August 31, 2006

Small Loans on a Large Scale

Is microfinance the key to ending poverty in the developing world? New research findings could help microfinance institutions lower their interest rates and reach more borrowers.

Microfinance, an economic development model pioneered by Bangladesh’s Grameen Bank in the 1970s, was once the realm of NGOs. But in recent years, private-sector financial institutions have discovered that making small loans to poor women can pay off. “I think there is a push toward private capital going toward the poorer sections of society,” says Professor Suresh Sundaresan, “not because of a philanthropic motivation, but because it’s good business.”

Sundaresan and PhD student Sam Cheung examined the issues facing both lenders and borrowers in the microfinance market, using data collected by the Microfinance Information eXchange (MIX), a nonprofit that promotes information exchange in the industry. Sundaresan and Cheung found that microfinance institutions reporting their data to MIX have more than 28 million active borrowers. Worldwide, banks account for 52 percent of the dollar value of microloans and 31 percent of the active borrowers, while NGOs account for 17 percent of the dollar value and 46 percent of the borrowers.

Microfinance is considered to be one of the most promising vehicles for economic development in poor countries. Most of the borrowers are female, and many microfinance institutions lend exclusively to women. The loans are small — the average loan is $848 in Latin America, $483 in East Asia and just $83 in South Asia — and the repayment rate is 90 percent, higher than that of high-yield corporate borrowers in the United States. But does microfinance offer a realistic solution to the problem of poverty?

“You would normally think that a 1,000-rupee loan is not going to deliver a family out of poverty,” Sundaresan says. “It’ll help them to sustain themselves a little better. That may be a welfare improvement, but it’s a long way from saying you’ve gotten out of the poverty trap. So the real point is scaling up.”

One of the biggest obstacles to achieving scale in microfinance is the administrative overhead, which drives up interest rates. Delivering small loans to a large number of borrowers is expensive, as is monitoring borrowers to make sure they are using the money productively. The average interest rate for a microloan ranges from 30 to 40 percent — a bargain compared to the 70 or 80 percent that borrowers might otherwise pay to a local loan shark but still much higher than corporate loan rates.

To find an optimal pricing structure for microloans, Sundaresan and Cheung built an interest rate model that incorporates the typical features of microloan contracts: (1) absence of collateral, (2) joint liability provisions, (3) penalties for default (such as exclusion from credit markets in the future) and (4) monitoring to ensure that funds are put to good use.

In a joint liability contract — the most common form of microloan — peer pressure replaces collateral as a motivator for repayment. Borrowers form groups and assume mutual responsibility for each other’s loans. Since group members select their own partners, much of the burden of screening falls to the borrowers themselves.

Sundaresan and Cheung’s research suggests that by doing less monitoring, microfinance institutions (MFIs) could lower their interest rates without hurting their bottom line, provided other safeguards such as joint liability and a credible default penalty are in place. Joint liability reduces the unproductive use of loans and can provide a stronger safeguard against default than monitoring, which is much more expensive to implement. So less monitoring would improve the welfare of both lenders and borrowers.

“Suppose you do less monitoring,” says Sundaresan. “Default will potentially go up. But then if the cost of the loan is going to go down, presumably more women will come to borrow. When more women come to borrow, the numbers are going to be in your favor because your portfolio is more diversified. So if you have all the safeguards in place, maybe you should ease off a bit on monitoring.”

The researchers found that when borrowers fail to repay their loans in spite of those safeguards, it is often because of an aggregate shock such as a heavy monsoon or an unforeseen epidemic. So lenders could potentially lower their default rates — and their interest rates — by requiring borrowers to purchase microinsurance.

Many MFIs are reluctant to expand the scale of their operations because they don’t know what will happen to their default rates. “Whatever default experience you have when you are catering to a thousand women might not hold true when you cater to a million women,” Sundaresan says. The same question arises with regard to loan size. “I want to be able to say that this model can apply to 10,000-rupee loans without substantially increasing default,” says Sundaresan, who has conducted field research on microloans in India. So far, he has been unable to find an MFI in India that is willing to test his model by experimenting with larger loan sizes.

Another impediment to scale is geographic distance and lack of information. Most MFIs serve a limited area because long-distance lending imposes higher screening and monitoring costs. India’s largest private bank, ICICI, is getting around this problem by partnering with small local financial institutions that have better information about prospective borrowers in remote villages. ICICI provides capital at a fixed rate to the local institutions, which lend it out at whatever price the market will bear. ICICI carries the loans on its books, but to give the local institutions an incentive for due diligence it requires them to cover the first 10 percent of the losses.

Even if more capital becomes available at lower interest rates, the fact remains that less than 10 percent of microloan borrowers turn out to be true entrepreneurs. Sundaresan tracked the borrowing patterns of nearly 50 women in two Indian villages over a period of 5 years. The real entrepreneurs borrowed larger amounts each year and gradually increased the scope of their economic activities, eventually pulling themselves out of poverty. Some of them now employ 100 or 200 other women.

For the other 90 percent of microloan borrowers, microfinance may offer only an incremental improvement in living standards. Still, in areas with large pools of unskilled labor, even a small infusion of capital can increase the welfare of a village or region — especially when the money is combined with education and technology. “The real issue,” says Sundaresan, “is how do you deliver the capital in a scalable manner and at a rate that is reasonable?”

Suresh Sundaresan is the Chase Manhattan Bank Foundation Professor of Financial Institutions at Columbia Business School.

Read the Research

Sam Cheung, M. Suresh Sundaresan

"Lending Without Access to Collateral: A Theory of Microloan Borrowing Rates"

View abstract/citation  Download PDF  

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