A_comparative - A Comparative Review of Major Types of...

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Unformatted text preview: A Comparative Review of Major Types of Rural Microfinanoe Institutions in Developing Countries Mm! {reel Eeller Abstract This paper describes dill'erent types of rural iiiieroilnauce Institutions. and examines Lhelr comparative advantages as well as related challenges to and strategies for deepening rurtd financial systems. The focus is not about which type of institution is better or worse for a particular target clientele in a particular operators environment. Instead. one of the major recommendations of this study is that there is no blueprint for rural mieroflnance. Institutional diversity is desired in enhanoe competition. depth and breadth of outreach. and welfare impact. Key words: agricultural development. financial sustainability. Inicrofinance institutions. outreach. rural development. rural lirmnee, savings and credit cooperatives. solidarity group lending. 'u'lllt-‘igt: banks Manfred Earlier in f‘I'II-Jles-orir for Euro] Lievelnpruem Tl'lirui'y and [‘I'Ilit‘y. lrtr-Liiuie iil' rapt-cultural Economics and Frontal Sciences in the Tropic:- ELEILI Subtroptirs. Uno'crslly of iiohr nheim. Stuttgart. Gennany. This paper was made possible by support provided in part by the US. Agency 1'0? international Development l'lJSfiiD] Agreement No. LAG-h UU-Qfl-Qflfllfl—flt} through Broadening Access and 51 rcngt hermig input Market Systems Collaborative Research Support Pnnb'mn [BASE—CHEAP] and the World Council of Credit Unions. inc. M'oceut. Alli-tests. inteniretatlona. rt'euinmt'ndallnns. and conclusions expressed here are LhflF-t‘. of the auLhnr and not necessarily those of the. supporting or collaborating Instltutlorts. Review coimitnatcd by Calutn G. ‘l‘iii‘eey. Why Is There a Renewed Interest in Rural and Agricultural Finance for Developing Countries? Since the widespread recognition in the mid—iQBDs of the failure of the old paradigm of directed agricultural credit with subsidized interest rates. rural and agricultural finance kept a low profile on the agenda of many governments and donors. Retently. there has been a renewed interest by policy malters. donors. and international development organizations In rural as well as agricultural. finance. prompted by publication of new strategy papers on rural and agricultural finance by major development organizations [see Wenner. 2002'. Food and agriculture Organisation. 1938: Klein et al.. 199533: and International i-‘tmd for Agricultural Development iiFnD]. QUE-OI. l basically see three principal motivations for this renewed interest. discussed below. The Decline in Formal Rural and Agricultural Eredlt Supply F‘lIsi. with the dismantling oi" government and donor support to subsidized agricultural finance starting in the mid—1980s. and In conjunction with structural adjustment programs delirilting and privatize-1g the supply of agricultural inputs. marketing of agricultural produce. and provision oi'credii previously given by parastatai organizations in many countries. the supply of formal rural and agricultural credit appears to have declined considerably. Little to known 196 Rural Microfinrmce institutions in Developing Cotottrtes about how much of this commonly perceived decline of stateudrlve'n credit has been compensated for by an increase in informal credit granted by traders. agribusiness firms. and inlbrrnal savings and credit groups.l in most developing countries. commercial banks have not entered the rural and agricultural credit market on a substantial scale. After liberalization. some commercial banks actually closed rural branches iii-tenner. 2002i. Macroeconomic stability. sound legal frameworks. and Financial sector liberalization are necessary. but not suificient conditions for expanding the financial frontier. A few developing countries. mainly in North Africa. the Middle East. and South and East Asia [Sicinwani ZEUS]. such as Emmi. China. india. and Pakistan. continued with their state-owned so bstdjzed rural banking infrastructure Elm. Zhongyi. and von Braun. 2002: Meyer and Nagarajan. Bil-Di]: All. Malllt. and Keller. 1994: Sliarnra. Foda. and Keller. ll-lEl'Eil. Other countries experienced success because they transformed their agricultural development banks with a focus on designing demand-oriented sort-“idea and recovering costs. as is the case with the Bank for Agriculture and Agricultural Cooperatives [ERAS] In Thailand and the microbahking system of the Rural Bani: {HRH in Indonesia Waron. 1992; Yaron. McDonald. and Fipi'ek. 159T: Patten. ltosengard. and Johnston. coon. Today. it is still important to recall why these institutions need to be either dismantled or transformed. Indeed. repeating the same mistakes would be a waste of scarce resources}1 I therefore '1‘wo studios. each cowering four .Iiri'rlcan countries. have not identified any flTecte of Financial Ubrrallzatton an the jZ-I'IM and availability of inl'orn'lal credit titles-Icy. 1999; Steele et til.. NET]. 2 For a comprehensive critique oi the old paradigm nl' subsidized and directed agricultural credit raid on changes in paradigms arid views. sec Mama “93-8-1: volt Flat-hire and Marne E1980].- Adams and van Ptochhe [IQB‘HL Kraimcn and Schmidt [mg-ti; anrl Meyer and Nacamlan millim- begin with a recorrunendatlon: We must icamficm the postfotlures of directed. subsidized agricultural credit programs eoen if these-Jotiures have been doctonented many years ergo. This knowledge is still relevant today. Yet. many view the decline of rural and agncuitural credit as disconcerting. and questions naturally arise as to whether it could he done any better in the future. The Role of Rural Finance for Agricultural and Econoan Growth. Food Security. and Poverty Reduction Second. while agriculture is. relatively speaking. a declining sector in the course of development. in many developing countries it is still a leading economic sector. the main exporter. and the major employer. especially for the poor and women. improved financial marl-tots aceElerate agricuiturei and rural growth. Financial services assist households in maintaining food security and smoothingr consumption. thereby safeguarding or enhancing labor productivity. the moat important production factor of the poor lvon Braun et al.. 1992: lleidhues. 1995: Morduch. 1995: Zeller. 1995; chlor ct al.. 199?: Zeller. econ. Because of agnwllan's strong ionvard and backerard multiplier effects for the overall economy [Mellon 1955]. economic growth in agricu]tu.re—especially in subsectors that directly or indirectly benefit smallholdcrs. tenants. and wage laborers—ls a key precondition for overall economic growth and poverty reduction. .t’il. present. most of the poor still live in rural areas. Doing Better This ’l'i1:ru.-.-“iI Third. and possibly most. important. the hope of being.r able to do it better this time clearly comes from our maceration of the financial sustainability of a small. but Increasing number of nucroi‘inancc Institutions iMFlsl and their considerable achievements in reaching large numbers Agricultural Finance Review. Fail EDGE Zetier 19? of relatively poor women and men. Successful MFIs [some for eimmple. featured in the Mtcrobnrtl-tirig Btdletinl already operate—at least partially—tn rural areas. albeit much of tlteir lending is for nonfarm et-iterprisesfL There is also more hope this time around because of more suitable conditions in both the macro—economy and agricultural sector in many countries [see Gonzalez—Vega. 2003] that underwent structural adjustment. financial. and agricultural sector reform. Retan experience during the 1990's in transl'omtation countries also strongly supports the view tltat macroeconomic and sectoral reforms need to precede efiorts to build rural financial systems and institutions. There is little hope in buildan sustainable. self-reliant banking structure as long as they are financially tied {to-id often dependent on! tosssmal-dng public-sector enterprises that are kept in business by state subsidies [l'ieldhues. Davis. and Sehrieder. 1998}. Moreover. the improved theoretical framework and empirical knowledge on how demand and supply of credit is determined and on the role of information asymmetry creating transaction costs help to foster a better understanding of the potentials and limits of financial services for poverty reduction and economic growl-i. Learning from Informal Demand. and Supply This sectiott highlights lessons learned from informal financial institutions. This knowledge has been Important for " l‘tnnttl'IILR innovations Include. for example. to] rim Marxism for Ste-ml advancement MEN. the Grantees Hank. and HEM: in handset-sh who began as 1111:” ammonium: organizalions tNGflsi In the tmd- ii'li'i'la; [til transfortttation ofthc rural baiil-t network of Hit! in Indonesia: [cl Pmdem. an NGD that transformed Lrito Indore Buncorsol in Bolivia: [dl tilt Self-Employed worm-it's Association terms]. a women's man-men: tn must-st. indta. that was one of Iht'! fu'ot. NGDs to fan“ a. bank and Lo retail Lnsuraruit pmtlucra such as 1m- and health insurance to poor women: and lei Calpia. a mlcmbaitlt in El Salvador that alters financial. senders to a broad (“Bertie-lo. int-ludtng small farmers. institutional inntwation and differentiation to formal rural finance. Lending Among Relatives. Neighbors. and Friends Borrowing from socially close lenders within the moral economy is often the first recourse of poor households [or financing expenses. especially those related to essential consumption expenditures. Transactions are collateral-free. and in most cases interest is not charged. These are essentially informal mutual aid schemes that have the principle of reciprocity at the core of transactions. Hence. both the lender tdeposit-taker. or insurance provider] and the client gain from the transaction. and the process is self-sustaining. The borrower is able to finance urgently needed expenditures quickly and with few transactions costs: a lengthy appraisal process does not exist. little or no paperwork or travel time is involved. and the terms of transactions are well understood. The lender gains a right to reciprocity that he or she can lay claim to in the future. Furthermore. the risk of loan recovery is at a minimum since tltc lender only lends to persons who are part of his or her social network. within which contracts can be enforced. For each partner. therefore. the longrtea‘rn gains associated with maintaining borrowing privilege is greater than the short-term gain of reneglng on the payback. Such social capital and ttyhmtdlfil'tanctnl cone-nets can be exploited and used through the formation ofmemher-bnsed institutions. Rotating Credit and Savings Associations [Roscoe] Found in many countries. ROSCAS are also network-based. These associations. which may even operate under a designated. sometimes remunerated manager. pool sayings front members each period and rotate the resulting pot among thent using various rules. The process ls repeated until the last member receives 193 Rural Mtcrofi'tonee Institutions in Deueiopo-tg Courttttes the pot. Because of the rotation rules. these schemes are less suited to address household rislt unless the timing of the receipt tomcidcs wllh unexpected events. Other ROSCns auction the fund. Still others allow the fund to be paid out earlier in times of crisis of one oiits members. at times requiring a premium payment. Also. unlike demand deposits. once the savings are. committed. they cannot be addidrawn immediately and the member is required to unit her tum. The main purpose ofa RDSCfl is to accumulate sayings and channel this to borrowers In some prespeclfled order. therebyr fulfilling an Important lntermediation function. informoifinoncini self-help groups exist in nutny comm-lies. and lame inspired to some extent the innomttions in solidarity group lending as toe-ll as hurtling. biannual Moneylenders and Pawnbrokers 'I‘ypically. informal moneylendm-s and pawnbroltecrs are approached when the amount demanded ie.g.. loan amount and its tinting. sometimes requiring a need for confidentiality} cannot. be fulfilled by sociallyr close lenders. such as friecrtds. neighbors. or RDSCAs. Moneylenders charge explicit interest rates In order to obtain real positive returns on their capital. in fact. Interest rates are usually high. and real rates in the range of 540% per month are common. Commonly. tnoncylendcrs lend only to households about whom they possess enough information. However. they may aLso lead to others about whom they possess less Irtlbrrnailon lfpunitltre actions agalnst those who default are feasible. Landing may be secured either by physical collateral [e.g.. land. movable property such as gold and jewelry. or by production assets such as animals and standing cropsi. or by sot-tin] collateral. such as third—party guarantees or loss of reputation in one‘s social network. These collateral substitutes are effective. in sustaining the informal lending business because conh‘act enforcement is legitimized by social norms. Member- based institutions. sucttas utiler bunks, groups. and settings and credit cooperatives. have a comparative admth ooer socially distant banks in using social oopttoijor the enforcement of their contracts. Also. deposit-toing institutions Fetus a oomporotiue fldlitmft'ig-E in using informal enforcement mechanisms coupon-ed to institutions that tend “cold "' money. Tied Credit Informal. but socially andtor spatially distant lenders frequenfly tie their loans to complementary transactions In land. labor. or commodities as they lack adequate information about the creditworthiness of the borrower or suitable physch or social collateral. Thus. traders disburse input and consumption credit to farmers in exchange for the right to market the growing crop: shopkeepers increase sales by providing credit for food. farm inputs. and household necessities: and landowners secure access to laborers to whom they lent In the hungry season. The important feature of these types of transactions is that the lender also deals with the borrower in a non-lending capacity and is able to use this position to screen applicants and enforce contracts at relatively low transaction costs comparcd to a pure money-lending contract. In the complementary nonflnancial contract. the lender often exercises near-monopoly power [such as often occurs between landlord and tenant or employer and laborer] that may feature usurious it.c.. monopolistlcally priced} interest rates. Tied credit has frequently been used by state—owned marketing boards that monopolize agricultural input supply and output marketmg It Is also used by agribusins processing firms that. control critical bottlenecks in the. production or marketing of agricultural and often perishable products. However. the Agricultural Finance Re‘otew. Fall 2006 Keller 199 dcmgutntton nnn' {liberalization ofogncnltumt markets has reduced the scope ofustng tted (“timers as collateral stabstitttIES In rural lent-Thy. The four informal Institutions described above provide valuable financial scntoes. and much that}.' be learned from them. However. they should not be romanticized. Lendlnll,r among family members and friends as well as RDSCss ma}F bear a high risk. for poor people. for example with respect to default or social emlusion. information tends to be segmented and to circulate within specific groups or networks excluding others [Robins-on. Eflflll. Communlties can be driven by vested interests oflhe Inca] elite. Moreover. all of the noose tnstmutms have sea-tons ltntttdttons with respect to lens and also transformation liquidity. and risk dutcrsttleolton because they.r are based on personal relationships and reciprocity and deal in socially. culturally. economically. or geographically ilrniicd sectors. While finance is certainly not charity. instii utionvbuildlng and innovation in ntral finance can be significantly fostered by public investment. Such investment must be. appraised with the some evaluation criteria as for any other public investment. The social bonefll‘ooSl ratio of public support for MFls will be affected by many factors. including the macro policy. socioeconomic. and agroceolog‘ica] environment {chler and Meyer. 2002}. Some cnotronnrtsnrs may be so hostile to fictional—sector development that puhtte Investments in Mitts will certru'nlp getter-cue o negnttoe soettll relttm. whereas in others the some inmatmcnt can be ldghiy profitable. Types of Rural Financial Institutions Introduction The highly diverse rural and agricultural eharacteriotlds call for different types of financial institutions. each having comparative advantages and addressing specific market. segments. lnstllutlonol trmooottons tn mtcrofinonce are nasty the pure product ot'moncctforoea instead. the orator otnooottons in confomuty with market principles have been fostered by public muesttnents or by private ttltt'tltstio action. The. large and successful MFIs reaching the poor in developitul,r countries have. all rolled on public investments by denote and governments. at least during their formation stage. Because of widespread market imperfections concerning financial senior-s to the poor. institutional innovation and expansion in mteroflnance are seldom solely market—driven. but a process that has been nurtured by the public sector. civic organisations. and altruich leaders." The following examples may.r substantiate this claim. I Solidarity Groups: The Eruption Bank. Professor Muhammad Yunus addressed the banking problem faced by the poor in Bangladesh through a program of privatelyr funded. altruiaticallg.r motivated action-research. in told. with help from his graduate students at Chittagong Unlversitv. he designed an experimental credit program to serve the poor. It spread rapt-ill}.r to hundreds of villages. Through a special relationship with rural state—ounerl banks. he disbursed and recovered thousands of loans. However. the. bard-{era refused to take over the project at the end of the pilot phase. 'l‘heg.r feared it was too expensive and risky in spite of Professor 't‘unus' success. Eventually. through the support of donors. the Grameen Bank was founded In 1933. and now serves more than two million borrowars. ‘Pnuotejocp'om RM has contrttnded ltn'lc. to the memo-tonne rsuolutton that las- hose tutti-mam tn the post to years chotcfor—protlt nova will be nestled to {to to scale. and have ordered the omnflnmeo ninth-f. rag” thrown thejolmdutton ql'rntcmbnnksfrom scratch. Going to scale was enabled by creation of microbanidng knowledge—mainly through nort- Istrut-rrnmcni organisatlonsu-that was greatly facilitated by altnllstltv action and pubUc aneslmcrI-t. 20C Rural Mtcrofutrmce institutions in Developmg Countries % I Credit Union Movement in 19th Century Europe. The origins of the microfinance movement lie in Germany. where the concept of the credit cooperative Was developed by Friedrich Wilhelm Raiffetsen and Herrmann Scltolxe von Delltzsch in the 134th and ldfitls. Their altruistic rather than profit-maximising action was motivated out of a concern to assist the rural population to break out of their dcpcndence on moneylenders and to unprove their welfare. After this institutional innovation. sincr about lBTC. the unions expanded more and more rapidly within Gemiany with little or no government support. Similar emerimcnts were conducted in other European countries at the time, and the cooperative movement quickly spread to North America and other regions [Hollis and Sweetman. 1993]. For example. by 1920. the Ukraine had over two million members of savings and credit cooperatives. and post~socialist Poland now has TDDCCD members. I State-owned Microbanle in tndouetliit. A much—heralded example of the microfinance movement is the village- lcvel lt’ilCrUlJflnlt system of the BRI in Indonesia. This state-owned bank Serves about 22 million nucrosavers with autonomously managed microbial-tits. 'l'l’tejyl are highlyr profitable. The mienibanlts of Hill are the product of a successful pro-business transformation of a state-owned rural credit program during the mid 19803. The above uniovations have something in common. They were created as the product of action by the state. donors. or altruistic leaders who facilitated social experimentation and institutional innovation. Hugo:- Types of Rural idiot-ottoman Institutions Institutional Innovation. This term does not necessarily mean to create a new institutional type at the international level {as the pioneers of the cooperative movement did]. but includes the adaptation ofan etdstbig institutional type to the constraints and potentials ofa certain client group in a specific local environment. The many different types or MP1s can be distinguished by two criteria: their legal status and their lending technology. thh respect to their legal status. one Call distinguish credit. projects. credit unions." village banks. and private- ioreprolit microbanlrs. Credit Projects. Credit projects are implemented by a supporting organization [state development agency or a non-government organization [NGCIJ] and are limited in time. Usually as part of or linked to a larger [integrated] rural development program. the rationale of the credit project to to finance critical inputs of so-cslled project beneficiaries. Issues of i‘u'tanelal sustainability usually receive little or no consideration at all: interest rates are often subsidised. repayment is low. and overhead is high. These give- and—t'orgive credit projects undermine systematic. long—team efforts to strengthen the financial system. The practice of revolving credit fluids features similar weaknesses [ltrahnen and Schmidt. 1994}. As credit projects and revolving credit funds laclt vision for institution-building. they will not he discussed further. Credit Unions. Credit unions are owned and controlled by their members and function according to democratic rules {if not disturbed by the central or local government. as is the ease in many developing countries. or by cronyism among members}. Profits are reinvested. or shared among members. Credit unions—especially larger ones with remunerated staff and professional management—are focused on profit. but the cooperative origins and the member-based governance structure also feature equity concerns for weaker members. “ In this paper. the term credit union is also used for savings and credit cooperatives. Agfietdtnrui Firtcruca items-tn. Fall 2006 Keller 2'01 __'_—_—-———_-——— The one-pcrsonfone-vote rule is a clear expression of the cooperative spirit of self- heip and care for weaker members In the cooperative movement. Credit unions are registered under a country‘s cooperative law or are included as a special category in the banking law. but may lack effective external sup-envision or authorizing legislation. The unions form regional and national networks that enable thenr to transfer excess liquidity. Credit unions are a viable lnstitrrtional type for rural microfinance: They can draw on 151] years of experience In rural and urban areas. and are in fact the number one provider of nricroflnance. The major comparative advantages of credit unions lie in their ability to servioe large numbers of depositors. and use these savings to provide a diversified range of loans to individual members. Other key at rengths are their ability to sustainably achieve a large breadth of outreach. and also considerable depth as suggested by median savings deposit and loan size and their distribution in several countries such as Bolivia. Ecuador. the Philippines. and $11 Lanita [Branch and Evans. 1995i: Evans. 2031]. While most members of credit ttnions are non-poor. they also reach many poor people because of their breadth of outreach. Recent. innovations in rural areas include lending to village banks [in cooperation with Frendom from Hunger in the Philippines] and to solidarity groups. Here. one key innovation is that potential credit union members are offered a choice his group loan itsllage banking} product or an individth loan product or a voluntary sauntgs prtxlttt'i [not lied to borrowing}. Government institutions have. often misused the cooperative movement for political purposes. In fact, government interference is a malor cause of cooperative failure—especially in developing oorrntt‘les. Cooperative perfonnance in rural areas Is mixed [Hraverman and Guasch. 1989: i-fuppi and Foster. 199D]. and changes in the regulatory and supervisory framework as well as technical assistance are often called for to improve performance. Krahnen and Schmidt titans] assert that the ownership and governance structure of credit unions tends to favor depositors over the interests of owners and borrowers. leading to a safetysofiented policy that sacrifices profitability and efficiency. However. under the risky conditions of rural areas in developing countries. this conservative policy can indeed be risk-eflietent in the eyes of risk- averse depositors and low-income owners. As Krahnen and Schmidt conclude. this conservatism is one of the reasons why credit unions are so widespread and have persisted for so long. after all. it is the majority of savers who are the backbone of a credit union. Village Barth. Village banks are send—formal. member—based institutions that are promoted by international NGCIs. first by rises and then later [with modifications to the orignai type with respect to complementary services or greater decision autonomy granted to members] by Freedom from Hunger. CARE. Save the Children. and others. Members own the village bank. but ownership is not [ta-inale registered. Members can decide on interest rates for internally generated savings deposits and arr-lending their internal account. Village banks usually feature high Interest rates on loans and savings deposits compared to going rates in the commercial banking sector. The banks serve a poorer clientele compared to credit unions. and have a high share of female members. 1village banks are promoted with the ultimate objective of reducing poverty. Emphasis is therefore on depth of outreach and impact on poverty reduction. and NGDs often provide complementary services such as education or business training to enhance impact. it village bank ls less complex in structure and administration than a credit union. thus enabling less educated members to manage the bank. However. startwup costs 202 Rural Microflnnnce Institutions in Developing Countries for formation and training are believed to be relatively high and are externally financed by Ll'lE supporting N00 and its donors. The main form of credit guarantee relies on social pressure. One of the major comparative advantages of village balms—especially for rural areas— is that they can operate as member— govemed. autonomous Institutions. and thus are highly flexible in determining rules of admission and the level of savings and loan interest rates adapted to local socioeconomic conditions. While the. expectation is that the village banks accumulate and retain sufficient equity capital to become sell-reliant. this objective olilnanclal sustainability has for the most part not been achieved. Village banks have shown great strength in reaching poorer clientele bui not in reaching financial sustainability. most likely because they chose more disadvantaged locations and clientele initially. Unless they are linked with a bank. credit union. or federation of village banks. a major disadvantage of village banks is that their savings and loan portfolio ls constrained and influenced by the local village economy. including Ilte threat of covariant risk. Because oi' the entail size of village banks [30—50 members]. it is unclear whether they have significant comparative advantage over informal community-based institutions in financial intermediatlon and pooling of risks. other than the access to donor-I'unded external capital for alt-lending to the local rural economy. From a financial systems perspective. the long-term sustainability and outreach of village hanks hinges upon their ability to integrate into the formal ilnancia] system. They need to establish linkages with banks or credit unions [or refinancing and for earning return on otherwise seasonally idle funds. as this seems to be their long-run competitive advantage compared to informal institutions. Federations of village banks may also serve these. intermediation functions across villages and rural areas. If they choose this mode of market integration. they will come close to couperaiive models. Chao-Herofi [1995” describes the successful example of the formation oi" self—reliant village banks that established a refinancing linkage with the National Agricultural Bank in Mali. Member-Based Institutions. Being membersbfled institutions. credit unions and village banks have some common characteristics and strengths. as reported in Table 1. These include building institutions that can empower communities as a whole and create social capital: their lower—cost iii—depth Information. for example. on low—income or illiterate clients: and the flexibility [at least In principle] to adjust interest rates and other terms for savings and credit products to location-specific; demand schedules. all these points are highlyr relevant for extending finance to heterogeneous rural areas and clientele groups. To be sustainable in rural and ogficulturnlfltonce. it Is critical that credit unions and village banks have mechanisms in put-cc to deposit amass liquidity or coll in loans throth rt linkage with bottles. or o second-tier or even nattonnt—teuelfademiion. Como-trait Hairs and sensmntity constitute clear limits to expansion and threats to surutuni‘for loool stand-dime institutions. Solidarity Credit Group. With respect to lending technology. there are dll'i'crcncos between individual lending and solidarity group lending. The magor characteristics of solidarity groups are listed in Table. 1.6 Major rural MFis [such as lIZZ-rameen Bani-t. ASA. SHARE. and the rural operations of the women—owned SEWA bank in lndia] ofl'cr loans to solidarity credit groups. The use ofsoiicidrity groups as retail institutions allows MFTs to reduce their transaction costs. and thereby increase their depth of poverty outreach? I"ill this paper. solidarity groups- are not considered to he MFls. as Table 1 may suggest. However. because they are an Institution. they feature comparative advantages as well as disadvantages that. are. relevant for rural agricultural lending or lending to the poor. an meaau cement of poverty outreach of micro- I'Inanoe institutions. see Keller et al 12065] and. van Bastelaer and Heller meme]. Agricultural F‘tm'trtce Review. Fall 2005 Zetter 2D?!- Large-scale solidarity group lending schemes operate either as banks [e.g.. Grameen Bank. SEWA]. or as Nil-C's piss. SHARE] that use the services of rural banks for deposits and payments between NGD branches and headquarters. ASA. an NGO founded in the isms. is financially sustainable in its established branches. perhaps because it efficiently uses the existing niral {state- owncdl banks. therebyr reducing overhead EDSTS. The four MFIs listed above are widely considered as sucocssl'ul In reaching poor women so that the amount ofsubsidy they have matured or currently require appears welt spentfiom a social investor's point of view [Morduch 1999]. Because they charge Inter-eat rates above the 'market' rates of banks. and bemuse they reach highly unattractive segments in the eyes of for-profit financial providers. the potential detrimental effects on competition in the financial system may have been low in the past. However. as competition becomes fierocr between the large. group-based MFls in Bangladesh. subsidies for individual poverty-focused lull-“Is may need to be reviewed in order to provide a more level playing“ field. The comparative advantages of solidarity credit groups in increasing depth of outreach are increasingly recognized and used by other Mt‘is. Linkage Type. This alternative retail group—based type builds on preexisting informal self-help groups {SHGsi. such as RDSans. Its major advantage is that group formation costs were already borne by the members. Like other member— based institutions. the “linkage model" tKropp. 1989: Seihel. 1985: Scibcl. Bassele. and Michell-hull. 1994} seeks to combine the strengths of erdsting informal systems [client proximity. flexibility. social capital. reaching poorer clients] Twith the strengths of the formal system {c.g.. risk pooling. term transformation. prtwision of long—tann investment loans. financial Inten'nedlntion across regions and sectors}. Linkage banking has been promoted by the German agency for Technical Cooperation [G'I‘ZJ in Indonmia and other Asian and African countries. and by the National Bank for Agriculture and Development in India [Meyer and Nagarajan. 2000}. Although 'linltage hanking' certainly has some comparative advantages for meal tntermediatlon. especially for poorer clientele. little empirical evidence exists to date on its performance. Don Rat-ll loading by member-Bacall Institutions and Solidarity Groups Transfer Transaction Costs to Clients? Yes—but by doing so. tvl'FIs can exploit the tnfon'rtatlonal cost advantages of member- based institutions. thereby lowering MFIs' overall system transaction costs when reaching poorer clientele [compared to a direct. Individual relationship between lender and borrower]. This question is raised as a point of critique against member-based and member-owned Institutions. most forcefully against village banks and solidarity group lending. While credit unions offer individual loan contracts. their participatory decision making creates transaction costs as well. albeit presumably not as hiin on a per capita basis as they are in village banks or solidarity credit groups that feature weekly meetings. However. this disadvantage. of higher transaction costs for clients does not weigh heavily in the eyes of those clients of member-based MFIs who are not able to get an individual loan contract from a commercial or microbanlt. precisely because Individual contracts carry higher transaction costs for the lender when dealing with poor. illiterate clientele—all other things equal. Merchants. Microhanks. as defined in this paper. represent a wide array of institutions. They do. however. have in common the primary operational focus of reaching financial sustainability. "they differ from commercial banks in two respects. First. they actotowladge and wish to serve the demand for financial services for micro- and small—scale 204 anl Mirroftnnrtcs institutions in Developing Countries Table 1. Types of Mieroflnenee Institutions and Major Characteristic- [1} Credit Unions less. supported by WU‘CCU. RalEfe-lssen. Denlai'dlnsj {9] Village Boot leis“ supported by FlNCfit ot' CIDRJ New group. on average 100—20111 members Democratic tone person a one vote] Member [equity shame} Purehase of shame; sometimes type of DCE'LIpeIliun or some} group New group. on Members average 30-50 rrternhers Bottom-up; demoerafle [members].- links with banks supported by Nflflfsiate Willi-1E1: member: payment for membership [El-l Elem [e.tt.. individual Investors: Donors Top-down Information on the ElanmSol. BRI village relationship with providing equity. elionl banks. WIS-Supported the client private firms or ban ital individuals. foundations. or state te.g.. 5R1] I4] Solid-lit}! Grmrp Rm Mode]. ell'lter hy NIT-Os lent. ASA. SHnREl or hanks tGraiueen Bankt. hui lately.r Moo by uL'ltr-r .‘r'lFl types. used |E-| linkage Retell Menu [n.g” promoted melted as a member ofa group try- peers. or {wrest by supporting institution New group oenter [5-6 groups of 5—10 members each] Meritber it! a pmidsting Si—iC-t Preeadstlng informal Men-them I[group or groups Mix of bottom-tip and top-dam by GTZJIFAD and with tenable sist- approaehes peers. hook. or NABARD in India] who can obtain [supporting NGG approval loans and save as a agency! mentbersl group with a probllr: or pm'ate. brink Sow-oer: Adapted front Lapenu and Keller [2001}. entrepreneurs. but often avoid mentioning owned by their members. but instead are the words 'poor” or ‘poverty' in their owned by individuals or by legal entitles. mission statement. Second. the}.r use Legal entities can be the state. NGDs. or eollsteral substitutes and other private companies. limovations.Just like other MFIs. “That the social and powrty focus of hflerohanlts Include the state—owned mornher~based MFls is clearly embedded oommunity-leuel banks of EiRi in in the ownership and therefore inoeniiv: Indonesia. Baneosol in Bolivia structure. rnierohanlts depend on the {transformed from an NGU]. Calpia in El social commitment of their owners to make Salvador. the present—eta},r Spatltassen in compromises between making more profit Germany. or mterohanks "built from or staying at the. lower end of the market. srrateh' with technical assistsnee from Althoug-t profits can he Increased by companies such as International moving up the market. this does not Frojoktconsult [IPCL Their main differenoo tteeesssrflg.r require a redueiion in sentees from credit. unions and village hanlts [or to poorer ciientele. as serving a range of NGO-led hanks such as Grameen Bank clients to often a sal'er and better long-term and SEWA Bank! is that they are not strategy. figficnitnrnl Finance Rouieto. Fall 2005 Keller 2'05 Table 1 . Extde Member sarmgs Focus on savings; credit mostly from savings Focus on credit. less on savings ExitTi'iaJ loans; later member savings through gracing internal account Focus on both credit and savings sen-ices Client savings. equity Ipartiailgr provided by donors or state]. Find mnimereiai loans. Exlernal loans and grants Focns on credit: mainly Utri'npulsory savings. some with micro-Insurance pro-ducts Eliternal loans: member savings Eat-1 rigs ilrst Ihut just as collateral] Due to their heterogeneous origins. the ownership structure differs retrial}r in practice. Calpia. for example. grew out of a credit progarn with a strong sustainability locus [liavajaa and {Emission-Vega. 1999}. and is owned by nonprofit NGGs. Microbanits lend mainly on an individual basis [such as BRl community banks or IPC—supported banks} but also feature soliciiaritj.r group lending {such as BancoSoll. lClearly. cheats would prefer to have an Indl'fldual loan If they could get it with the same terms as those prmdded by men1hor- based institutions [if tire for new Ignore other benefits oi" member-based MF’ls. such as social capital formation and sense of ownership. self-help. and pride]. This is Pyramidal elructnre: unions or [secrettonalIr local branches: bottom-up Decmtrolized at me “liege level [linkage wtlh a funnel bani-L credit union. or fedora Lions of village Initiate poaaihlei Centrath with local branches Pyramidal smtcture. {utensil}.I top-doom Decentralized at the utilage level: linkage with closest basil: branch Salaried staff and elected. calming Members Elnrirrl members tall-managed]: some I'l'iPifg.r bf remunerated Sat-rings. social Ffl‘bfifinrfi Conventional Salaried siafi' collateral as well as iru'im-‘Eilnri: collateral substitutes Sella rind stall" Group pressure Salaried workers from the formal li'istltuliori; ITLFIy he NG'D stafl' Savings. social pressure. NGD lntemiediaiian so because participation in ang,r of the above MFi types carries additional transaction costs on behalf of the client. e.g.. for meetings. Yet. because of informational advantages of member-based institutions dealing with poorer clientele. member—based Institutions can he more efficient in mfironrnenis with lower population density. higher illiteracy. and poor road and communications infrastructure. Microhanks offer relititlveig,r high loan sizes {see Table 2]. indicating their depth of poverty is weaker compared to the other MF‘I types shown in Table 2. It follows that their breadth of outreach to the poor ii.c.. numbers of p-mr reached] will depend more on their scale as opposed to other 205 Rural Microjinnnce institutions in Developing Cout‘ttt‘ies Table 2. Indicators of Financial Sustainability and Poverty Outreach. by Type of HF‘I Hicroflnance luofitottion Hinton“: with Coop- Solidarity trill-no Individual Unhagc Indicator- entire Group Bank Donn-mt. Model Rnpctyntcnl Rate of Loans l'l‘itl 9‘9 95 96 9'5 Indicators- of Poverty Outreach: :- Fmflu ul'fcmale mttmhttrs ulth 3-? 34 4'0 'P'E - Average loan star [$1 359 255 122 T3? 218 + Luau size [as 'ltt of per capita GDP] 52 25 NE. 45 r Atwage sin: of savings deposit not 301 .3? 32. TB 23 - Sat-rings deposit ias % of per capita GDPI 8 E El 5 Source: Laprnu and Keller milli- Notas: The data ocr. derived from a postal survey conducted by the International Food Policy Rmraneh Institute ill-‘Pltll in lB'tl'EII. The survey respondan were intemntionol NGfltt involved in mtcrodlrtttnce as well as national. rrgmnal. and tnlcntatjnnal n'ocmilnancr networks. These. reap-unclean were asked to identity 3: i'lLIIIIhCI offlhflfl-OLGFIRHCE of U1: Mills their support in Mitt. Attica. and Latin nrnerica. Cli'the ‘13 international NED: contactod. 2'9 [ET'litl responded. and ultim- 26 networks contacted. 12 i45'lttl responded. though lead than hallol tl‘le microflnaoee neL'I-N'm'l'iti responded. the Information provided a hrouti overview of MFls by region or country. Itt total. the data refer to 1466' HMS In 85 developing countries 1with an estimated number of 43 million savers and IT rnllllnn hon‘mters. Most oft—ht: writ-Niles that did not answer are rtLtLional nel'tvto‘lte with more liJTI-lltd COW-THEE Ufl-flfltl-l-Lll-lfil'lfi- T111151}? '3'" EamPl-ln-E M5 3 number of shot-immings. which are acknowledged elsewhere [Lapentt and It'll”. soon. Nonttl'lttletlfi. The mulls t-cportfil in Ihltt tahle suggest some general patterns that appear plausible. MFls.“ However. the presumath hotter—off clients of nticrohanits Ina}.r not have any.r access to traditional commercial banks. and loans to small and medium enterprises as. well as larger commercial farmers can make an Indirect contribution to povch reduction. c.g.. by creating salarledjobs for poor people. While depth of outreach is certainly not their comparative advantage {unless the}: begin to link up with tillage bani-ts or soliclari'q.r groups. as BancoSoi did at one time]. the advantages oi“ microhanlts lie in servicing the neglected middle rrtarlcot.”Er " As noted earlier. there are Flows to using average loan sine as a reflecliott of depth of outreach. Modhm loan. sim- ut' oven halter. distributions ol' size ol' loan and savings tiepasits. prtw'ide more reliable information on depth oi'outreurlt Using average. loan size can inctdvrt‘iecrtthr rnaaltt the t‘JePfll and breadth of outreach to Ihr. poor. "LPG cit-milks its target clientele an "micro and small mterpiieaeo. small tat-titers. and onset comparatively weal: rcottotttlo unit-v." Wmuu in calculations from data reported at ll'fl's Itint-'llet-ltti iii January :ttltln. the average outstanding lottrt also at [PC-suptntrtetl Inlt-‘rohanks as a prrcentagc of GDP per capita ties at 213. This is well ah:an the smatter- For rural areas and agricultural finance. microhanks offer comparative advantage for larger. commercial farmers [with or without classical collateral]. agribusuicss reported in the Microbial-tiring Bulletin tail-iii]. which are 4-5 for all lt'llT'Ia and 33 for i:lt'i.'?t.t'ti'.'lElll:.r sustainable MFis. This comparatively high value could he ani‘lh'I-ltbd LEI the circumstances oflPC'a approach: to] moo-l microbanlts operate In i'orrtter socialist countries or Eastern Europe. lo] the lending methodolog- [individual versus group lending]. and [ti the charter [hanks versus credit unions or NGfl-oupponrd village brothel. Still. the respecttvc numbers according to the HEB are lower than lPC's numbers: 85 for Eaairnt Europe. 53 for uttitvtdoal lending. and 135 for banks. It acct-r15 more likely that microbanlts auppotrtetl by IPC target the. high-end and small mterpricea lttlttl not the population with Incomes around the povcrn- line}. The reap-ochre numbers i'toro the MBE are 159 for high-end and to? for sit-tail enterprises. in contrast to 15 [or low and and 64 for broad. I-towtmr. lF‘C's numbers very stronglyr by country. ranging, from l2 in the Philippines up to Tl I in Moldova. IPC definitely och-cs a. nenlll'tior clientele In Eastern Europe [297}; the data for UIEIT pmjccta tn other countries trot seem more in line with MBB‘s general numb-era. For example. according to personal communication 't't'iT—l'i Juan Buthtnflu. a recent tttudz.r h}- the Ohio State University in El Eel-radar on Catle [which receives technical aEIEIIEItEl-nce front [PEI I'ourui that 40% of Its runtl clients were P0411“. and 20% oi than wen: extremely poor. Agnculntroi Fumes Retrtetu. Fall 2005 Keller 20'? traders. and processors. However. microhanlcs offering lower loan sites. such as IRIS-supported banks in the Philippines and Mozambique. will certainly also penetrate the middle and of the microtinance marl-Let. This competition— mainly with credit unions—"should be seen as healthy iii'carrled out on a level playing field]. as it will force credit unions and ntlcrobanlrs to further innovate. Because credit unions and nticrobanlrs have distinct comparative advantages. they may coexist and fiercely compete in some market segments. while dominating others. Afier‘ all. this is atrocity what we want. its suggested by Table 2. the village bank. linkage type. and the solidarity group reach relatively more women and poorer clients compared to the cooperative and the microbanking models. Other Rural Financial Institutions Each of the above MFl types shows comparative advantages and disadvantages. Our discussion now turns to state-owned development banks. commercial banks. and other providers of rural and agric'tdtural Finance. Development Banks. Development banks focus on medium— and long-term financlng of larger mral and agricultural projects [with a high content of public goods. or high impact on economic growth that the private sector for one reason or another fails to finance]. Some of these banks focus on particular economic sectors. Due to their development objectives. they can and do support microiinance networks and apex institutions. and provide refinancing to member—based financial institutions. such as rural tillage banks lace. e.g.. the case of the National Agricultural Development Bank in Mali deacribed by it‘ruman [1998] and Chao- Berofl'tltitiiatl. National and international development banks. such as the Genital-i Bards for Reconstruction [wat the interamerican Development Bank [IDE]. and. the European Bank for Reconstruction and Development [EBRD]. provide funds for upgrading“ promising NGO-run schemes [such as Calpia] or by giving equity grants for newly built microbanlcs. Because these banks are [partly] privately owned for- profit banks. questions mayr arise {as with credit guarantee schemes] as to whether this results in true additional lending to microfinance clients ii.e.. higher economic growth}. or in a crowding-out type of competition with credit unions which receive [but in my opinion. not substantiated by data} the lowest amounts per client in public Investments by donors and governments. The equity Investment can be critically considered a transfer of public funds to private masters. and if the primary [or even declared secondary] objective is not depth of outreach or impact on poverty reduction. it. is difficult to justify these public investments on equity grounds as 1titell. However. titti‘fi.r can be justified provided that these microbanks constitute critical elements in the rural financial system [for example. serving agro-lndustrg.r and rural small and medium enterprises. and as second-tier institutions serving credit unions and village banks}. Transfoth of State-me ogrieultm'al or Rural Banks. If not transformed based on business principles. these banks are a continuing burden to the taxpayer and to rural financtai systems building. They constitute the classical case of government failure in rural finance. The lessons learned from the old paradigm still apply today in many countries such as China. indla. Egypt. and Pakistan. However. provided there is true political commitment and ownership of reforms. some of these banks can be successfully transformed [as BRI and ease demonstrated] with business—oriented management reforms. in a study of rural state-owed banks in Nepal. Srt Lanka. and India. Steinwand {2003] analyzes. recent refdnn efforts that seek to apply and adapt some of the lessons learned in Thailand and indonesia. 203 Rural Microflnortce Institutions in Developing Countries —————-———-——-—___—___________,__ Profit and success in business is not necessarily incompatible with public ownership it“ management is given the right tootmtioes. Therefore. it is too early to write off the Iranst'orntatlon approach and to argue that BAAC and ER] are exceptional cases from which one cannot. learn lessons applicable to other countries. Often. state-med development banks possess large branch networks for rural financial intetrncdtation. and have staff who are especially familiar with agricultural enterprises.m DownacIJing Commercial Banks. Doamtscaling aims at inducing commercial banks—through technical assistance and stall training. for example. funded by public funds—to enter Into the neglected upper and lower middle market. Heater-Fer. recent experiences by lPC with this approach highlighted many obstacles. such as those. described by Schmidt [2001] and iron Fischlte [2003}. These obstacles are likely to be more challenging for bani-ts entering into rural and agricultural finance because their stall” are not skilled in financially assessing investments In crop and livestock production and may cherish big-hank investment culture. Merchants for Wholesale Trailers. Agrarpmceasora. and Large: Farmers. Many present—day rural financial Institutions effectively screen out this relatively wealthy group either directly by settng targetu-ig criteria or Indirectly by offering financial products at little relevance to this clientele. who demand larger short—term credit lines as well as long-term incestment credit. larger traders and farmers as well as agribusiness processors are an equally neglected clientele who have critical func- tions to fulfill in agricultural development and therefore rural poverty “Sf-t also lFfiD'a- rural finance pulley on this puitii. Gonzales-Veils and Graham {1595] raised the question of whether stoic-owned tagrleulturali development bunks could potentially play a significant role as a count of rural and mic-refinance. They tdenilfy conditions. and opporLunitica for successful transformation. reduction. lvlicrobanlts targeting this clientele In rural areas could have considerable potential compared to credit unions. as these types of clientele are ten wealthy for credit unions. to countries with a haunting agricultural economy. such as many in Asia. trader input credit to farmers is important. Equally Important. can be the provision of finance to capital-intensive agro— processors such as dairy farms. Partnerships of public and private banks can play a role in enabling larger-scale investments with high expected social payoff. Contract Fanning. In so—ealicd “bottleneck” markets. agribusiness firms play a viable role in rural finance and technology transfer Through contract farming. Bottleneck markets exist because of the specific characteristics of some crops [cut flowers. export pineapple and other fruit. and organic coffee] and animal produce [milk] which ofler a high likelihood to the processor that the farmer will not sell his or her produce in another competing marketing channel. Before agricultural Ilbm‘alizaiion. there were many politically crested bottlenecks through which crops Twere sold. lifter liberalisation. the array of potential crops shrank tremendously. and cumpelitlon in the processing sector case even for classical plantation crops such as oil palm trees. Contract farming can reduce the risks of processors and farmers. enhance. provision of teclmolotnr. inputs. and loans to farmers. and increase the quality and quantity of procluca for processing. ThE’fiE intrinsic risks and other advantages could be better exploited in repeating. long-term contracts. and agribusiness firms may be able to borrow against these contracts from commerch bani-ts. It appears that contraetjonninp is El stable. but under- exploited and Lottiecreseorched commercial opttcnfor opticalmroiftnante in developing and transitioning countries. Agriculter Finance Reutcw. Fall 2006 Seller 209 Conclusions This paper began with a recommendation: team‘an posifoiiurcs. Which institutional type [or model] is best suited for rural and agricultural finance? Three major reasons call for institutional diversity in rural areas. and further public investments in institutional innovation and adaptation. I i-‘irst. donors and governments and other social investors differ in their relabrr- emphasis on direct or indirect pathways of poverty reduction through financial systems development. So. too. do the types of rural financial institutions revieived in this paper. I Second. the diversity of socioeconomic contexts and the dtii’erent levels of political. social. and economic dcyoiopment require that the various institutional types are adapted to the local context. Because of the diversity. Lbere is need for several institutional types that compete with one another in some marltet segments while dominating others. Because of the specific characteristics of rural areas and of agriculture. institutional and technological innovation and adaptation are crucial to reduce transaction costs for institutions and clients alike. Progress is achieved by testing different strategies and learning from failures. Such limovailon can be enhanced through participatory processes—Willi. by. and for poor worsen and men— which address the diverse demand for financial services. innovation can also be enhanced by publicfprivatc partnerships to strengthen financial and other services providcd by agribusinesses and traders to farmers. for example through contract fanning or leasing of specialized equipment. I Third. the main Institutional retail types in rural finance it.e.. credit unions. microbani-ts. and village banks] all have their justification because of their specific comparative advantages. lnsiead of choosing one approach [targeted to the poor vs. targeted to non—poor]. the best use of public support. is to alloy».r both extremes and in-between approaches within a rural financial systems perspective—specifically. to allow and support the building of a diverse system of financially sustainable institutions. Indocd. the second orator recorrurszndotion of this paper is that there is no blueprint for nrmimnnce. and trtsttntttoriol mnomtton and adaptation to spectflc socioeconomic and ogroecologtcol contents as well as to spectfic clientele groups are always required. The paper's third recommendation is that public investment in specific rural financial projects should be pursued with a financial systems perspective. This implies that. when building financial Institutions. public action and public! private partnerships need to also foster horizontal and vertical integration in it necessarily decentralized rural financial system. Village banks. solidarity groups. and preexisting self—help groups are possible first-tier types at the rural retail level with a high depth of outreach. The village banlt as a first—tier retail institution has comparative advantages over solidarity groups and informal self—help groups. but lacks the size and diversification needed to become a stand—alone institution able to deal 1:vith seasonality and covariant risks that can be pervasive in rural areas. Of course. this need for integration ti.e.. linking Wlth commercial and development hanks] also arises for credit unions and for microbantts. Hence. integration of first- tier institutions. be they tillage bruilts. credit. unions. or microbanlts. is very essential. The issue of size Is in this context very important: Any HP] will be strongly affected In rural areas by seasonalin and covenant risks. Stami- olonc retail mmlfinnnciol bistitutions are doomed to punish once public support is phased out. Consequently. larger size and diversification of clientele and products are very desirable to sustainably serve rural populations. :10 Rural Minolta-tones Institutions in Developing Cowtines Greater exposure to rural areas. or to agriculture. in general. and to specific crops and animal husbandry enterprises in particular. all raise the need for horizontal and vertical integration of village banks. credit unions. and mlcrobanks. Thciaiter two can also assume a useful role in rural areas [in addition to their first-tier retail function] as second-tier financial providers to village banks or solidarity and other self—help groups. The third tier of rttral finance will then consist ol‘ commercial. [transformed] state- owned. and cooperative banks. These institutions illl important functions in rural financial systems development. and are. also nodded it} fund larger rural and agricultural investments. some of them through publicfpnvate partierships investing in new agribusiness processing and trading firms. However. these third-tier institutions do not have any comparative advantage in dealing with the micro— and small enterprise sector. fanners. and other poor or not-so—poor rural dwellers. Fourth. designing. experimenting with. and building financial institutions benefiting the rural poor and not-so-poor require economic resources and adequate consideration ol‘ longer—term social returns. and the case of publicly funded research and development [RM]— periorttted In partnership with the private and civic sectors—tn rural finance appears strong. Given the renewed interest in rural and agricultural finance. a word of caution against over-emphasizing its role for poverty reduction and economic yowth concludes the. paper. 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