Geri Mason & Jason Korsmeyer
Geri lives in Tacoma, Washington, is currently teaching at the University of Puget Sound and is a PhD candidate focusing on the China microfinance sector. Jason now lives in Boston and spent a year researching and writing on China microfinance with Wokai in Beijing.
The popular definition for microfinance is small loans given to low-income entrepreneurs who lack the ability to receive loans from a formal bank. However, this definition is incomplete and only refers to a part of the microfinance industry known as microcredit. Microcredit was the first aspect of microfinance to develop, but as microfinance grew, it became clear that the poor needed more financial services, so microsavings, microinsurance, and remittances where introduced. Today, the most succinct and complete definition of microfinance is as follows: a variety of financial services, such as credit, savings, insurance, and remittances that are provided to poor entrepreneurs. To wholly understand this definition, we must explain microfinance’s origin and growth.
Modern microcredit originated in war-ravaged Bangladesh in the early 1970s. In 1971, Bangladesh won its independence from Pakistan, but the damaged inflicted from war, along with the subsequent floods and famine, pushed Bangladesh into extreme poverty. In 1976, a professor named Muhammad Yunus, in response to the poverty engulfing the country, began to give small loans to the poor. Due to the lack of available resources, Muhammad Yunus provided loans using his own money, with the conviction that they would be repaid. To the surprise of others, the loans were repaid, and by 1983, the government registered the Grameen Foundation, Muhammad Yunus’s organization, as a formal bank.
The Grameen Bank employed three specific lending practices that generated its success. First, the Grameen Bank loaned under joint liability contracts, a system which enables the lender to regulate borrowers without credit histories or collateral. A joint liability contract requires an individual seeking a loan to form a group, consisting of three to eight other individuals from the same community seeking credit.
Five was the common group size used in the Grameen model. Once the group was formed, loans were dispersed to two people within the group at a time. When the first members of the group take out a loan, each person in the group is responsible for the loan. So if one individual does not repay his loan on time, or falls into trouble repaying at all, then the rest of the group has incentive to cover that amount. If the entire loan is not repaid, then no other member of the group is able to take out another loan. Thus, the joint liability contract effectively replaces credit histories with group guarantees, and collateral with peer pressure and monitoring, using access to future loans as an incentive to monitor and insure fellow group members.
Second, the majority of Grameen Bank loans were, and still are, issued to women. Professor Yunus was initially drawn to lend to this segment of the population by witnessing the hard working women, with viable business ideas, that were excluded from the formal credit markets of Bangladesh because of their gender. It has since been found that women have statistically higher rates of repayment than men. Familial connections and domestic responsibilities, as well as their close ties to social groups and the importance of societal norms and peer pressures in their daily lives, have been cited as major reasons why their repayment rates have consistently been higher. The combination of these factors makes women less likely to abscond with or misuse loan funds. The practice of extending credit to women has empowered females in poor households throughout the world.
Third, interest rates charged on loans are higher than they would be at a formal bank. It may seem counterintuitive to charge the poorest borrowers higher interest rates. From the perspective of the Grameen Bank, however, this practice is necessary because the transaction costs of lending to poor clients, without collateral and in the absence of complete information infrastructures, are much higher.
The screening process of a formal bank would involve a quick credit history check. Informal financing of this kind, however, involves seeking and confirming personal knowledge of the borrower, as there is no formal record of her credit history. Monitoring costs are also higher, involving personal visits with the borrowers and their projects. A third factor increasing the transaction costs of lending to the poor is the lack of legal recourse in the event of default. Even if the legal infrastructure exists to sue for the loan principle, the cost of the legal procedure will be much more than the principle amount of a micro loan.
To visualize this difference, consider the following numerical example. Assume that the absolute transaction costs of a single loan is the same for a formal bank as it is for a microlending institution: $10. Hypothetically, if a formal bank’s average loan size is $10,000, and it costs $10 for them to draw up a contract, complete a credit check and have an agent meet with the borrower, then the percentage cost to complete the transaction on the entire loan would be 0.1%. But, if the Grameen Bank’s average loan is $100, and its transaction costs are still $10, the total percentage of the transaction cost would be 10%. Therefore, to combat this relatively higher transaction cost, the Grameen Bank needs to charge higher interest rates.
This only explains one side of the story, however. The more interesting question is: Why would poor borrowers be willing to accept high interest rates? Surprisingly, the reason is because poor borrowers can expect large returns on their investments. The most common example used in economics to explain this phenomenon is to imagine a poor corn farmer. If this poor farmer doesn’t own a plow, his corn production will be very low. But if he is able to buy one plow, his production will increase drastically. By buying a second plow his production will increase, but less than when he added the first plow, and for each additional plow the farmer adds, his increase in production will be less and less. This economic concept is known as decreasing marginal returns to capital, and can be applied to other industries as well. For example, adding the first freezer to restaurant or sewing machine to a tailor shop will be more productive to the business than subsequent additions. Poor borrowers are willing and able to pay high interest rates on loans because high returns are expected from these initial investments.
By establishing these three characteristics in lending practices, the Grameen Bank was able to provide loans to the poor and also able to cover operational costs through interest rates and service charges. Poor borrowers lives are improved through access to loans, and microfinance institutions can become financially sustainable through the process of providing these loans.
Many institutions worldwide have adapted the Grameen Bank model and met with success. One successful example is the Foundation for International Community Assistance (FINCA). In 1984, FINCA initiated the “village bank” system in Bolivia to provide micro loans. The success of this program has allowed FINCA to establish itself across Latin America, Eurasia, Africa and the Middle East; and, in February of 2007, FINCA surpassed the 500,000 client milestone. In 1993, the first pilot microfinance institution initiated operations in rural China.
As these new institutions emerged, it became clear that loans were only one financial service that poor individuals could benefit from. Access to formal savings increases household stability and allows safe holding liquid capital in poor households and communities. Insurance protects low-income farmers from floods, droughts, and other unexpected disasters. Remittances give individuals who have relocated the ability to pursue economic opportunities and send earnings home to family members. As the microlending industry has developed and evolved, lending institutions have put together a collection of financial products in the aforementioned areas to better serve the needs of their clients as microfinance institutions offering a complete set of financial services.
With these developments, the current outlook for the microfinance sector is positive. Not only has the industry received worldwide recognition—the UN declared 2005 the year of Microfinance and in 2006 Muhammad Yunus received the Noble peace prize—but also, the sector’s potential is bright. In 2004, the Social Enterprise Associates estimated the market demand for microfinance at 300 billion, of which only 30 billion has been met. There is no doubt that an industry which will increase by 270 billion dollars, or 1000%, will only grow in significance. And while the financial potential for microfinance is impressive, more importantly, microfinance has provided 750 million poor individuals with the tools to increase their income, create businesses, and improve the stability of their household.
Great post, Geri!
Posted by: Ryan Calkins | March 23, 2009 at 01:39 PM