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A CONSENSUS in the global academic community is developing that microfinance does not have an economically significant impact on the lives of the poor.
Over the years, the World Bank has been a prominent supporter of the microfinance sector. However, in quite a few studies supported by the World Bank, the conclusion is that this sector is not having any serious impact on poverty alleviation. This adds to a number of rigorous academic studies arriving at the same conclusion.
Microfinance is potentially a very important sector for a developing country like Pakistan, so something must be done to fix it. In order to save microfinance, one first needs to develop a deeper understanding of the underlying narrative surrounding this sector.
In general, a lender has two primary concerns while dealing with a potential borrower: the borrower may play unfair with the money; and there is a downside from backing failed ventures.
The failure of the microfinance sector to have any real impact is connected to the twin causes of small loan sizes and high interest rates
Traditional banks attempt to mitigate both concerns by requiring that a borrower must provide collateral. However, this collateral requirement excludes a large segment of the population from the pool of potential borrowers.
Microfinance lenders attempt to mitigate the first concern by developing extensive selection and monitoring networks that typically rely on the notions of group liability and peer pressure. Mitigating the first concern has allowed microfinance lenders to extend financing to the poor who cannot provide collateral.
However, the second concern is a lot harder to mitigate. The way micro-lenders deal with it is to simply spread the risk around by targeting a large number of borrowers. There are two major disadvantages of doing that. Firstly, it greatly lowers the amount of funding per borrower, especially when borrowers have low debt repaying capacity. In fact, the funding is typically so low that it cannot be used to start new businesses. Micro-loans typically just end up being utilised for consumption.
Secondly, developing a selection and monitoring network for a large number of borrowers greatly increases the operating costs of micro-lenders. Consequently, they charge very high interest rates to stay sustainable. So, we end up with a microfinance sector that extends small loans for consumption at very high interest rates. Borrowers still prefer to get such loans because it is a better alternative than going to the village money lender, who charges even higher rates.
The failure of the microfinance sector to have any real impact is connected to the twin causes of small loan sizes and high interest rates. These twin problems in turn emerge from the failure of the micro-lenders to mitigate the second concern in any other way than by simply spreading the risk around to a large number of borrowers. Is there a better way to mitigate the concern that the funded ventures may fail?
I propose that microfinance lenders sacrifice breadth in favour of depth by using a different lending contract. The contract most suited for this purpose is a risk sharing or a mudarabah contract.
To understand this better, let’s take the example of Ahmed who wants to open a tandoor in rented premises in a locality in Rawalpindi. He needs about Rs0.5 million for this purpose. Traditional commercial banks do not lend to him because he does not have collateral. Micro-lenders typically do not lend more than Rs50,000, a sum much smaller than what Ahmed needs.
Lending Rs0.5 million to him on a risk sharing or mudarabah basis mitigates the second concern by giving the lender a stake in the upside potential of the proposed business. This upside stake can potentially counter the downside from the risk of business failure. So, the second concern is mitigated.
However, the downside is that now the first concern is harder to mitigate. Obviously, the temptation to steal Rs0.5 million is greater than the temptation to steal a considerably smaller sum of Rs50,000. To counter this perverse incentive, a tweaking of the existing selection and monitoring network is required.
For this, peer pressure and group liability need to be strengthened with efficient monitoring to successfully implement risk sharing or mudarabah contracts. I suggest two ways of doing this.
Currently, micro-lenders employ a large number of monitors who go door-to-door for collecting payments. With a risk sharing contract and fewer borrowers, a smaller number of monitors can be more intensely utilised. If one wants to figure out the total sales of Ahmed’s tandoor in a month, a monitor can randomly select a few days in a month and watch how many rotis are being sold. Or one can simply count the number of bags of flour used on randomly selected days. So, the first possibility is that a micro-lender maintains the monitoring function in-house and employs the monitors, however,
in a somewhat different way than usual, as suggested by the above example.
The second possibility is that this function is outsourced to a third party that gets paid a fraction of the profits accruing to the micro-lender from the business being monitored. Either way, the institutional capacity to implement risk sharing contracts can be developed over time via trial and error.
To conclude, if we want to save microfinance, then we must move beyond the inflexible debt contract. And microfinance deserves to be saved.
The writer is a research fellow at the University of Queensland and an Associate Professor of Economics at LUMS
Published in Dawn, Economic & Business, June 16th, 2014
