An_overview - An Overview of Recent DeveloPments in the...

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Unformatted text preview: An Overview of Recent DeveloPments in the Microfinance Literature Valentino M. i-iortnrslro and Martin Hotonami Abstract T1115 paper presents an overview of ink-refinance and mlcroflnance research. The objective is to show that ntteroflnance research has come full E‘ll'cle.‘ from policies to lending methodologies and to organizations In the IEIBDs. and back to a focus on policies. Specifically. t'lfl’filflpmea‘ils tn the. flimrelical literature: on asymmetric. information. transaction costs. contracts. and banking identify the challenges that MFls must overcome. Recent trends toward liitcrmedlation and commercialization have brought about renewed focus on identifying appropriate policies to promote a viable mlcrollnance industry. The paper concludes by describing some current challenges faced by the induso-y and offers a possible research agenda for agricultural economists. Key words: flnanela] Institutions. nucroflnanee. mlct‘oflnancc institutions. poverty. turn] llnonce Valentina l-‘l. l-larlarslta Is an assistant professor In the llllpilrlmtnt DI'WUNUI'EI Economics and Rural atclolomr. Auburn University: Marlin Hollnuinn la a lead flnaIICI-fil spet'lallst Will] the Consulloliva Group ltl Aasiol the Poor tiff-AP} :II Ilrtr world Bank. Washington. lhfl. limit-w coordinated by (Zr-turn t}. Turvev. Development of financial institutions boosts economic growth and benefits the poor more than other segments or the population [King and Levine. 1993: Beck. Demirguc-ltunt. and tonne. 2004]. Worldwide. niieroi‘inance institutions [it'lFIs] expand the frontier of finance by providing loans and other financial services to the under-served poor. Mtcrollnanco has attracted significant attention lately. especially after the. Untted Nations designated 2005 as the International Year of l'ttlicrocredlt.I Mitre-finance started as "a collection of banking practices built around pretendingr small loans [typically without collateral] and accepting tlnjr savings deposits" Lamendariz de raglan and Morduoh. 2005. p. 1]. Today. tnany MFIs offer payment and savings [aeilitiea insurance. housing. and longer-term loans. Microflnance programs seek to reduce poverty by promoting salt—employment and entrepreneurship as well as by alleviating liquidity constraints and contributing to consumption and Income-smoothing. Microflnance programs pursue the double bottom-line objective of outreach [serving the poor] and self—sustainabilityr [cost coverage].2 The majority.r of l'vl'F'la still rely on traditional multilateral and bilateral donors for funds. However. nev-r private foundations. such as the Blll and Melinda ' ermfinanee Is a phenomenon typically associated wlth the dart-looting countries. but it has also attracted support lTI developed countries. In the United firatca. lit infliction. support 1rd to the revival of Community Development Financial Institutions in the leads. "Keller and Meyer 12002] Include impact as me third element 1n the "triangle" of niiorotlnance. consisting of EInancIaI Sustaimbillty. o‘utrrsm. and unpact. 145 An Duet-mete ofRecent Deteiopmcnts tn the Micmfitmce Lite-nature Table 1. Growth of Hieroflnsncc Clients Since 1997 Number of Total Number of ‘ii: Reporting Number "Poorest" ‘ of Date Institutions of Elite Clients Pm flimts 12K?- 1 It 100'? I313 13.4?B.?07 1000.000 56 12.011 .t'l 090- 925 203435.899 12.221.913- 53 mill-131999 I .Ofifi 21555.559 I 3,779.3?2 EB 123’313'2000 1.55? 30.531.107 19.32TJ51 fill- 12f31 Him I 2.186 54.932.23.15 23.3?3332 49 12f31f2002 2.572 HIE-06.030 41,534.??3 HE 123’313'2003 2.931 30.358343 54.?85.433 03 123'3 i room 3.164 92.2?0389 63.614.8Ti T2 Somme The State nfrhe Micrmmdit Summit anpntgn REM 2005 [Daley-Horde. 20-05]. “The "poorest" clients are defined as those lit-iris on under US$1 a day. Gates Foundation and the. Iieil Foundation. play an increasinglyr active role as both donors and investors. In addition. large private banks such as Cl’l‘lBANH and HSBC have entered what was formerly a niche market [Wall Street Joumoi. Elitiitill.3 These [quasi-l commercial investors may fund large international Inicrof'inance networks leg" ACCIDN International. FINCA. Opportunity International]. individual MFIs. or may adopt a "greenfieldinrf approach and create new.r micro and sirlail enterprise banks [Schmidt and Zeitinger. 2001!. Mieoiinance dates back to the IQTUs. when economics professor Dr. Muhammad Yunus. began making small loans to lgroups from local villages In Bangladesh. This effort resulted in the establishment of the lGrarneen Bani: in 19% as an experimental project to combat rural poverty by prodding credit. to the very poor. Edy 2005. the. Gramccn Honk disbursed about 0505 billion in loans to 5 million borrowers. son of them women. Microflnancc l'ios groom significantly on all continents. Data from the State oj'the Microcrai'lit Summit Campaign Report 2005 [Daley-Harris. 24305]. which traces the. 1'l7"1'.tl" .1 i'inI‘iI'II i-t-LLI‘I'I'}? Ill “11'. will: LII Irtirrrmijuruil fillimieh‘iill hanks. see Consultative Group to desist ll‘l'l." I‘Dor ICCihP. EUUEEII. number and poverty level of microfinanee clients around the world. illustrates the scale and growth of the lntllifil'i'y [T able 1]. The number of clients has grow from 13.5 million in 199? to 92.3 million in 2W4. The number of poorest clients [those living on less than $1 a day] has also grown. train 16 million in 199? to nearly 6'? million in 2004. it is also tjmaied that there are at least 10.000 microfinance programs. worldwide. li-‘Iicroflnance emerged as an innovation in lending to the rural poor in Asia. where previous interventions in rural financial markets [directed and subsidized production credit usually disbursed by agricultural deceloprne'nt banks} often failed. These interventions were extensively studied by agricultural economists. The global microflnsnce movement diil‘ers from rural financial market interventions because financial services are weaved independently and are not llrileed to [agricultural] production. Thus. mlcroflnonce has expanded to include the urban poor and now encompasses financial markets for marginslired clientele in rural and non-rural settings. its a consequence. it has been studied less by agricultural economists. Academic research also reflects changes in policy initiatives and Lhcir funding. although in the past 40 years billions of dollars were spent to support the Green sync-ultimo! Finance Review. Fall 2005 HMEtt'Skfl and Hotrmrrnn I49 Revolution. recently there has been a shift of funding away from agricultural projects. For example. agriculture accounted for 31% ot 1World Bank lending In 19?9—1981. but by RUDD—2001 it. had fallen to ICE-tn [Christen and Pearce. 2005}. This decrease in lending for strictly agricultural protects was due In part to an increase in support for reform and the strengthening of overall financial markets. A similar shift of funding has occurred in the inter— ninerican Development Bank. the European Bank for Remneruclion and Development. the African Development Bank. and the Asian Development Flank.“ This paper presents an overview of microflnanee and mieroflnanee research {Including research on rural mieroiinancel. and identifies some directions in which the industryT is heading.“ We seelt to show that mlerol'lnartee research has come full circle: from policies in lending methodologies and to organizations In the 19905 [Gmaiez- lregs. 1994]. and back to a locus on policies. Specifically. developments in the theoretical literature on asymmetric information. transaction costs. contracts. and banking identify the challenges that MFts must overcome. Recent trends toward intennedtation and commercialization have " For example. “rfnl'lt‘r [2002] shows that lending rn agriculture by lite inter-emoticon Development Berti: t't'll Iron: $1.6 billion In 19313—1990 to no lending in 199 i—IEHJE. while financial mrnr restructuring rose front 34 till million in [BEE—19W to $2.9 billion in IBB l— lEI'EIIfi. Sunllsrly, flttstneLng by IltL' European Bank for Rernnstroctioo and [Malawian-en: to t-ounu-les llt I'luslr'ril Europe tuid CeriLral Asia [ens region] for ltnsncial sector development and micro and small enterprise financing ontuuotetl to about $9 billion by EDGE. During the some period. funding I'ur agribusiness projects. at which. a very ntttull poi-tint: goes to ngriculturul production. amounted lo 33 billion. In ZIJUE. title ol'ihe Milan [Jet-skipntent Bank linuucirni,I was slimmed for agriculture and 5% was designated 1'or1lle financial sector development. A lmrtllnt of lllis hunk lentilng [$510 rnilllonl was swell‘hmlly designated to mtcroflnsnee. and the tilujbrlty ul' microflnsncc lending in Asia Is. in rural areas. The Mnean Ekatelnprnent Hank's lending [or agricultural and t'Ltr-il development was 15% and financial sector lending was lfl'ltt. “Comprehenle surveys oi recent developments of the Ilteraiore are: fu'rttendsrlz de Million and Mordueh WHO-5]: Canning and Unit]! {forthcoming}; Beau and Weller IEDO‘H'. see also Keller and Meyer [2M2]. brought about renewed focus on identifying appropriate policies to promote a viable mtcrolinance industry. The remainder of the paper is orgamned as i'otlows. First. we briefly describe the main challenges In lending that are identified in the theoretical literature and show how Irmovalions in lending leg. group Ioansl can alleviate Information asymmetry problems and improve the provision of financial sendces to marginalized clientele. This is followed by a discussion of some organizational dilemmas laced by microflnanee institutions. Issues related to the external environment in which MFIs operate are then highlighted. Next are sections providing a brief oven'iew oi'the state of tnierollnance Impact studies. and a summary of new developments in rural rnicrollnance. The. concluding section Identifies current challenges in the industry and suggests topics for future research of interest to agricultural economists. Some Theoretical Underpinnings of Morofinanee Methodologies Donor and government intervention ltt rural credit markets in the 19605 and lflms encountered significant problems. and this experience contributed to mltiai skepticism about mlcrottnance. For example. Adams and von Pisth t1992] emacluded that rrdctroflnance is 'de'ja vu" In part because they equate It to tmtcrolcredit. While the first microfinanoe programs pmdded credit-only tthus microcreditl. charging market-based interest rates In an attempt to become free of subsidy. microlinsnce has since evolved toward Intermediation with MFIS introducing savings products as well as more sophisticated llnaneiai products te.g.. microinsurance. home pttrchase loansl and services [various types of payment facilities]. at the other extreme are opinions that are too enthusiastic about microfinance. and mispercepllons that microfinanec has a clear social impact on all borrowers {addressed here In the section on impact 150 An (heroism oJ'Recent Deaetopments in the MIL-refinance Lita-attire studies]. or that most mierofinance programs- could both serve the poor and turn a profit. titti‘lnendaris dc lighten and Moiduch. 20051. The original group-based mlcrolending and other innovative lending practices developed parallel to. or even In advance ol‘. the theoretical literature on asymmetric information and the microeconomics of banking and eorporate finance t5tiglits. 2M]. Without development of the theory. however. our understanding of these new practices 1would have been incomplete and superficial. Ftir misrnple. when Dr. Yunus began making small loans to groups of local villagers in Bangladesh in ihe lama. it was to take advantage of economies of scale. t-Iowm’er. as time progressed. it became clear that there were many other advantages to this lending practice. and. the new theoretlcal models helped explain the mechanisms behind the success. It Is now acceptor] that underdevelopnient of financial markets is due to market failures rooted in poor Information. high transaction costs. anti diflicuiites tmt'orelng property rights. This section presents the basic models of adverse selection and moral hazard [ex post and ex ante} and identifies the challenges posed by information asymmetries on financial contracts as well as how the first mlcroflnance innovatlon— group lending—helps improve on roosting market outcomes? Adverse Selection In the standard model of adverse selection. there are two types of borrowers: "safe" and "risky." The sale borrower can Invest $1 and get H with probability I. while the risky borrower can get E {Qa- E] with a pit-inability p. where D c p c 1. Assume that p‘t—ta y. and that the lender must cover its cost lrby setting its gross interest R (principal and interestl equal to k. The borrower keeps IE — it}. Under "'i'his schon presents simplified examples of asymmetric lui'on'rIa-tlon models sumimrued In Arnienrlartr. do Fight-on and Murdoch [2005]. asymmetric Infon'oatioo. the bank does not know the proportion ofsafe borrowers o. and will set. Its gross Interest. rate [3...] equal to k R -__.___._ io+il —ql*pl m =k+A<R. Slight: and Weiss {1981] show that in equilibrium credit may be rationed because if the interest rate is higher than 9. only risky borrowers would want to boFrow at the higher Interest rate and sale borrowers would cost the market [adverse selection]. The Implication Is that there Is a need for policies winch promote transparency and decrease asymmetric infomiaiion. It can be shown that with ajoinl—Iiabillly loan {group loans]. the adverse selection problem is mitigated. Under a group—loan scheme. each borrower obtains a loan. but all In the group lace consequences if a member encounters repayment difficulties. Thus. under a group contract. we can have assortatlye matching of safe with safe. and risky wtih nsky borrowers [Ghatak. 1999}. Assuming each risky borrower can earn income Q's-2R5} [R9 is gross interest under group loans}. the bank will face (sate. safe] pair with probability q and (risky. risky] pair with probability [1 - 1;]. Therefore. the population probability of success is g=1-[l-p]2and =4: iq-ii alto] Rn I'II" since 9' :- p. Thus. the lender can attract the safe types back into the market. Even under random matching of Individuals within a group [such as FINCPL groups in the Andes. where groups are formed randomly iKarIan. sooail. group loans can resolve the adverse selection problem by making risky borrowers cross—subsidise safe types. since the higher returns of risky bon'owers can cover losses of both safe and risky partners [Amendariz dc tighten and Gollier. zoom} 7 Other notable adverse selection models “with jlziirtt-liabillt}r conirucls are provided by Ghatak [1999. 20001. Agnhritttiroi Finance Review. Fall 2065 Horrorsim and Holmionn 151 Moral Hazard In the typical ex ante moral hazard problem. the principal cannot observe the agent after the agent takes a loan. so the principal [lender] would like to offer a contract that induces effort from a borrower. Assume an investment project taltes $1. a. non-sitirking borrower will generate revenue y with certainty. while a shirklng borrower will generate g with probability p and zero with [l - pi. A borrower's decision is determined by his or her incentive compatibility [1C] constraint. {y - Hamil] 13:55:49 _ RumilL Where antt is the principal and interest. and c is a borrower's cost of working. This implies that the interest which can be extracted is defined by its y [c.e'tl —p]}. Stigiitz [19“le demonstrates that under a group tending contract. the lender can do better. in a two-person group. if both put in effort. both will Incur the. cost of effort. Tire _1oint return with effort is {fly 23mm} file. but If both shirk. they will repay their joint-liability loan [fly ERgmrtli] only p2 fractions of the time. If one is lucky and the other is not. the lucky individual is responsible for the full payrnenl. and there is no surplus: the group's to is {so 2%,1— see pitay - 2 ..t and amps y — cm — p2]. Since-t1 p l: 1 - p. under ex ante moral itaaard. the group gross Interest is smaJIEr than the gross interest without a group {Hgmldl 23' Rmrtlrl' Under the ex post moral hazard problem. the major concern is that after the. outcome is realized a borrower may refuse to repay and the lender cannot. discern if the default is strategic or not [Towns-end. 19TH]. In the absence of peer monitoring. m'eryone will default strategically and the bank will never lend. 'lhis problem under group contracts has been the subject of considerable research [Besiey and Coats. lQQE: Miiendariz dc Agl'ljon. 1999]. A group loan can force the borrowers to incur tex post} costs of monitoring or to find out the actual outcome of a prujeei. it group members incur m. they can observe the actual outcome with probability q. and if d is the social sanction imposed on a borrower who tries to avoid repayment. then repayment will be chosen if y — Rm... :- y - ptd + Rama]. The gross interest is then Rm”... e loftl - ofld. In the absence of peer monitoring. the chance of obsming actual revenue is o = D. and there is no lending. To minimize the probability of suffering Joint liability. monitoring will occur under small at e qy. Group-based financial services are not entirely new or used only in microflnanoe. Historically. models such as credit cooperatives [credit unions]. farm credit and insurance mutuals. and other mechanisms such as Rotating Savings and Cradit Associations tRDECAS] eidsted in rural and low—income areas.” Advances in the modeling of asymmetric information problems also help better explain tinanelal services provision via credit coopmaums iBaneflee. Besley. and Guinnane. [9941. Similarly. the mechanism of RDSCAS. whereby members pool resources by contributing a small amount each period and take turns to use the common pot of money to meet their credit needs. has also been explored [Besiey Coats. and Loury. 1993i. Mlnroflnance is not only about. group- ioans. hmvever. in fact. researchers and practitioners agree that many successful Individual microfinance schemes rely on other mechanisms of screening. monitoring. and contract eritorcemcnts such as dynamic h1centives. or mochanttin'is incorporating elements explained by the literature on tnultl- period and repeated contracts. limited communism. and reputation.“ These may be more cost-effective in countries without dense rural populations such as those in the Eastern Europe and Central Asia region or Latin America [Armedarlz tie lighten and Morduch. 200m. " Ghatait and Gulttnane HESS] provide an excellent twen'tew {If Itirlztup-iiaserl practices. 5' Cmoing and Udry [forthcoman prmridc a recent mien-law. 152 An Overview ofReectttDeoclopments in theltiicrofinonce Literature —______________________ There is a perception that microcredit products are well defined and that loan officers react quickly to repayment difficulties. but actual contracts are more state-contingent than generally believed [for example. a lender could agree to let a borrower miss a couple of payments. or forgive a portion]. suggesting incomplete market outcomes llldry. 1994.- Town-tsentl. 20133]. The literature on nuilti-perlod sovereign debt. as well as l-lolrnstrom's sutlleient statistics tying up investment outcomes to agent‘s effort and the environment. suggests an explanation for these "anomalles" to accepted practices :[Grossman and Van Huyck. 1938: Holmstrom. 1979i. When financial markets are incomplete. limited commitment is a serious problem. Reputation—updating mechanisms Under mulli-perlod moral hazard produce results different from the. one—shot moral hazard [InmbcrL 1933]. Mold-period moral hazard outcomes improve on single—period outcomes only if there is an exclusive relationship between a borrower and a lender and they pro—commit not to renegotiate contracts lFelltngham. Newman. and Sun. 1935}. In practice. this may d...
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