Some might not have heard about Muhammad Yunus. He is considered one of the most visionary business pioneers in finance. Economics professor at Bangladesh University, awarded in 2002 the Nobel Peace Prize, founder of Grameen Bank, was the first trailblazer for microcredit and microfinance practices. It is remarkable how far those ideas have gone nowadays: spread globally and grown rapidly over the past 15 years, the industry has reached approximately 150 million clients, almost 20% of its potential market of three billion poor. Yunus was the first one to think that it would be possible to make profits out of people and businesses that are not believed to be able to pay back their loans reliably and which are consequently out of the traditional credit market. Difficulties for poor people to access financial services are due to the social (e.g. lack of education) and geographical distance (e.g. strategic choice to not locate in poor areas) to the traditional financial institutions and to their intrinsic nature of poor, that is the inability to offer a collateral and the absence of a steady or high income. Muhammad Yunus defined a new role of financial institutions in development to ensure that limited resources are channelled to activities able to generate high private and social returns. In fact, financial services for poor people are a powerful instrument for reducing poverty, enabling them to build assets and increase their incomes. Savings, loans, and money transfers enable poor families to invest in businesses, to improve living conditions, affording better food, health and education. Microfinance has undoubtedly marked the world of international development in poor regions.
To understand the dimensions of this on-going “revolution”, we shall examine in first place the market for microfinance borrowers. From the results of the 2014 report of Microcredit Summit Campaign we comment briefly the highest numbers of clients relative to their population by countries. Among the countries considered in this chart, only Bangladesh appears to be approaching market saturation, while others still show that large percentages of their poorest people do not have access to financial services (inclusion in the financial system means that the person has an account and full access to all those financial services that put that account to use in a meaningful and beneficial way).
The chart below shows, for each region, the percentage of adult population living on less than US$1.90 a day with respect to the percentage of them that are microfinance borrowers as reported to the Microcredit Summit Campaign, 2014.
The studies of the report display that most countries with high population densities and lower GDP per capita, characteristics that are frequently found in much of Asia, have higher proportions of their poorest populations (that is living under US$1.90 a day) with access to microfinance loans. In Latin America, Middle East and North Africa those poorest reach a smaller proportion of the population. The real troubles for MFIs (Micro Finance Institutions) are in Sub-Saharan Africa: it still has a large proportion of people living on less than US$1.90 a day, but low population density and higher operating costs make it difficult for those institutions to reach these clients cost-effectively.
The situation of the worldwide financial inclusion briefly depicted is somehow surprising. We now move from some basic economics principles to understand why capital does not naturally flow to the poor. The principle we are about to consider is the one of diminishing marginal returns to capital, derived from the assumption of concavity of the production function (the assumption is intuitive: the more the firm invest and uses capital K, the more output Y it produces, but each additional unit of capital K will bring smaller and smaller marginal gains).
It basically says that businesses with little capital should be able to get greater returns on their investments than richer ones, which use more capital, and thus to be able to pay higher interest rates. According to this principle, money should move from rich depositors to poor businesses. The marginal gains obviously determine borrowers’ ability to pay. So the poorer the firm, the less the capital used, the higher the marginal returns and the higher the ability to repay loans, even at high interest rates. The Nobel winning economist Robert Lucas Jr. finds surprising results across countries applying this principle: for instance, Indian borrowers, in 1990, should have been willing to pay capital 58 times more than American ones, and money should have been flowing from USA to India.
Why empirical world shows us the opposite? Why money flows to rich countries from poor indeed? Why traditional credit market fail in poor regions? Well, in the model we have not really taken into account few important factors when the bank is considering to lend capital to someone: the risk of investing in such uncertain environments as developing economies, the lack of information about poor borrowers and their inability to offer collateral as security. About incomplete information it is useful to define two types of problems. The first problem, adverse selection, occurs when the bank is not able to identify the degree of risk of the customer. The bank would like to charge riskier borrowers with higher interest rates but, given the asymmetric information, it would raise the average interest rate, leaving poorer people out of the credit market. The second problem, moral hazard, occurs when the bank is not able to verify the level of effort of their clients in ensuring the good realization of bank’s investment projects. Moreover, these problems are amplified in countries where the judicial system in weak, that is where it is not able to properly enforce contracts. Banks too do not have the instruments to efficiently collect information and enforce contracts, given the high transaction costs arisen when operating in poor communities (it is naturally more costly to handle many small operations instead of few big ones).
Reducing transactions costs and overcoming information problems are the true goals of microfinance. In communities where the lack of banks is a reality, microfinance becomes the way to bring money form the outside to the communities, which otherwise would have relied on local moneylenders, local traders, or simply neighbours and relatives. Of course microfinance is not the first attempt to overcome these problems. In the past, low-income countries gave the responsibility to large state agricultural banks to allocate funds and subsidized credit to rural areas, in order to increase their productivity, wages and labour demands. Not only that, states started to compensate entering banks, which otherwise would be discouraged by the perspective of losses due to investing in a risky country with high transaction costs. These subsidies were also used to keep interest rates low, but the policy turned out to be a disaster, because wealth and political favours substituted profit as the measure by which the credit was lent. So the poorest areas were left behind and eventually subsidised banks created monopolies.
Then this is when the story of Prof Muhammad Yunus and its Grameen Bank begins, where the concept of “microcredit” is firstly presented to the world. Grameen’ s lending contract to businesses is very different from the traditional ones. Usually, the borrower offers the bank a collateral as security, gets the money and starts investing them to make a profit and in the end he repays the loan back plus interests. If he is not able to repay, and his investment is not successful, he looses the collateral. The problem arises when the client is too poor to offer a collateral. Grameen tackled it tacking advantage of the strong relationships between the individuals of a community: groups are voluntarily formed and each individual is supposed to help the other when one is not able to pay back his loan. This is the so-called “joint liability” condition and this is how it works: the groups are formed by five people where loans are distributed firstly among two of them, then among other two, and after that to the last member of the group. The cycle of lending keeps going as long as the members each time repay their loans reliably. As a consequence, if a member of the group defaults and the rest of the group refuses to help him with his debt, then the cycle interrupt and no additional loan is distributed to the rest of the members. The incentive to pay readily, to make sure the other members put effort to pay off their debts (here is how the method can limit moral hazard) and to select proper group members who are thought to be responsible is clear in this system. Risk borrowers will have no choice but to form groups with other risky borrowers. While all borrowers face exactly the same contracts with exactly the same interest rates, voluntary matching means that safe borrowers pay lower effective interest rates because their expected costs (including the cost of repaying for irresponisble group members) will be lower. Grameen also creates “dynamic incentives” which consists in starting with very small loans that gradually increases as long as reliability to pay off the debt is shown. The bank also uses a weekly repayment schedule, pretty unusual for traditional banks, which reduces the financial risks.
The problems of market failures that come from asymmetric information, high transactions costs and difficulties in enforcing contracts have been shown to be possibly avoidable by microfinance. It challenges evergreen assumptions about what poor households can and cannot achieve and shows the potential for innovative contracts and organizations to improve conditions in poor communities. It increases growth by providing financial resources to poor individuals otherwise cut out of the credit market. Microfinance is a clear improvement over the traditional banks in the fight against poverty, but achieving complete financial autonomy of low-income areas is a goal far from fulfilled.
The concept of “microfinance” was pushed by the recognition that households could benefit from accessible and defined financial services, focused especially on savings and not just on credit. Initiatives to provide “microinsurance” were also taken in rural areas, where usual cost related problems and information asymmetries are amplified by the major aggregate risk of contracting a disease or being hit by a flood. In order to get rid of those subsidies that characterized commercial banks experiences in the past, efforts are being made to adopt sustainable solutions to financial programs, especially the ones that use subsidies as a mean to help businesses in their early start-up phases. In order to do so, programs will need to mobilize capital by taking saving deposits or issuing bonds or banks must look for profitability from commercial sources. Another problem for microfinance to tackle is that its services are becoming more and more expensive. Applied interest rates rises. That could seem natural, given that microfinance is serving particularly borrowers with high credit risk, and defaults, as long as small loans are becoming more common, are becoming more frequent. Microfinancers have been forced to collect money from commercial lenders that charge high interest rates. A paper by MIX Market, which collects data from 1500 MFIs, shows that funding costs for them increased by 75% from 2004 to 2013 and interest rates from 30% and 35%. In the end, higher interest rates due to higher costs, which derive from operating with poor communities, are natural for financial institutions. The graphs below from MIX datas could help to show this relationship:
Rising interest rates has obviously a dark side: it would cut out from the credit market the poorest households that cannot pay for credit at high prices and as a consequence the gap with better-endowed entrepreneurs would be larger and larger, leading entire regions to a credit related poverty trap. Returning to the principle of diminishing marginal returns to capital, this is eventually consistent with the model, given that we have made the implicit assumption that everything but capital is constant (so we have not considered education level, network, access to inputs, etc.). Poorer entrepreneurs have then lower marginal returns despite having less capital and thus they would not be able to face high interest rates.
The combination of decades of innovation in the delivery of financial services to lower income populations and new digital technologies will make it possible for the financial system to reach the poorest communities with a set of basic services. Savings, credit, payments, and insurance can help to lead the way to the end of extreme poverty. It can create an economic system that provides every person with enough income to meet basic needs for nutrition, education, and health. As long as these objectives are accomplished, problems such as increasing interest rates and high costs derived by operating with the poor would decrease and more people would have access to financial services. Many pathways con be found to work together across the traditional divides of government, business, finance, and social services (e.g. improvement of graduation programs, reinforcement of agricultural chain, etc.). Each of these pathways asks MFIs to ally with social service providers, businesses and government agencies.
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