Microfinance

1. Microfinance

2. Overall motivation for microfinance • Lack of access to financial instruments (savings, credit) is a key obstacle to poor families seeking to improve their own lives • Many investments that are good for households' long-run prospects require large up-front costs • e.g., tuition for education, capitalization of small enterprises • But it is often difficult to pay such up-front costs • Savings mechanisms are inefficient or nonexistent • Credit mechanisms poor • Microfinance institutions seek to fill this gap, by bringing financial services to the poor and previously unserved

3. Microfinance: common elements • Focus on providing financial services to those excluded from the formal banking sector • Most common: credit • More recently: savings • New frontier: insurance • Credit mostly intended to finance self-employment activities • Provide small loans (as small as $75), to be repaid over several months to a year • Many dispense with collateral requirements • Key for poor households with few assets • How are microfinance lenders able to do this?

4. Asymmetric information problems • Adverse selection: individuals who know they are likely to default select into borrowing pool, raising default rates and interest rates for everyone • “Hidden type”, “hidden information” • Moral hazard • Individuals exert less effort than the lender would desire, raising default rates and interest rates for all • Ex-ante: less effort is exerted to make the “project” succeed • Ex-post: even if project succeeds, may voluntarily default • “Hidden action”

5. Group liability lending • Widely-publicized mechanism of Grameen Bank for dispensing with collateral requirements • a.k.a. joint liability • Idea: make everyone in a group of ~5 borrowers jointly liable for repaying each of the loans to group members • If group doesn't repay each loan, no-one in group gets subsequent loans • Not the same as “group lending”

6. Group liability in theory • Why does it work? • Helps solve asymmetric information problem that usually exists between lenders and borrowers (and that is costly for conventional lenders to deal with) • Adverse selection • Moral hazard • Reduces adverse selection • groups will only form if all have confidence in individuals' repayment • people generally know each other beforehand, members will be “selected” for their reliability as borrowers • Reduces moral hazard • creates incentives for within-group monitoring and enforcement • In the end, key is to reduce transaction costs for lenders, allowing them to serve borrowers with very small loans

7. Group liability drawbacks • What drawbacks might group liability have? • Increases tension among members • Leads to voluntary dropouts • Can harm social capital among members • More costly for clients who are good risks, because they are more likely to pay off loans of their peers • Bad clients can “free ride” off good ones • Makes it more difficult to attract and retain good clients • As groups mature, loan sizes typically diverge • Smaller clients may not want to guarantee larger loans of other group members • Overall: group liability’s beneficial effect on repayment may reduce client base (and poor’s overall access to finance) • Also: bank profitability may be lower

8. Gine and Karlan (2006) • Field experiment in the Philippines • Microfinance bank where borrowers (all women) organized into joint-liability groups of 20 • 169 pre-existing centers randomized into: • Treatment: converted to individual-liability centers • Control: no change from joint liability • Findings: • No impact on repayment rate • Attracts new clients to individual-liability centers • Caveats • Groups were still formed under joint liability (so still benefit from joint structure’s impact on adverse selection) • Only moral hazard is affected by experiment • Next step: form groups under individual liability, and test effects

9. Karlan and Zinman (2007): Motivation • Credit markets thought to be imperfect due to asymmetric information problems • Adverse selection • Moral hazard • Policy responses • Microlending: resolve adverse selection, moral hazard via joint liability, group lending • Subsidies for lenders if moral hazard, asymmetric information problems make private sector lending unprofitable for the poorest sectors • Appropriate policies depend on understanding extent of these asymmetric information problems

10. Karlan and Zinman (2007) • Goal: quantify importance of various information asymmetries in a credit market • Adverse selection • Repayment burden • Moral hazard • Typically assumed to be unobservable • Experiment with a consumer lender to the working poor in South Africa • Randomization used to separately identify these effects • “offer interest rate” identifies adverse selection • “contract interest rate” identifies repayment burden • dynamic repayment incentive identifies moral hazard

11. Experimental design

12. Findings • Evidence of moral hazard • Dynamic repayment incentive has significant effects on default • No evidence of adverse selection or repayment burden overall • But analysis by gender reveals: • adverse selection for females • Repayment burden for males • See Tables 4, 5

13. Table 4

14. Table 5

15. Discussion items • Why is it important for loan supply decision to be “blind” to the experimental offer rates? • And was it, in fact? • Why present results for the standardized index of three default measures? (Kling, Liebman, and Katz 2007) • Ditto the seemingly unrelated regression (SUR) • How to interpret results by gender?

16. Savings

17. The role of savings • Transform a series of small payments into a usably large lump sum (Rutherford 1999) • For investment • As buffer stock (self-insurance) • Less costly than credit: no need to pay for lender’s risk

18. Barriers to savings • Problems with self-discipline • While understanding the need to save for the future, individuals can’t resist the temptation to spend now • Strong social pressures to share accumulated assets with others who have immediate needs • Reflective of informal insurance/risk-sharing arrangements • High transactional or informational costs • Distance to branches, unfamiliarity with formal financial institutions, difficulty filling out forms, etc. • A barrier to formal savings

19. Informal savings • In the absence of formal savings mechanisms, households in poor countries have developed a variety of informal means to save • Cash savings at home • But vulnerable to temptation, theft, and pressure to share with others • Asset accumulation and decumulation • E.g., livestock • Czukas, Fafchamps and Udry (1998) • Rosenzweig and Wolpin (1993) • But this comes at an efficiency cost • ROSCAs • … but some innovative MFIs are starting to offer formal savings

20. SafeSave • Helping overcome transactional cost barriers to savings • New program in Dhaka, Bangladesh • Deposit collectors visit people in their homes • Clients may deposit as little as one taka ($0.015) when the collector calls at their house each day • Accounts with balances above 1,000 taka ($15) earn 6% interest. • Clients may withdraw up to 500 taka per day ($7.50) at their doorstep, or up to 5,000 taka per day ($75) at the branch office • 22,000 clients, with average savings balance of $22 Source: http://www.safesave.org/

21. Commitment savings • Do people need help with self-control, with committing to savings? • Ashraf, Karlan, and Yin (2006), “Tying Odysseus to the Mast” • Randomized offer of commitment savings product to customers of a rural bank in Philippines • Customers pre-commit to save a certain amount or for a certain time period before withdrawal • Withdrawals not allowed before pre-committed amount or time period, except for emergencies

22. Table 1

23. Table 2

24. Table 3

25. Table 5

26. Table 6

27. Comments on Ashraf, Karlan, and Yin • Effects may be due to helping overcome: • Self-discipline problems • But also: helps resist pressure to share with others • More research needed on whether this is substitution from other forms of saving (other banks, or physical asset holdings) • A follow-up paper indicates that savings do not seem to be sustained in longer term

28. Risk and insurance

29. Agenda • Risk-coping mechanisms • Townsend (1994), Udry (1994), and related literature • A field experiment in Malawi: insurance, credit, and technology adoption

30. Micro-level responses to risk • How do households cope with risk? • In rich countries, people have insurance • Fire insurance, home insurance, auto insurance, life insurance, medical insurance • These insulate people from the potentially ruinous effects of catastrophic shocks • In poor countries, formal insurance markets tend not to exist or to be very limited • The poor have to rely on informal insurance • A vast literature in development economics illustrates the ingenious ways poor households insure themselves from adverse shocks • A theme: idiosyncratic risk is easier to cope with than aggregate risk

31. Poverty and vulnerability: a vicious circle Poverty Vulnerability

32. Ways to cope with risk • Ex ante: smooth income • Ex post: smooth consumption

33. Smoothing income • Choose a safe production technology: farm a food crop like cassava rather than a cash crop like coffee • Avoid risky new investments, transitions to different technologies (Malawi example) • Diversify income sources • Diversify farming plots spatially • References: Morduch (1992, 1995, 1999) • Note all of these are costly (reduce average income, even while making income more stable)

34. Smoothing consumption • Reciprocal transfers (informal insurance) • Coate and Ravallion (1993), Townsend (1994), Udry (1994), Ligon (1998), Banerjee and Newman (1993) • Credit: Udry (1994) • Asset sales: Rosenzweig and Wolpin (1993) • Savings: Paxson (1992) • Labor supply: Kochar (1999) • Migration by family members: Rosenzweig and Stark (1989) • Remittances: Yang (2008), Yang and Choi (2007)

35. Theory: risk-sharing between households • Basic result: if there is a Pareto-efficient allocation of risk across households, one households’s consumption should not depend on idiosyncratic shocks • 2 households, indexed by i=1,2 • Uncertain income, separable utility • Pareto efficient allocation of risk between households 1 and 2 implies: • Any two households’ marginal utilities are proportional • consumption moves in tandem • If utility is CARA:

36. Empirical implication • Consumption depends only on mean village income (and household’s weight in the Pareto program), and not on idiosyncratic shocks • Consumption should comove within villages • Empirical test: regress household consumption on idiosyncratic shocks, controlling for village income (or village fixed effects in panel setting), and idiosyncratic shocks should not have effect • Townsend (1994), Ravallion and Chaudhuri (1997) find high degree of comovement in consumption across Indian ICRISAT households, even with substantial idiosyncratic income variation • But can reject full risk-sharing (idiosyncratic shocks do have some effect)

37. Insurance, Credit and Technology Adoption: Field Experimental Evidence from Malawi Xavier Gine World Bank Dean Yang University of Michigan

38. A technology adoption puzzle • Green Revolution high-yield crop varieties have led to significant increases in agricultural productivity worldwide • But there is enormous variation in the extent to which households have adopted these new technologies • In Malawi, hybrid maize adoption has lagged behind Kenya, Zambia, and Zimbabwe • Need to look beyond credit constraints: even when credit offered, only 33% of farmers took up a loan for improved seeds

39. Credit or insurance as the key barrier? • In observational data, the relative importance of credit constraints and imperfect insurance may be confounded • Example: widely-observed correlation between wealth and adoption of new technology • May be because wealthier farmers have better access to credit • But wealthier households may also have better access to (formal and informal) insurance mechanisms • Disentangling the two explanations is crucial to good policymaking • Needed: exogenous variation in insurance

40. Technology adoption, risk, and credit • Key question: Does risk inhibit adoption of new technologies? • High-yielding varieties have higher yields but may also be riskier • So households unwilling to bear fluctuations in their consumption may decide not to adopt • Downside risk of adoption may be exacerbated when adoption requires credit • Failure of crop is compounded by the consequences of default • Problem: absent or imperfect insurance markets

41. This paper • A field experiment where insurance was allocated randomly • Question of interest: Does providing insurance against a major source of risk increase farmers’ willingness to take out a loan to adopt a new technology? • Adoption decision: whether or not to take out a loan for improved groundnut and maize seeds

42. Harvesting groundnuts

43. Weather insurance and loan take-up in theory • Risk-averse farmers choose between traditional seeds, and taking out loan for improved seeds • Improved seeds have higher mean yield, but are riskier • Consider attractiveness of bundling loan with weather insurance (at actuarially fair rate) • Loans subject to limited liability: in case of default, lender can only seize the value of production • Under certain conditions, farmers might take the uninsured loan if offered, but prefer the status quo (traditional seeds) to the insured loan • Basic idea: limited liability provides implicit insurance • Insurance premium may exceed benefit from insurance • Rosenzweig and Wolpin (1993): welfare gain from actuarially-fair weather insurance is minimal

44. Simple model • Output from traditional seeds: YT • Output from improved seeds: YH, YL with probabilities p, 1-p • Output positively covaries with rainfall • Farmers are offered loans to purchase improved seeds (repayment R); lender can only confiscate production, but cannot seize assets (so there is a consumption floor) • CRRA utility: u(c) = c1-s/(1-s) • Farmers are heterogeneous in risk aversion (si) and low-state income from improved seeds (YL,i) • Some farmers offered loan bundled with actuarially fair rainfall insurance policy (loan forgiven if low state occurs) • Does rainfall insurance raise loan take-up?

45. What farmers take up the loan? • Find coefficient of relative risk aversion sTU(YL) such that farmer whose si = sTU is indifferent between traditional seeds and uninsured loan for hybrid seeds • Farmer takes up the uninsured loan if si < sTU • Find analogous cutoff for insured loan, sTI(YL) • Cutoffs will be function of income from improved seeds in low state, YL • See Figure 1

46. Figure 1

47. Key partners in project • Rural lenders • Malawi Rural Finance Company (MRFC) • Opportunity International Bank of Malawi (OIBM) • National Smallholder Farmers Association of Malawi (NASFAM) • Contact with farmers • Insurance Association of Malawi • Underwrites insurance • World Bank / University of Michigan • Technical advice on design of insurance policy • Design of randomized evaluation

48. Experimental design • Joint liability loans for “clubs” of 10-15 farmers • Participation is individual farmer decision • Randomization across 32 localities • Treatment: farmers offered hybrid seed loan with insurance against poor rainfall • 393 farmers • Control: farmers offered hybrid seed loan only (no insurance) • 394 farmers

49. Loan details • Farmers given option to purchase either groundnut package only, or both groundnut and maize • Seeds and fertilizer for planting 1 acre (groundnut) or ½ acre (maize) • Initial deposit of 12.5% of principal • Repayment due in 10 months • 27.5% interest rate (33% annual interest rate x 10/12) • Maize repayment: • Uninsured: $36 • Insured: $40-$43 • Groundnut repayment: • Uninsured: $34 • Insured: $36-$38

50. Weather insurance policy • Farmers insured against poor rainfall as measured at nearest weather station • Paid continuous amount depending on shortfall below “1st trigger”, up to maximum amount for rainfall at or below “2nd trigger” • Insurance premium = actuarially fair price + 17.5% surtax