While you ponder an antidote to the notion of microfinance as just another dreary option for the poor – stuck somewhere between the advantages and disadvantages of what moneylenders and bankers have to offer – I want to close out the discussion of moneylenders vs. microfinanciers. In a comment last week, Bill Abrams of Trickle Up reminded us of the classic 1989 paper by Bob Christen. It reveals the origins of some fundamental operating assumptions of microfinance over the past couple of decades. Most, but not all, still hold up.
My Freedom from Hunger colleague Lynne Davidson Jarrell has summarized Christen’s paper very nicely. Here is her summary for our benefit – I’ll come back at the end for a couple of comments.
The goal of this discussion paper is to identify lessons for MFIs based on the experiences of informal moneylenders. The author describes four lessons, which fall under the general headings of credit risk, loan costs, borrower selection, and mechanisms for payment collection.
Christen argues that microbusinesses are generally good credit risks. He uses data on return on assets to make his point. For example, a study of 320 small businesses (with average business assets of $833) in 40 poor neighborhoods in Costa Rica showed that businesses had an annual gross return on assets of 700 percent. (Other similar studies found similarly high returns.) These studies also showed that the smaller the business, the more frequently the entire inventory turned over. Informal moneylenders will seek out such microbusinesses. But formal lenders find these businesses too risky and the costs of processing their loans too high.
Lesson for MFIs: microbusinesses can be excellent credit risks when you consider their return on assets – and the smaller, the better.
In addition to the obvious direct financial cost of the loan, Christen describes transaction costs and accessibility costs (the cost of lost opportunities when the loan cannot be obtained quickly), both of which he finds are lower for the informal moneylenders than for the formal lenders. Informal lenders “take the credit to the client with a delivery system that is tailored to the client’s particular business needs” and can make the loan available quickly. So although the direct financial cost of a formal lender can be much less than that of an informal lender, the total cost is often considerably more.
Lesson for MFIs: keep transaction and accessibility costs low, thereby reducing the total cost of the loan. Take the loan to the borrower and make the application process easy.
Informal moneylenders have a much easier time gathering personal and business references in order to make an assessment about willingness or ability to repay a loan. Relative to formal lenders, informal lenders pay more attention to the general financial health of a borrower and less attention to the borrower’s investment plans. The informal lender is, however, generally more directly familiar with the borrower’s business and therefore more able to spot a “bad” business plan.
Lesson for MFIs: seek non-traditional means for identifying trustworthy clients. Group guarantees helps with this. Also, incremental lending (starting with small loans until the borrower is better known) minimizes the need for extensive up-front credit risk analysis.
Informal lenders impose sanctions on defaulters – and are known to do so; and these guarantee mechanisms are simple and inexpensive (e.g., accept a TV as a guarantee) relative to those used by formal lenders (e.g., legal proceedings).
Lesson for MFIs: establish simple, inexpensive sanctions for defaulters and use them. (In the case of the rare calamity – as opposed to borrower negligence – the terms of the loan can be renegotiated.) This helps increase the probability of repayment and keeps costs lower for everyone.
Clearly, microfinanciers have been quite faithful to these lessons from moneylenders. Not so clear are the lessons on what not to do. How can microfinanciers be superior to moneylenders? Pasts posts have pointed out the greater reliability and structure offered. What else?
Note the striking examples of high return on assets of microenterprises. Christen was writing specifically about credit for microenterprises, which means careful selection of micro-businesses as moneylenders would tend to do. This is not the typical borrower profile for massive-scale microfinance institutions – no surprise in light of earlier posts based on Portfolios of the Poor.
Banerjee and Duflos offer a treasure trove of evidence and logical reasoning in their new book, Poor Economics. In Chapter 9 (“Reluctant Entrepreneurs,” p. 213), they assert that “… the vast majority of the businesses run by the poor never grow to the point where they start having any employees or much in the way of assets.” They show that marginal return on a dollar investment can be very high for a tiny business while overall return is very low – they are not making much money. Moreover, the average poor “entrepreneur” gets stuck on micro. Their graphical analysis predicts that marginal return will drop rapidly as the micro-business grows and then reach a point beyond which it cannot profitably grow without infusion of far more capital and management skill than is typically available, even when served by microfinance providers. This explains why most microfinance clients do not grow their businesses and often prefer to have two or more tiny ones. Except in relatively unusual circumstances, it is financially irrational to try to grow to the level of small-to-medium enterprise.
Financial service providers, both moneylenders and microfinanciers, who target true entrepreneurs are limiting up front their scale of outreach. Those seeking massive outreach de facto must ignore the rhetoric of “microenterprise credit” to accommodate a mass market of “reluctant entrepreneurs” (as Banerjee and Duflos call them). I will return to this assertion in Theme Three (More Profitable Business & More Household Income?).
In the next posts, I will take a different look at the benefits of massive-scale microfinance which is used by the poor for their own purposes regardless of any pledges they make to invest loans in microenterprise.