How do microfinance programs achieve such high repayment rates? Do these programs offer a solution to poverty?

Microfinance programs have achieved repayment rates typically above 95 percent. They have also successfully targeted poor individuals who have historically been excluded from accessing credit, including women.1 Given such success, it is important to ask how microfinance programs have been able to succeed when so many other credit extension programs have failed. Or, in other words, what exactly is new and different about microfinance? In this essay, I will show that microfinance programs have been able to achieve high repayment rates because they effectively overcome the obstacles in failing credit markets, the most important being information asymmetries. I will then proceed to evaluate the potential of microfinance to act as a solution to poverty. I will suggest that there are reasons to be cautious about the potential of microfinance, but that there is hope for microfinance to act as a mechanism to help particular groups of people in poor countries move out of poverty. Informational Asymmetries and Failing Credit Markets Asymmetries in information largely account for the imperfections in credit markets. There are two basic ways in which informational constraints limit the ability of credit markets to function as they would under perfect competition. First, lenders cannot perfectly monitor how the loans they issue will be used. That is, they cannot know for sure whether borrowers will use the money on risky or non-risky ventures, or whether the money will even be used in a productive fashion whatsoever. For example, a loan may ostensibly be taken out for a particular project, but then instead simply be used to increase the borrower’s current consumption, making it difficult for the borrower to eventually repay. Alternatively, the loan may be used on a high-risk venture, with a high probability of failure, which would also create a situation in which the borrower is unable to pay back the loan. This is known as involuntary default, and in this situation, there is little the lender can do to get the money back.2 Second, lenders cannot be sure of whether borrowers intend to repay. There are situations in which the borrower may be able to repay the loan, but simply does not find it in his or her interest to do so. This is known as voluntary or strategic default, and in the absence of strong legal enforcements, there is again little that the lender can do to get the loan money back. Without knowledge of the inherent characteristics of borrowers, or of their previous credit histories, lenders have no way of interpreting borrowers’ true intentions.3 As a result of these informational asymmetries, lenders fear both adverse selection and moral hazard—i.e., choosing the “wrong” borrower, or encouraging irresponsible behavior once a loan has been taken out. Thus, they tend to make overly cautious estimates regarding how many loans they should issue, and what rate they should charge for the loans. Additionally, lack of collateral makes it even more difficult for the poor in these communities to access potential credit markets.4 Informal moneylenders partially fill the gap that institutional credit lenders are unable to in rural credit markets. At the local level, informal moneylenders have much better access to the type of information required to operate effectively, and are also able to accept forms of collateral that institutional lenders may not be able to (labor, for example). Still, the use of informal moneylenders tends to make rural credit markets segmented, rationed, and unaffordable for the poor. Lenders will

1

Jonathan Morduch, “The Microfinance Problem,” Jorunal of Economic Literature, Vol. XXXVII: 1571. 2 Debraj Ray, Development Economics, 529-586. 3 Ibid. 4 Ibid.

only issue loans to a limited clientele with whom they have a personalized relationship, will limit the credit that they do make available, and will also charge inordinately high interest rates.5 Traditionally, attempts to overcome the obstacles of rural credit markets have failed. Institutional lenders find it too risky to operate without access to the required level of “microinformation” that is generally more readily available to informal moneylenders. Informal moneylenders, on the other hand, do not find it in their interest to charge lower interest rates on their loans, or to make credit more widely available.6 Microfinance Institutions and High Repayment Rates Microfinance institutions have been able to fill part of the gap in rural credit markets by developing mechanisms to build upon the local information available to informal moneylenders, while also being able to extend more affordable credit to the poor who lack collateral. One of the most innovative and successful tools employed by microfinance institutions has been group-lending. Grouplending enables microfinance institutions to issue affordable loans to the poor by combining the advantages offered by local information with the “social assets” of enforcement.7 In the absence of collateral, group-lending is based upon joint liability, which holds all members of a group accountable if one member defaults. By utilizing peer selection and monitoring, grouplending helps to overcome the risks of adverse selection and moral hazard faced by both institutional and informal moneylenders. In the group-lending model, low-risk borrowers will group themselves with other low-risk borrowers, and will continually monitor how other members of the group are using their loans, so as to ensure repayment. Additionally, there may be strong social incentives—ranging from informal insurance relationships and threats, to social isolation and physical retribution—that may also prevent group members from defaulting.8 Combined, these elements of group-lending promote high repayment rates, even in the absence of collateral. Group-lending is not the only repayment mechanism employed by microfinance programs, however. Microfinance institutions also use dynamic incentives and regular repayment schedules that differ from standard loan contracts. Regular repayment is particularly important, since it screens out undisciplined borrowers, and provides early warnings if there are potential repayment difficulties. Additionally, all microfinance programs only issue “progressive” loans to borrowers, which provides incentives for repayment since borrowers can expect to obtain more loans in the future.9 Microfinance Institutions and Poverty Reduction Given the success of microfinance programs in achieving high repayment rates amongst poor borrowers, it is critical to assess the extent to which microfinance offers a solution to poverty. Before proceeding, it is important to note, as Morduch does, that there is a serious lack of sound statistical data on microfinance’s capacity to reduce poverty. One of the reasons for this is that it is difficult to control for other variables when comparing individuals before and after they receive their loans, which is how microfinance institutions typically evaluate their performance. Because microfinance programs have been so successful at targeting good borrowers, it is difficult to say how these borrowers’ lives would have been different without a microfinance program. They cannot simply be compared to others who did not receive loans, since they possess certain characteristics that made them good borrowers in the

5 6

Ibid. Ibid. 7 Morduch. 8 Jonathan Morduch, “The Microfinance Problem,” Jorunal of Economic Literature, Vol. XXXVII: 1575. 9 Ibid: 1580-1590.

first place. These same characteristics—creativity, drive, etc.—may have allowed these borrowers to find other ways of increasing their welfare even in the absence of microfinance programs.10 Although it is clear that microfinance alone is not responsible for reducing poverty amongst borrowers, it is still important to note the role that microfinance does play in providing the tools for this select group of people to move out of poverty. Access to credit allows borrowers to invest money in productive activities that will supplement future consumption without sacrificing current consumption. Furthermore, once individuals have successfully repaid one microfinance loan, they can then access yet another, larger loan, to increase production even further, and continue to move out of poverty. There are limitations, though, on the extent to which microfinance programs can act as a solution to poverty. Microfinance programs have such high repayment rates as a result of their ability to target “good” borrowers, as outlined above. Hence, microfinance does not offer a solution for ending poverty amongst other, “bad” borrowers in these markets. Still, even though these individuals are not able to directly benefit from the credit opportunities afforded by participation in a microfinance program, there are still positive spillover effects from the presence of microfinance programs in their communities. These are often referred to as “tie-ins,” and can include social services, such as healthcare and education, which have important benefits beyond those whom they directly service. Finally, it is important to briefly consider the viability of microfinance programs when discussing their potential to reduce poverty. Currently, many microfinance programs are subsidized so that they can provide loans with low interest rates to poor individuals. The Grameen Bank, for example, currently charges between 12 and 16.6 percent interest, but would have to charge between 32 and 45 percent to cover all the subsidies it receives. Hence, the “win-win” position often advanced by supporters of microfinance does not currently play out in reality.11 In order to determine whether or not these programs would be financially sustainable in the absence of subsidies, further research would need to be conducted to evaluate the elasticity of demand for credit by the poor. Currently, the extent to which these programs can reduce poverty is at least partially dependent on the willingness of grantgivers to continue to subsidize them. Conclusions Microfinance programs have been able to overcome asymmetries in information by utilizing mechanisms that take advantage of local information and social enforcement. This means that they have been able to combine the advantages of a large, institutional bank with strategies that have typically been employed by traditional, group-based modes of informal finance. As a result, they have been able to achieve high repayment rates, and issue loans to the poor who lack collateral, and would otherwise not have access to credit. As a solution to poverty, microfinance has the potential to help those segments of rural credit markets it has been able to target as “good” borrowers, but does not offer a panacea to poverty, since it is clear that is not the way to move all individuals out of poverty. It is, however, an important component of a poverty-reduction scheme that should not be dismissed.

10 11

Ray, 582. Ray, 581.

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