The Microcredit Revolution

1. The Microcredit Revolution • Recently, institutional finance on a small scale, i.e. “microcredit”,has revolutionized finance in developing countries • More than 200 million households (estimated) taking loans from microlenders, scattered throughout the entire developing world • Compare to probably less than 10 million four decades ago • Rapid, and unexpected, growth in lending to poor households, a “revolution” Ex.Nobel Peace Prize, Kiva, Mixmarket

2. The Microcredit Revolution • What is “microcredit”? • “Provision of small loans for income-generating self-employment activities” – World Bank • Loans can be as little as $200, often less than $2000 • Self-employment in e.g. agriculture, crafts, sewing, small retail, etc. • Method for targeting capital toward entrepreneurial uses by those at the bottom of the world income distribution • Compare to large grants or loans for infrastructure – the fear is that high-level aid often does not reach poorest

3. The Microcredit Revolution • What is “microcredit”? • Sustainable (i.e. cost-covering) lending in the absence of collateral • Micro-lenders typically charge high enough rates to cover costs (higher than commercial bank loans, less than “moneylenders”) • Sustainable lending requires efficiency and ensuring high repayment rates… how? • Non-patronizing approach to poverty alleviation • Not hand-outs; market-based support for self-advancement

4. Microcredit – Does it Work? • By now, 1000s of microfinance institutions (“MFIs”) have extended loans to several hundred million households worldwide • But does it work? Does it help households out of poverty? • Many studies have attempted to test empirically for the effect of microcredit on poverty, income, consumption But this is much harder than one might think: Can compare borrowers with non-borrowers, but might there be unobserved differences causing both borrowing and success? Can compare areas with microcredit access with those without access, but might MFIs have purposely entered in either high- prospect or low-prospect areas?

5. Microcredit – Does it Work? • But does it work? Does it help households out of poverty? • Two recent cutting-edge studies have given convincing answers 1. Banerjee, Duflo, Glennerster, Kinnan partner with an MFI in India to run a field experiment (Remember, MFI = microfinance institution) The MFI lists 100 neighborhoods where it would like to enter, then enters in a randomly selected half of these neighborhoods  This leads to “clean” test for effect of access to microcredit on household outcomes They find significant increase in business startups, but no effect on consumption, at least in short run They explain this by households combining the small loans with own savings to start firms

6. Microcredit – Does it Work? • But does it work? Does it help households out of poverty? • Two recent cutting-edge studies have given convincing answers • Kaboski, Townsend exploit a natural experimentin Thailand They study a massive credit program by the Thai govt. that provided 1million Thai baht to every village to start a village bank This provides quasi-random variation in infusion of credit per capita, since villages vary in size  This leads to “clean” test for effect of access to credit on household outcomes They find not much change in investment, nearly 100% increase in consumption – a puzzle They resolve this with a theoretical model where people save for a rainy day, but decide to save less now that they have access to credit

7. Microcredit – HOW does it Work? • “Loans to poor people without any financial security had appeared to be an impossible idea.” – Nobel Press Release • How have lenders been able to lend successfully in these markets without access to collateral? • Two prominent theories: • Group lending – lending to individuals as members of groups (often of 5-10 borrowers), where each member of the group is liable (responsible) for each other member’s loan This was a big innovation of the microcredit movement • Dynamic (repeated) lending – lending to an individual repeatedly over time, and using the borrowing record of the individual to adjust terms/availability of loans

8. Microcredit – HOW does it Work? • How have group contracts and dynamic contracts enabled lending? • First, need to know why credit markets often fail Economists focus on three problems, at three stages: 1. Adverse Selection: will offering loans without collateral attract the riskiest borrowers, since the down-side risk is borne by lender? Potential Problem: either safe borrowers refuse to borrow, or too-risky borrowers choose to borrow, or both 2. Moral Hazard: will loans without collateral give borrowers incentives to take excessive risk, since it is borne by lender? Potential Problem: excessive risk-taking, inefficient project choice 3. Strategic Default: will borrowers with no collateral at stake refuse to repay, even if they can?

9. Microcredit – HOW does it Work? • How can Group lending overcome: 2. Moral Hazard? (Potential Problem: excessive risk-taking, inefficient project choice) Borrowers are responsible for each other’s loans, so they pressure each other to use precaution, choose prudent projects, not take excessive risk, so they will be able to repay their own loan Works best when borrowers have “strong” social network 3. Strategic Default? (Potential Problem: choosing to default, even when can repay) Borrowers are responsible for each other’s loans, so they pressure each other to repay when they can Again, works best when borrowers have “strong” social network

10. Microcredit – HOW does it Work? • How can Dynamic (repeated) lending overcome: 2. Moral Hazard? (Potential Problem: excessive risk-taking, inefficient project choice) Borrowers want to be able to continue borrowing, so they use precaution, choose prudent projects, do not take excessive risk, so they will be able to repay their loan and borrow in future 3. Strategic Default? (Potential Problem: choosing to default, even when can repay) Borrowers want to be able to continue borrowing, so they pay back their current loan in order to maintain a good reputation and be able to borrow in future

11. Microcredit – HOW does it Work? • How can Group lending & Dynamic lendingovercome: 1. Adverse Selection? See notes.

12. Microcredit and the Macroeconomy • Two-way impacts, potentially, between microcredit and the macroeconomy: 1. How do macroeconomic outcomes affect the success of microfinance institutions? (MFI’s) • How can microfinance impact a country’s overall development?