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The economics of micro-finance
This column is based on my trip to Hyderabad, earlier this year. Here is part of the introduction:
Microfinance is not actually “micro” in scale. It is far more organized than the individual moneylenders in poor communities, the traditional source of finance. Spandana borrows from banks, has about 2,000 employees and deals with about 800,000 loan recipients. The resulting economies of scale make possible lower interest rates. Spandana has been lending at interest rates of 10 to 15 percent a year, while other Indian microlenders may have rates ranging up to about 30 percent a year. Traditional moneylenders receive 5 or 10 percent a month or more. It is no wonder that Spandana has grown.
Spandana seeks to earn a profit through higher repayment rates. Unlike the moneylenders, Spandana lends to small groups of 5 to 10 people rather than to individuals; each member is liable if other group borrowers do not repay. The carrot is that good borrowers become eligible to receive higher sums.
Yes I am a fan of micro-finance. One overlooked benefit is that the weekly repayments enforce fiscal discipline and responsibility on the borrowing families. Otherwise the money often goes to deadbeat relatives. Here is the full article.
Posted by Tyler Cowen on August 10, 2006 at 06:32 AM in Economics | Permalink
Comments
I am mostly in favor of microfinance. However, the argument Ms. Reddy uses that "the final proof of the effectiveness of her programs is that “the women keep returning, three, four times in a row.”" could be used by drug dealers as well. It is not generally seen as a good thing when people keep returning to payday lending companies in the USA.
Posted by: Jeff Lonsdale at Aug 10, 2006 8:57:56 AM
I like microfinance, too, but the offers of more credit after performing well on previous loans reminds me of the Peter Principle. Will everyone get increasing loans until they end up with one they can't repay?
OTH, the average poor person probably has more sense than the U.S. Congress.
Posted by: DK at Aug 10, 2006 9:08:31 AM
Tyler, great column in the Times today. I am pretty disheartened to learn that the Indian government is moving to regulate and/or shut down profitable microlenders. This is exactly the kind of private sector-led development solution that has the potential to reach scale and impact millions of lives in a sustainable way (by injecting low-cost capital into poor communities). Why does the Indian government have to go and ruin everything?
I've also blogged about your column here - I would send a trackback, but we turned them off because of spam. Thanks again - and great work.
Posted by: Rob at Aug 10, 2006 9:35:09 AM
DK, that wouldn't matter at all to the bank. The banks expect some loans to fail. The average borrower if they know that the loan must be repaid is unlikely to borrow more often then they need. A part of the beauty of microfinance is that once a person proves themselves able to pay back their initial loans they begin to function as microlenders. They have established some level of ccredence with the bank and they can go back to the bank for future loans to be lent out at interest rates of their determination.
Posted by: Max at Aug 10, 2006 10:40:24 AM
DK, that wouldn't matter at all to the bank. The banks expect some loans to fail. The average borrower if they know that the loan must be repaid is unlikely to borrow more often then they need. A part of the beauty of microfinance is that once a person proves themselves able to pay back their initial loans they begin to function as microlenders. They have established some level of ccredence with the bank and they can go back to the bank for future loans to be lent out at interest rates of their determination.
Posted by: Max at Aug 10, 2006 10:40:51 AM
Similar opposition and allegation against microcredit are being voiced in Bangladesh, the country with the largest penetration of such loans. Grameen Bank disburses half a billion dollars a year to its more than 5 million borrowers. A government sponsored wholesale microfinance organiztion (PKSF) has capped the interest rate at 12 percent (flat rate) for its partner organistions. The argument is that the rate is "too high". What is missing in the debate is a proper benchmark. It is true, compared to the commercial bank, the rate is high. But the yardstick for these loans are the rate charged by money lender--10 percent per month or 120 per year. The detractors also do not understand that the higher interst rate of microloans reflects the true cost of running these operations. Since the loans are small, the cost per loan is high and the interest rate reflects such cost. Tyler is correct to point out that there is opposition to high interest rate for historical reasons. High interest rate charged by money lenders were responsible for unsustainable debt burden and eventual suicide of farmers in many parts of India. Numerous famine inquiry commission by the British Colonial Government found that unsustainable debt burden was the reason for higher mortality during famine. On a personal note and a shameless self-promption, my book on Grameen II will be published by Kumarian Press this November.
Posted by: Asif Dowla at Aug 10, 2006 1:03:13 PM
Max,
"DK, that wouldn't matter at all to the bank. The banks expect some loans to fail."
Aye, and not necessarily even the unprofitable ones. All depends on what your fixed originations costs look like, what you're charging, and how long before the thing charges-off (if ever.) Frankly, "good" loans at low rates that prepay can be money losing propositions. I wonder if any of the lenders use automated decisioning to cut down on costs. There's clearly less data on these folks than western consumers with bureau files, of course.
Posted by: Bernard Guerrero at Aug 10, 2006 3:44:59 PM
DK - "Will everyone get increasing loans until they end up with one they can't repay? "
Have you heard of the term "capital structure"? As long the borrowing is done effectively, loans are an excellent way of financing growth.
Posted by: jult52 at Aug 10, 2006 5:55:06 PM
Tyler,
There was an article in the last month or so, I think in Business Week
(or maybe Forbes) about micro finance that mentioned a website
where you can deposit as little as $100, which then gets parceled out in small
increments to capitalists. Their track record of paying back their
loans is very good.
Posted by: Bill Stepp at Aug 10, 2006 7:52:20 PM
An acquaintance of mine started a 'cow bank' micro lending business in India (he said he needed the karma after the
way he earnt his fortune).
He said that the loan default rate was negligable, but the trick was to only lend to women,
because they feel a personal obligation to repay and additionally will spend the money on something useful to the entire family
(ie an extra cow so they can sell surplus milk etc). On the other hand, men will piss it up against
the wall and do a bunk.
PS: pay day lending is often just a polite way of saying 'loan shark'. Though I'm sure many here would deny the
validity of the very concept of 'loan shark'.
Posted by: Stephen at Aug 11, 2006 1:33:56 AM
_pay day lending is often just a polite way of saying 'loan shark'_
I'll deny your claim, at least. The purpose of a true "loan shark" is only partly to make money off of high rates via a spread over his cost-of-funds, not really. He looks to get the debt compounding to the point where the mark would feel social opprobium simply by admitting the existence of the debt and/or the reson he borrowed the money. (i.e. you're into a shark for $100K because of a gambling or drug problem) At that point, the shark starts extracting "favors", payments-in-kind, etc.
A pay-day lender is charging the borrower out the nose, but ultimately all the same legal protections are in place and the borrower faces no more sanction from either society or the lender for defaulting than any other borrower.
Posted by: Bernard Guerrero at Aug 11, 2006 10:42:27 AM
Mirco finance only works if the the person getting the loan knows how to use the money to make more money. If not, the borrow ends up just as poor, and in debt. Loaning money is easy, teaching people how to use it to make money is hard.
Posted by: capturedshaow at Aug 13, 2006 11:20:15 PM
Dear Mr.Tyler, Microcrdit in India has problem but lots of potential.Only viewing from Banker buisness it offers big market.But my experience in working with successful project with commonwealth suggest that repayment and interest alone should not be the yardstic of success in microfinance.It is the devlopment component mainly providing opportunity to genrate income and more importantly to make people BAKABLE.Microfinance is a plateform form such unpreveledge group to have access ti finance and get ultimately mainstreamed in delopement.So far bankers have neglected them,and now wnen they see big business-with large no. of poors in devloping countries,they cry over it!! Microfinance should therfore devope innovative products that suits poor and contribute significantly in devoping poors.In India it has also successfully mobilise savings to a large extent and empowered people,especially women in its real sense.India is big country and trying to devlope appropriate models which are needbased.Any experience to suppliment it/ Thans and congrats for raising some imortant issue.
Posted by: pathak chandramauli at Aug 14, 2006 9:56:17 AM
I have long been searching for an in-depth and objective analysis of the effects of micro-financing on rural development. If someone can direct me to some useful resources I’d be grateful.
In Bangladesh where micro-financing is omnipresent, and where I am currently involved in development work, I see very little evidence of its beneficial effects among the poor. Sure enough, you can point to one family (even a thousand families) who might not be as well off without the help of one of literally thousands of micro-financing programs. Yet, it is well recognized that in fighting disease and poverty, Bangladesh has made little, if any, headway in the past thirty years.
What I do see, however, are large NGOs who gained their prominence through micro-financing programs, and have now become multi-million dollar (multi-national) corporations involved in everything from food products to cellular phone service.
Something feels intuitively wrong to me. For one thing, how can micro-financing organizations charge 25-30% interest to their customers who are without fail the most abjectly poor of society? Wouldn’t this be called loan-sharking in US?
I’m not trying to be critical; just expressing the uneasiness I feel about the purported benefits of micro-financing. I would like to be proven wrong.
Posted by: JM at Aug 16, 2006 7:22:46 AM
More on recent development in India's microfinance market:
"Even multinational banks with operations in India like ABN Amro, Standard Chartered, HSBC, and Citigroup are moving into the microfinance sector. They are striking up partnerships with other microlending specialists in India, and there is even talk of creating a secondary market for these loans.
Microloans could be bundled together into larger bond issues and sold to Indian and global investors. If that happens, it could create the kind of liquidity that might take microlending in India into a higher realm."
Sounds promising to me.
http://www.businessweek.com/print/smallbiz/content/aug2006/sb20060822_940979.htm
Posted by: Pienso Blog at Sep 2, 2006 8:25:12 PM
Thank you for this great discussion on microfinnace. I wanted to alert everyone's attention to our resource att microcapita.org where we post usually several times a day on the topic of international microfinance investment. Additionally, a search of our site with keywords like "usury" or "interest rates" addresses many of the questions raised above. Our goal at microcapital is to promote responsible investment in microfinance, but to also discuss the issues with candor. I have pasted some examples of our work below. Thank you again for this great discussion, cordially, David Satterthwaite.
Friday, April 28. 2006
Chicago Microfinance Conference Sets Pace, Providing Almost Everything, Even "Dirty Little Secrets"
The Big Two Business Schools in Chicago have made an inspired play to claim the annual microfinance conference mantle in the U.S. The ambitious students covered all the bases in the second annual one day event. Hats off!
The Players Plenary even focused on the "dirty little secrets" of microfinance, achieving a rare level of candor for a large microfinance conference, choice examples of open secrets were:
1. Usurious Interest Rates: Private and public charity dollars are re-lent to people who make less than $2 a day at rates of 40-100% annually, for more on this topic, please see past blog here. Moreover, these same charitable agencies as well as profit-seeking firms mis-represent the real interest rate charged, for more on this topic, see past blog here. (For a more technical explanation of microfinance interest rates, see past blogs here and here.) Sadly, no one at the conference actually admitted to committing usury funded by taxpayers and tithers, although one gentleman did almost face the crowd, then shied away at the last moment.
2. Misrepresentation of Repayment Rates: Microfinance is over-sold, claiming "98-100% Repayment Rates," for more on this topic see past blog here. It is refreshing to hear insiders publicly acknowledge that these figures are often wildly overstated.
3. Very Low Default Actually Means Bad Risk Management: Monica Brand of ACCION woke up the crowd by asserting that the star performing micro-banks with (verified) 99% plus repayment rates are not taking enough risk. For instance, she politely questioned micro-financiers for turning up their noses at consumer finance.
4. No Yield Curve in the Developing World: The fact that insuring against foreign currency risk is Next to Impossible when your inventory is micro-loans in Madagascar depresses even the most cherry and optimistic micro-financier, see past blog here and whitepaper here. Grant-makers committed to not distorting competitive markets could instead toss into a pot to solve this ferocious issue.
Probably the Only Elephant in the Room Left Standing by the end of the great day was the biggest one of all. Microfinance may soon be the property of banks, not governments and charities. If these founders want more than just a legacy in microfinance, then they will quickly adopt "social enterprise" strategies to claim a seat at the table.
Otherwise, a consensus emerged that perfecting the conference would require getting micro-bank customers in the conference hall. Given the high cost of travel to Chicago, video-conferencing may be the trick for next year, so please mark your calendar now because Chicago is golden in late April.
Monday, January 9. 2006
Microfinance Interest Rates as a Function of Transaction Costs
It is often observed that the interest rates charged to borrowers of micro-loans are quite high. According to the United States Federal Reserve Board, the average interest rate charged by commercial banks for a 24-month personal credit loan was 12.22% in the third quarter of 2005. The average annual percentage rate charged on credit card debt was only slightly higher at 12.48% for Q3 05; yet the APR charged for a typical loan by microfinance institutions (MFIs) in India ranged from 20% to 40% (p.4) in 2003. In lesser developed nations such as Indonesia or the Philippines rates reached up to 80% (p.4). These rates are quickly and errantly decried as exorbitant and usurious, when, in fact, they are the product of some of the most fundamental principles of economics and are advantageous not only for the lender, but the borrower as well.
Interest rates charged for lending are a function of a number of factors, of those, transaction costs and risk figure prominently into the derivation of microlending interest rates. Microlenders are subject to significantly higher transaction costs than banks in the developed world, both in absolute and relative terms. Three types of costs (p.3) are associated with the lending process: the cost of funds for on-lending, the cost of risk (loan loss), and administrative costs (identifying and screening clients, processing loan applications, disbursing payments, collecting repayments, and following up on non-repayment).
With regard to loan administration, Microcredit is an industry that is heavily dependent on personal contact for its execution (p.2). This is very time-consuming and resource intensive, and allows each loan officer to reach only a limited audience of potential borrowers. By contrast, much of the administrative process for commercial banks leverages technology for computerized credit scoring, communication with clients and payment processing. Not only is the administrative process less efficient for a microlender for each loan, but the problem is compounded further by the fact that while a developed commercial institution may lend a large sum of money to one borrower, a micro-lender will lend very small sums to many borrowers, thereby multiplying the total administrative costs by X number of borrowers.
The factors noted above contribute to a higher absolute transaction cost per loan, it is also important to note that the transaction costs relative to the loan size are considerably higher. The following example on Microcredit Cost Structure from a paper by Brigit Helms and Xavier Reille, both of CGAP, (p.2) clearly illustrates this principle:
“Compare the costs of two hypothetical lenders, Big Lender and MicroLender, each of which lends US $1,000,000. Big Lender makes a single loan, while MicroLender makes 10,000 loans of US $100 each.
The costs of capital and loan loss risk vary proportionally with loan size. Both lenders need to raise US $1,000,000 to fund their loans and will have to pay the same market rate—say, 10 percent—for the money. If both lenders have a history of losing 1 percent of their loans to default each year, they will need a loan loss provision of that amount. Both lenders can cover the cost of their capital and their risk by charging 11 percent (10% + 1% = 11%) on the loans they make to their customers.
Administrative costs are not proportional to loan size. Making a single loan of US $1,000,000 might cost Big Lender US $30,000 (3 percent of the loan amount) in staff time and other expenses involved in appraising, disbursing, monitoring, and collecting the loan. Big Lender can cover all its costs by charging the borrower an interest rate of 14 percent (10% + 1% + 3% = 14%).
However, MicroLender’s administrative costs for each US $100 loan will be much higher than 3 percent of the loan amount. Instead of US $3 per borrower, MicroLender is more likely to have to spend US $20 or more per borrower. Big Lender has to deal with only a single borrower, but MicroLender has to deal with 10,000 borrowers who typically do not have collateral, financial statements, or records in the database of a credit reporting bureau. Many of these clients may be illiterate. Lending to, and collecting from, such clients, requires time-consuming personal interaction.
Assuming Big Lender’s loan is repaid quarterly, it has to process four payment transactions per year. MicroLender’s borrowers probably make repayments monthly or even more frequently, generating at least 120,000 transactions per year. While Big Lender’s administrative cost is US $30,000 per year, that of MicroLender is at least US $200,000. Covering this cost requires a 20 percent charge on loaned amounts, resulting in an interest rate of at least 33 percent (10% + 1% + 20% = 33%). Note that administrative costs may be much higher in young MFIs that are too small to take advantage of economies of scale.”
It quickly becomes apparent that a considerable portion of the higher interest rate charged to borrowers by microlenders is derived from increased costs associated with the transaction. It is a simple fact of business that costs must be covered in order to continue operation. Further premiums must still be added to the interest rate to account for the many and varied risks assumed by a micro-lender. These factors will be explored in greater depth in a subsequent entry.
At this point, it is important to keep in mind that despite these high interest rates, micro-loans still provide positive marginal benefits for borrowers. Moreover, the potential to increase these benefits exists as the infrastructure of the industry grows, lowering costs. And finally, the high rates charged by microlenders are still considerably lower than those charged by informal sources, such as local money lenders. These important topics will also be examined in full in the coming days.
Tuesday, January 17. 2006
The Risky Business of Borrower Default in Calculating MicroFinance Interest Rates
In a recent edition, we covered micro-lending interest rates as a function of transaction costs; and today we present interest rates as a function of default risk. Lenders must charge borrowers additional interest proportionate to risk, and despite the reported high rates of repayment, micro-lending is a risky enterprise.
Default risk is a critical part of any lending decision and micro-lending is no exception. While micro-lending is trumpeted as having historically high repayment rates, information to support this is limited at best. Of the 260 MFIs that reported their “Portfolio at Risk over 30 days ratio” to the MIX (a World Bank clearinghouse for microfinance information) for 2004, the average rate was 4.76%, with some MFIs reporting up to 63.65% of their portfolio delinquent (200 other MFIs listed on the MIX did not report this delinquency figures). By contrast, consumer credit card loans in the US reported only a 3.99% delinquency rate for Q4 ‘04. Delinquency for Commercial and Industrial loans was lower still, at just 1.83%.
Not surprisingly then, microfinance delinquency figures show an industry that, on average has shown to be riskier than lending in the US. (The star micro-banks beat the above US delinquency benchmarks, but alas, there are few stars),
Compounding default risk, the lender often has limited, if any, courses of action to mitigate damages in the event of default. Poor people lack the assets to back-up their loans, and poor countries lack civil infrastructure, such as adequate court systems, to collect bad debt. Without a safety net for defaulted loans, microcredit portfolios can quickly go bad if borrowers perceive that there are no consequences for loan default.
More often than not, micro-loans are made without collateral; depending on cash flows from the enterprises they fund in order to receive payment. This dependency on cash flow cycles can yield further increased risk in seasonal enterprises that demand loans with longer maturities. Agriculture, in particular, stands out in this regard. Likewise, any trade in goods or services that is highly demand elastic also presents a greater risk.
Further compounding the risks are the harsh environments in which microfinance exists. Impoverished areas lack general infrastructure necessary for day to day business. “The clients of K-Rep, an excellent Kenyan microfinance bank in a small town on the fringes of Nairobi, are a pretty resourceful lot, but when the government stopped repairing roads, picking up rubbish and spraying for malaria, some were at wits’ end. Drainage in the marketplace was plugged by uncollected garbage and customers stopped coming. Maria Njambi, a single mother with a ten-year-old child, used to have a viable business selling fruit and vegetables she bought with credit from K-Rep, but she had to watch her inventory rot and has stopped repaying her loan.” (from “The Hidden Wealth of the Poor,” The Economist)
HIV and AIDS, among other diseases, pose very serious risks in developing nations. Those who become ill, or must take care of the sick, often must divert their time away from work and subsequently default on their loans.
Some micro-lenders have been quite successful in creating social safety nets that help hedge the default risk. Grameen Bank, for instance, one of the largest microfinance institutions with total assets of US$514,718,843 as of 12/31/04, “insists that the [borrowers] be organized into groups of five, with each person in the group committing to guarantee the loan payment of the other members in the group.” (p.2) A number of other mechanisms in this vein exist; including sequential lending, in which borrowers are able to take out increasingly larger loans as they pay off existing debts.
The higher interest rates charged for micro-loans are, in effect, insurance against default, a premium for the added risk. For a more in-depth discussion of how default risk and other factors affect interest rates in developing markets, please see “Credit Rationing in Developing Countries: An Overview of the Theory,” by Parikshit Ghosh, Dilip Mookherjee and Debraj Ray
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Posted by: levan at Sep 12, 2006 3:30:59 AM
What all of you are missing is that any lending at interest is evil. All major religions have prohibitions against it for this reason.
When the loans are circulated that is a temporary good thing, however lenders never create the money to pay the interest and since the money supply is finite. Money to pay the interest must come from the principal of someone else's loans this guarantees that the second borrow cannot possibly repay his loan unless he uses a large piece of a third borrowers principal.
This keeps just makes the poor poorer and the rich richer. The lenders don't want the money because almost every country has a private fractional reserve banking system that allows them the create out of thin air all the money the market can use. They want the true wealth which is land, homes, natural resources and capital equipment.
Please become educated about the interest death spiral which can be found from link from my site.
I am an issuer of interest free money.
Posted by: Just Money at Mar 9, 2007 5:01:11 PM
David Kernell, the 20-year-old son of Democratic Representative Mike Kernell of Tennessee, got popped. According to CNN (“Democratic lawmaker's son indicted in Palin hacking”), he reset the password and gained access to GOP VP candidate Palin's personal E-mail account. It is alleged that he read the contents, took a screenshot of her E-mail directory and obtained other personal information. The information that may have been compromised includes E-mail addresses and pictures of family members, one or more cell phone numbers of family members, family birthdates and more from Palin's address book. Interestingly, after turning himself in, David Kernell pleaded not guilty. He pleaded not guilty despite the fact that he (allegedly) took the information he hacked from Palin's personal account and posted it to a public Web site. Not only that, but he posted the new password he’d created, which would enable others to easily access Palin's E-mail themselves and view any of the contents. As a result, Kernell Junior may be subject to the heat of a five-year prison term, $250,000 fine and three years of supervised release. That’s enough to turn anybody into a fluffy white piece of popcorn. At the maximum of $1,500 per loan, that bail would require about 167 individual payday loans to free that fluffy little popped grain treat from being overcooked by cellmates.
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