taka for every 100 taka lent to men” b) Microfinance enterprises’ standpoint: women are more conservative in their investment behavior, have no access to other sources of credit, among others…

6. Recent research, however, shows that: • GLJR under the threat of social and bank sanctions is not the only way to ensure high repayment rates. In particular: • Under individual loan contracts, a non-refinancing threat may suffice • All forms of collateral (precious to the borrowers more than to the lenders) can be equally effective • Public repayments can be imposed as a way to insure that social sanctions are effective And this has in turn popularized microfinance in sparsely populated areas. Eg., Eastern Europe and Latin America d) Aside for an under-provision of savings and basic insurance, microfinance is not under-serving farmers in most developing countries, not even now (commodity prices crisis)

7. Managerial Issues • Microfinance enterprises struggle to meet a dual objective of alleviating poverty on the one hand and attaining self-sustainability on the other • Conflicting objectives have often led a number of practitioners to bias their managerial skill – formation in favor of one • Managerial skills in microfinance also change across regions: Asia versus Latin America, for example • Some researchers and practitioners would argue that microfinance should move away completely from “dual objective” . • Some even suggest that the core poor qualify for grants not loans. (PROGRESA/OPORTUNIDADES, for example Over-emphasizing self-sustainability and growth has its dangers, however….

8. Let us now turn to the issue of “subsidies” (next class in greater detail) • Ever since microfinance was invented, most NGOs and for-profit institutions have benefited from subsidies because social objectives • However, critics would argue that such subsidies are either detrimental or not needed because (among other things): • Microfinance enterprises can easily attain self – sustainability and make profits • Competition among microfinance entrepreneurs will prevent for-profit institutions to charge astronomical interest rates A way to tone-down the anti-subsidy critics is the idea of “smart subsidies” Infant industry argument? Skill acquisition? Poverty alleviation?  Next class

9. Other exceedingly important challenges: Based on growth estimates, heavily subsidized microfinance remains at its infancy: • Far less than expected households have benefitted from microfinance products • Not necessarily the core poor 3) Microsavings and microinsurance still exceedingly small • Potential “mismatch” between what microfinance institutions offer and what the potential clients would wish 4) Regulation • Interest rates - Next Class: Armendariz – Morduch (2005) Chapter 1: Rethinking Banking