Fintech in perspective

Fintech is perhaps the most fashionable thing in the impact investment world today. There is a widespread belief that it can be transformative in addressing not just financial inclusion but poverty itself in a significant manner. 

Like with all fads, we need to be cautious about separating the hype from the reality. Evangelists cannot, by their very nature, entertain doubts and have to ride the bubble. And the converts are, again by their very nature, likely to be blind-spotted to the limitations of fintech.

As to evidence itself, the story is mixed and inconclusive. 

So here is an attempt to put the promise of fintech in its perspective. And I will not dwell on its undoubted benefits on the financial inclusion side which is already well-documented and part of the fintech folklore. I am therefore referring to those fintech companies offering lending and savings products, and not to digital and mobile money intermediaries.

A diagnostic of credit markets in developing countries reveals two important constraints. One, on the demand-side, the credit-worthiness assessment of borrowers is too expensive or unavailable, thereby either making credit too expensive or inaccessible to the vast majority of borrowers. Second, on the supply-side, the cost of capital (for lenders) is too high to facilitate affordable enough median loans and the volume of aggregate credit available (to such lenders) is too limited to meet the demand, thereby necessitating credit rationing that favours the more credit-worthy of borrowers. Regulatory restrictions and financial repression (arising out of fiscal dominance) amplify these challenges. 

Taken together, these two costs mean that the effective lending rate faced by the BoP market is at least 10-12 percentage points higher than the base lending rate in most low-income countries. 

Further, these are unlikely to disappear or even meaningfully lower in the foreseeable future, and even technology may have limits to significant lowering of these costs.

The presumption behind fintech is that it can lower the transaction costs (by enhancing credit-worthiness assessments, and reducing the general intermediation costs) and crowd-in capital (increase volumes). Let's examine each assumption.

For sure, fintech lowers the intermediation costs - after all digital transactions are cheaper than brick and mortar cash-in-cash-out transactions. While in theory digital trails make credit worthiness assessments easier, and that is indeed practically the case, the costs to bridge this information asymmetry are significant and the relative gains are less and trickier to realise. Also, as we are finding out now, in practice such digital trails with good enough quality are neither easy to accumulate nor disentangle. However, this, with time and technology could be significantly addressed. But it will take a good time, perhaps very long, before its impact is felt by those at the bottom of the pyramid. For those excited about big data, here is a cautionary note from no less a source that Ant Financial - big data ain't strong data!

The bigger challenge is with the assumption on the supply-side. For a start, given the local currency nature of the loans, in order to avoid asset-liability mismatches, it is only prudent that the refinancing credit come from domestic sources. 

Second, unlocking a large supply of domestic credit is very difficult. Domestic sources are of two kinds - deposits and capital markets. Deposit taking banks access credit through the former and capital markets, while a non-banking financial institution (NBFC) like a fintech credit provider accesses credit from either the banks or the capital markets or from the shadow financial sector. But each of these sources of finances are inherently limited in developing countries due to constraints that are not meaningfully impacted by the beneficial effects of fintech intermediation. Banks balk at lending to all but the most reputed NBFCs, whose clients are likely predominantly the non-poor. Capital markets are very narrow in every developing country, despite a very long and rich history of efforts to create both the supply and demand-sides of the market (Latin America is the best example). Shadow financial institutions, while thankfully small as on date, are unregulated and pose so many systemic risks that encouraging it is hazardous for countries where even the regular regulatory systems are so weak. One only needs to look at China where shadow financing has engendered so many excesses and distortions across the economy. 

Even thinking in terms of the value of fintech in boosting savings, thereby increasing the supply, runs into its set of challenges. At the aggregate level, the household savings rates in low-income countries are so low, and of this the financial (compared to property, jewellery, and other physical assets) savings rate is even less. And the adoption of fintech savings products by the low-income segments creates a set of very intractable behavioural challenges. 

In simple terms, there is a very rich body of research work that points to the multiple market failures that are responsible for the limited formal credit availability in these countries and none of them are likely to be addressed in any reasonable enough time and in any significant manner by fintech innovations. 

It is one thing for a fintech company to reach $50 m in assets, an altogether different thing to be doing $500 m, much less in the billions (or a market having 50 fintech lenders with $10 m in assets, compared to having just 3-4). No wonder that outside of China, fintech lending has remained still-born.

Other fintech innovations aimed at enhancing the efficiency of financial markets, too pose challenges. For example, some fintech providers have sought to position themselves as loan originators for banks. Now this, in turn poses a big challenge. An outsourced loan origination coupled with the ability of banks to securitise and sell their loan books poses a massive incentive distortion challenge for banks with systemic consequences - banks will have no incentive to ensure that the loans are of good quality. And we know what happened with just the latter in the US (from the housing market) during the financial crisis.

This is not to at all say that fintech innovation is a dead-end or not interesting, but merely to highlight the very formidable challenges, especially on factors outside the remit of fintech, that need to be overcome to realise significant sustainable gains from the entrepreneurship that abounds in the fintech sector. 

The false dawn of micro-pensions

There is a disturbing irony in encouraging poor people, who barely manage to make ends meet just for physical survival, to save for old-age and insure themselves against diseases. Self-financed micro-pensions and micro-insurance, aided by the allure of modern technologies, are a fad in international development and impact investing. It is flawed on both philosophical and financial considerations.

The fundamental assumption with micro-pensions is that it is both desirable and possible for informal workers (or poor and lower middle-class) to save money from their current income to finance their pensions. 

The desirability condition is, at best, a benign paternalistic concern of outsiders for the welfare of the poor and informal workers during their retirement. I will leave this at that. The possibility condition is contingent on another assumption. These people have the incomes to save long-term for their pensions, and it is human behavioural and cognitive failings that prevent them from doing so. 

This assumption flies against the near universal evidence on the difficulty impossibility of long-term financial savings (pensions or insurance) among the poor. Forget the poorest, even the typical rural and urban informal worker in a low income country lives a virtual hand-to-mouth existence, barely surviving from month to month on their meagre wages. 

India, for example, has a pension and health insurance scheme for all formal sector workers which requires mandatory deductions from worker’s salaries. The mandatory deductions amount to slightly above 30% of the worker’s salaries, including the employer contributions. This is actually counter-productive because it deprives the badly stretched worker off money he badly needs today to meet daily needs and forces him to borrow at much higher cost from local money lenders for those needs, thereby likely making him more indebted. While the logic of making this voluntary at least for workers with monthly wages below Rs 15000-20000 is clearly understood, its politics very challenging.  

It is also for this reason that almost all developed countries have either lower mandatory deductions or higher government contributions for low income workers. In fact, this was a major component of the acclaimed 2004 Hartz IV reforms of Germany, often claimed as the cornerstone of Germany’s recent economic success. In case of the poor, it is almost always completely public funded social safety nets that provide pensions and health insurance. 

It is ironical that international development entities promote self-financed pensions and insurance for the informal workers even though it is an idea that is not even considered for their arguably far better off (both in relative and absolute terms compared to others in their respective countries) counterparts in developed countries. 

How many countries have self-financed pension schemes for informal workers? Is there any country at all that has this creature of innovation? In fact, how many examples of micro-pension business is there in any developing country? Is there any self-financing (or non-subsidised by governments) micro-pension company which has say, 100,000 regularly paying informal worker subscribers? Is there any micro-pension company in any country which has been in existence for even 10 years? Do we have entrepreneurs offering micro-pensions to the legions of part-time or contractually (hourly-wages) employed workers (say, McDonalds and Walmart workers), who form a very big share of the labour force in the US? Do we have impact investors offering financing for such entrepreneurs? If not, why?

This is a bit like Lant Pritchett’s example of women in rural India asking him how the women Self Help Groups were in the US! 

Even if we set aside the philosophical objection, there is the question of its financial viability. In order to be sustainable, a micro-pensions entity has to overcome the following constraints.

1. The country should have deep enough long-term investment opportunities. Pension funds will have very strict and low regulatory limits on equity exposure and that too to highly rated ones too. But in low income countries the supply of such instruments which are not very risky and which can generate a significant return (to cover inflation, costs and returns) is likely to be limited.  

2. These micro-instrument agencies are unlikely to have the expertise to manage these funds internally in a manner as to generate the required returns, thereby necessitating outsourcing of funds management responsibilities to asset managers, with the attendant high management cost. This is a problem for even established microfinance NBFCs in mature markets like India. 

3. Since poor people are unlikely to be able to make certain in-payments for long periods (and in case of micro-pensions are also likely to withdraw money at the earliest opportunity), the entity offering such instruments may have to offer the product with flexible terms. This would seriously limit the flexibility of its investment options.

4. Minimise customer acquisition and retention costs, as well as ensure reasonable average savings inflows for each customer, and that too among the most financially vulnerable groups of people

5. Overcome the business longevity risk and remain a going concern for a long time, in the range of decades, a critical determinant for a business like insurance/pensions. It is also not for no reason that large legacy institutions are, for good or bad, the ones who have been successful with penetrating the insurance and pensions market in developing countries. Successful pension and insurance companies don’t suddenly emerge overnight and grow big. The entry barriers are very high. They have to piggyback on existing credible platforms. 

6. Finally, as discussed earlier, success of these instruments will have to overcome the large body of evidence on poor people being unable to accumulate large amounts in cash (as against physical assets like house, livestock, gold etc), even through small periodic cash savings, required to sustain a pension or insurance scheme. 

There are the following costs associated with these constraints and the final investment returns have to offset them

1. Cost of routine operations (acquiring, retaining pensioners etc)

2. Outsourced asset manager cost (even if done in-house, the costs can be prohibitive, in terms of attracting and retaining talent etc)

3. Costs due to uncertain inflows and outflows associated with the nature of customers 

4. Reasonable profits for the entity

5. Inflation – typically high in all low income countries

In a typical case, the first four alone will aggregate to 10-15% returns, if not more. Add in a 10% inflation rate, and we are looking upwards of 20-25% rate of return over a very long-term for this to be commercially viable as a micro-pension entity. Can we imagine the enormity of this challenge? How many such asset managers (or any kind, much less those dealing with low risk instruments/asset categories) are there in any developing country who can generate such returns? And all this out into the future? 

As an illustration of a micro-pension program, MicroSave has this nice illustration of the Abhaya Hastham program of the Government of Andhra Pradesh for women self-help group members, which pays out Rs 500-Rs 2200 per month (depending on the age of enrolment, and in today's nominal rupee) by saving Rs 1 per day (or Rs 365 per year). As the graphic below shows, when the program reached 4 million clients, it required very significant top-up by government required to make it sustainable. 

Whatever the wonders of technologies like digital money and blockchains, we cannot escape the bitter reality that poor people have hardly anything to save. It is a constraint which cannot be relaxed. I cannot imagine that we are helping the poor by making them cut back on their basic human necessities to save penurious amounts for their old age. And that too by asking them to trust a financial model which does not stand the test of even a cursory scrutiny. 

The micro-pensions fad is yet another example of the unfortunate digression away from serious  debates on important development challenges like, in this case, fiscally sustainable and incentive compatible social safety nets. 

The return of micro-lending

The Economist has a feature on the return of micro lending,

In 2015, after examining the results of randomised controlled trials in Bosnia, Ethiopia, India, Mexico, Morocco and Mongolia, American researchers questioned whether microlending worked at all. As expected, offering small loans increased business investment. But it had a negligible effect on poor people’s fortunes. Borrowers seemed to cut back on wage work in order to spend more time bent over their sewing machines or running their small, not terribly profitable shops. These days international donors and charities are much more excited about other approaches, including mobile money and “graduation” programmes, which give livestock to indigent people and teach them how to take care of them. As the development caravan rolls away, though, microlending is booming. MIX, which collects data on the industry, estimates that the number of borrowers worldwide grew by 16% between 2014 and 2015, to 130m. The total loan portfolio is now worth about $96 billion. In India, which has more microborrowers than any other country, lending was 64% higher in the second quarter of this year than a year earlier, according to MFIN, a national industry body.

This is worth pausing,

If capturing new clients is essential to success in microlending, creating new loan products is not. “There is zero innovation,” says Ratna Vishwanathan, the head of MFIN. “It’s a vanilla product”. That is a shame because, although small loans are plainly popular and do no economic harm to the average borrower, they could equally plainly do a much better job of helping people become less poor. Like many tiny businesses, Mr Iqbal’s shop swings up and down. He can be extremely busy around Hindu festivals, when people like to shop, but is idle at other times (when your correspondent arrives at his shop, he is napping). In the slowest months, he cuts back spending on himself and his family until he can scrape together enough for the monthly payment. And he knows to take on only as much debt as he can service in the lean season. At this rate, he is no more likely to prosper than he is to default on his loan.

This applies not just for micro-finance, but regular banking itself. As I have blogged earlier, the focus of financial inclusion has so far been confined to enabling access to institutional finance. But, as India's Jan Dhan Yojana program shows, access still leaves us with critical last mile gaps. It may be that poor people, farmers, and small businesses need products that cater to their unique requirements. 

Unfortunately, we are busy tinkering at the margins,

An experiment in Kolkata by two American researchers, Erica Field and Rohini Pande, found that offering borrowers a grace period of just two months at the beginning of a microloan doubled the rate at which new businesses were created. Borrowers were able to take bigger risks, which brought bigger rewards on average. After three years business profits were 41% higher and household incomes were up by 19.5%. If microlending could routinely deliver results like that, it would still be the height of fashion. IFMR Lead, a research organisation based in India, is now testing an even more flexible loan. In conjunction with Sonata, it is offering a few hundred people microloans with two three-month “holidays”. Borrowers will still have to pay something each month, but much less than usual.

This is unlikely to get us far. In fact, it is more likely with such products that they fall prey to scale dynamics. As (or, If) such types of loans increase, the rigour of screening will necessarily (to keep transaction costs low and arising from the dynamics of a growing business line) come down so as to be commercially viable. Moral hazard can get baked in very quickly. The cost of capital for lenders can rocket upwards. It is one thing to do such loans in small pilots under the watchful eyes of high bandwidth research assistants, but an altogether different thing when scaled up. 

The flawed wisdom on microfinance

The conventional wisdom that underpins the micro-finance and self-help group movement is based on three assumptions about poor people

1. They need money.
2. They are willing to borrow if they have access to credit.
3. They can use borrowed money to enhance their livelihoods. 

Now, a closer analysis would reveal that neither of these assumptions are as axiomatic as they would appear. Consider the first assumption. A recent J-PAL policy paper that summarizes findings from RCTs on micro-finance uptake among beneficiaries in Ethiopia, India, Mexico, and Morocco who were provided easier access to micro-credit, find modest demand for credit. A more plausible assumption is that poor people need money at certain times, when faced with certain unavoidable requirements.

As regards the second assumption, again the story may be complicated. Consider a society where debt comes attached with a stigma. If this were to hold, then families are unlikely to borrow even when plentiful credit is available. They would borrow to meet unavoidable consumption requirements - festival or marriage expenses, medical treatments etc. But they would not do so to meet avoidable consumption (eg. buy consumer durables) or investment (eg. expand business) requirements.  

Finally, the idea that poor people, in general, can work their way out of poverty through entrepreneurship is not only ahistorical (which society has escaped poverty by entrepreneurship?) but also simply an inversion of the conventional wisdom on risk allocation - risks should be assumed by those best able to bear it. Most business activities, however small, carries considerable commercial risks. Expecting poor people, who just about manage to make ends meet, to bear those risks appears a case of risk-burdening those with the least ability to assume commercial risks.

Incidentally, the J-PAL paper is a great read, with several interesting insights - micro-credit access did not lead to substantial increases in income; micro-credit driven business investments rarely resulted in profit increases;  none of the seven studies found a significant impact on average household income for borrowers; and there is little evidence that micro-credit access had substantial effects on women’s empowerment or investment in children’s schooling. 

Update 1 (01.10.2015)

Evidence that questions the utility of microfinance. David Roodman of CGDEV has a book where he writes, "The best estimate of the average impact of micro-credit on the poverty of clients is zero". A comprehensive DFID-funded review finds that the microfinance craze has been built on “foundations of sand” because “no clear evidence yet exists that microfinance programmes have positive impacts.”

The last-mile challenge in banking for the poor

It has always been thought that lack of access to formal bank accounts prevented poor people from saving more and once accounts were opened they would be able to more optimally manage their finances. But now that we have made some progress, albeit tiny (only 5.5% of 650,000 Indian villages have bank branches and half the adults in the country do not have access to bank accounts), with access through the campaign for total financial inclusion (TFI), have the desired outcomes been achieved for those people?

Surprisingly, it does appear that having a bank account does not automatically translate into its use, much less efficient management of personal finances. Livemint points to a study by Skoch Development Foundation which found that only 11% of 25.1 million no-frills accounts opened between April 2007 and May 2009 are operational mostly because of the high costs.

India Development Blog points to an IFMR study of the impact of TFI campaign in Gulbarga District of Karnataka (claimed to have achieved 100% financial inclusion), which found that 36% of sample households remained without access to formal and semi-formal savings mechanisms and more importantly, access to bank accounts did not translate into bank account usage. It was found that the accounts were used mostly to manage NREGS payments or SHG transactions. Critical to the lesser than expected account usage is the high transaction costs, especially by way of travel costs.

I am inclined to believe that even if access to formal banking systems, by way of opening a bank account, is increased, actual usage is likely to remain low unless bridge the last mile gap and take banking to the door-step of the people, especially in rural areas. The recent decision by the Reserve Bank of India to approve the deployment of mobile bank business correspondents, equipped with electronic terminals, to transact at the sub-branch level is certain to increase the quality of access. This will ensure that, unlike now, rural account holders are more likely to actively transact using their accounts.   

In this context, mobile phones have the potential to revolutionize banking and increase utilization dramatically. Mobile phones-based technologies offer the attraction of directly placing the bank account in the hands of the customer, thereby lowering transaction costs and increasing the likelihood of account usage. It may therefore be tempting to get carried away by this possibility, coupled with a campaign to increase financial literacy, and assume that it will ensure account usage.

However, dovetailing NREGS and other government cash transfers through TFI accounts, extensive use of business correspondents and mobile phone-bassed technologies, and financial literacy, while necessary are not sufficient conditions to ensure optimal account usage.In fact, unless complemented with other initiatives, mere increase in access to banking accounts, could be counter-productive. It could just as easily enable access to debt and other less than desirable financial products, whose extensive adoption could be detrimental to the interests of the poor people.

Behavioural science teaches us that even with access to their accounts and adequate financial literacy, human beings are cognitively constrained. This in turn means that despite firm commitment to save or spend on certain things, people tend to renege and fall short on achievement. People discount the value of later rewards by a factor that increases with the length of the delay. They are therefore tempted to spend on immediate needs as opposed to save for important long-term requirements. Further, drawing from theories of "mental accounting", it has also been found that people tend to save optimally when they they know what they are saving for.  

It is therefore necessary that the bank accounts are structured to address these cognitive biases. This assumes importance since we need to bear in mind that the ultimate objective is not to merely enable access to bank account, but to enable poor people with systems to more effectively manage their scarce finances. What can be done to ensure that poor people save more, optimize on their interest returns, manage their long-term needs like health care, children's education and pensions, make more effective purchase decisions, and so on? In simple terms, how do we ensure that people not only manage their finances effectively, but also overcome their cognitive urges which are often determental to their interests?

I have written about several examples of how innovative financial products can overcome such cognitive biases and increase the likelihood of optimal outcomes for poor people with management of their finances. In fact, bank savings accounts and financial products, with subtle commitment features, have the potential to dramatically increase not only usage but also effective usage of bank accounts. I have bloggged earlier about Save More Tomorrow, default pension savings, lottery savings products, products to increase fertilizer consumption, multi-tier accounts (also here), and budgeting family expenditures. See also this and this.

In this context, there is a big window of opportunity. Bill and Melinda Gates Foundation have just pledged $500 million to helping poor people learn to save money. They propose to fund research and project interventions in this area to emulate the examples like the hugely successful mobile banking for the poor — via cellphone in Kenya and Bangladesh and smart card in Mexico. Spurred on by the low domestic savings rate, this area has been the focus of considerable interest in the US too. It is appropriate that some part of this be leveraged into experimenting with financial products and structured accounts that help overcome cognitive biases.

It needs to be borne in mind that TFI and optimal utilization of bank accounts by the poor needs to go beyond mere door-step acceess to bank accounts.

Negative interest rate for microloans

This announcement by the Andhra Pradesh state government is certain to be another defining moment in the history of competitive populism in India, one that is certain to be emulated by atleast a few other states.

"The members of Self Help Groups in the Andhra Pradesh will get interest-free loans up to Rs 5 lakh from January 1... However, women would be eligible for interest waiver only if they ensure prompt repayment. As banks were now charging 14 per cent interest on loans to self help groups, the interest-free loans would cause a financial burden of Rs 1,400 crore on the State Government... To cater to the micro credit requirement, the government has set up a cooperative credit society under the name 'Stree Nidhi' with an initial corpus of Rs 1,054 crore."

Andhra Pradesh has an SHG bank linkage lending target of Rs 10000 Cr this year, nearly half the national target of Rs 22000 Cr. Of this Rs 10000 Cr, Rs 9000 Cr is in rural areas while the rest is for SHGs in urban areas. The state has 1.11 Cr women in SHGs.

Given the nearly 10% rate of inflation, the state government would actually be lending at minus 10% to these SHGs. It would form the most generous bank-lending program in scale anywhere (possibly anytime) in the world.

Visualizing Kiva flows

David Roodman has a superb graphical visualization of the cross-border flow patterns of over 4.3 million different types of microloans - education, health, food, agriculture, retailing etc - channeled through Kiva, the ostensibly person-to-person microlending site.

Intercontinental Ballistic Microfinance from Kiva on Vimeo.

The graphical illustration is stunning in its ability to convey the emergent dynamics of such activities. The flow patterns show how the numbers of lenders and borrowers build-up with time. Once a small trigger initiates the flow, (presumably) demonstration effects tap into latent demand among the massive pool of borrowers and generates confidence among lenders. It is also an excellent illustration of how social systems develop and the importance of initial patterns in consolidating the final outcomes.

The borrowers are concentrated in West Africa, Kenya, Latin America, Peru, Chile, Philippines, Indonesia, and parts of Eastern Europe whereas the lenders mainly come from US, West Europe, Australia and Japan.

On a more general note, I believe that a lot of complex public policy challenges can be more effectively communicated using vidualization graphics. For example, a time series trajectory of visuals of an area can highlight how specific infrastructure or other interventions there impacted the area's development in a cognitively striking manner. In fact, such visualization can beautifully capture the emergent dynamics of social and economic systems in response to specific triggers.

The populist assualt on incentives - MFI loan defaults

I had blogged earlier about a study by Citigroup economists Willem H. Buiter and Ebrahim Rahbari where they identified factors that could affect future global economic growth. One of the more interesting factors pointed out was the dangers to growth genereated by "the populist assaults on the incentives to work, save and invest". Here is one such example.

Mint quotes Vijay Mahajan of Basix who claims that, thanks to the state-wide default on Microfinance Institution (MFI) loans by self-help groups (SHGs) in Andhra Pradesh, there could be "92 lakh households in Andhra Pradesh who are appearing on the defaulters list of the National Credit Bureau".

Even assuming an element of exaggeration in the figure, it is an extraordinary situation. As far as I can remember, this is the first truly big example of a full-scale debt default by a large section of population. Unlike the loan waivers, where governments decree to write-off loans, here is an example of borrowers deciding to collectively and unilaterally extinguish their debt obligations, without abrogating their loan contract with the MFIs.

First, there is the legal-technical issue of these defaulters, forming a major share of SHGs and women in Andhra Pradesh, losing their credit-worthiness in a single stroke. How would the banks classify or risk-weight future loans to this massive category of borrowers?

More importantly, the larger message that would have been internalized by these women and their communities is that their contractual obligations to their lenders is no longer sacrosanct. The hitherto entrenched belief among borrowers that their private debt will always have to be re-paid is now shaken (the loan waivers have long since shaken this belief on government debts).

Similarly, lenders, of all kinds (who lend to these people), will now be aware that the credit risk of their borrowers have suddenly spurted. Markets will price it accordingly, with higher rates and stronger conditions, which in turn will adversely affect access and hurt borrowers. Unfortunately, this moral hazard is not limited to just borrowers and lenders. It covers all forms of contracts, and this is an even bigger concern.

As standard economic theories have taught us, a market economy is underpinned by bonds of loyalty and trust which facilitates contracts that form the basis of most market-driven transactions. There are a number of studies which have shown that developing countries have weaker contract obligation and enforcement capital and they are binding constraints on economic growth in these economies. The MFI default would surely have diminished the already limited contract capital available in such societies.

In this context, governments need to ensure that their policy decisions do not distort incentives. In the instant case of MFI loan defaults in Andhra Pradesh, even if the government wanted to punish the MFIs, it would have been appropriate if it was done without distorting incentives.

One approach would have been to, in some form, recover the loans through the regular government SHG institutions, with or without interest. The recovered amounts could then have been returned back to the banks that financed the MFIs. This would have punished the MFIs, who would have been deprived off their profits and would suffer credibility loss, without distorting borrower incentives nor causing loss to the financial institutions that funded the MFIs.

Are SHGs a public good?

Over the past year or so, the micro-finance movement has been the subject of intense scrutiny, faced with charges of fraud and exploitation. In Bangladesh, the Grameen bank and its iconic founder Mohammed Yunus have been accused by the Government of accounting fraud and diverting money. In Andhra Pradesh, micro finance institutions (MFIs) have been found indulging in practices that exploit the poor.

I have already blogged and written about these allegations and will not dwell on them here. Suffice to say that there are critical procedural/administrative problems and more importantly, serious corporate governance issues with many MFIs. In the absence of meaningful steps to address them, there are strong headwinds against any sustainable progress for the MFI model.

However, there are two interesting macro-perspectives from this debate, especially in Andhra Pradesh, that deserve greater discussion.

1. There is the argument that the spectacular success of MFIs in Andhra Pradesh overlooks the role of the government in creating a million-strong Self Help Groups (SHGs) that the MFIs could readily use (a la "ready cooked food"). There is palpable resentment at the fact that the MFIs, who merely walked in and piggy-backed on the fruits of the state government's efforts of more than a decade to develop SHGs, are claiming and getting a disproportionate share of the credit for the success of micro-finance activities in Andhra Pradesh.

In fact, the officials of the state government have even gone on record to argue that MFIs should confine themselves to non-SHG lending, "They cannot make profit by lending to the poor. Let them lend to the rich and make profit and leave welfare of the poor to the Government."

Without getting into the merits of how the credit for the success of micro-finance should be apportioned, it may be useful to examine what should be respective roles of the government and private sector in such areas.

Clearly, there are two distinct activities - formation and strengthening of SHGs and micro-lending to these SHGs. The strength of the former determines the success with the latter. In other words, SHGs form the fixed social infrastructure on which micro-finance rides.

I am inclined to see striking parallels between SHGs and classic public goods. It is now well-documented that apart from being channel to funnel credit to the poor, SHGs also play a critical role in women's empowerment and is a platform for enhancing the effectiveness of government interventions in many areas. Therefore, the net social benefits of SHGs exceed its net private benefits to the agency forming such groups. Private agencies like MFIs will naturally have less of an incentive to invest time and resources in forming SHGs.

In the circumstances, as is the case with public goods, it may be appropriate if governments focus on the formation of SHGs and invite the private sector to play a greater role with micro-lending. This does not mean an exclusive role for each in their respective areas, but a major role. So the way forward may be for governments to focus on forming SHGs and strengthening them, and for private sector to partnering with governments in increasing the volume of micro-lending. And all this assumes that the governance and other problems related to MFIs are largely resolved.

2. The second issue is related to the respective roles of the government and the private sector in combating poverty. More specifically, the success of the MFIs (most conspicuously, the success of SKS with its IPO) has generated a strong feeling that MFIs are making super-normal profits by exploiting the poor. This in turn raises the issue of what should be ethical standard for private agencies working in the area of development, the so called social enterprises.

Is it alright for a private social enterprise firm, playing by the rules of the game (assuming that the rules are themselves fair), to make profits even as it delivers on certain social objectives (as being delivered through the regular government initiatives)? In this case, is it acceptable if MFIs follow the rules, make micro-loans, and in the process also make handsome profits? Or should their profits be capped at some level? Or should the cost of lending be brought down and thereby reduce the excessive profit margins? Or should a share of their huge profits be ploughed back into helping the poor in some other effective manner?

In other words, is it acceptable for a private social enterprise, functioning with its capitalist efficiency and playing by the letter and spirit of the rules of the game, to work towards the objective of maximizing its profits?

Bootleggers, Baptists, and MFIs

A few years back, the now Clemson University Professor Bruce Yandle, wrote a famous paper that provided a crude theory of the demand for and supply of social policy regulation by invoking the parable of Bootleggers and Baptists.

Fervently supported by Baptists, early last century, some American states promulgated laws to ban Sunday sales of alcoholic beverages at legal outlets. Surprisingly, the biggest supporters of this legislation were the Bootleggers, who benefitted from the reduced availability and the opportunities to black market. In simple terms, Baptists demand prohibition to make alcohol illegal, while the criminal Bootlegger wants it to stay illegal so he can stay in business! And what's more, the Bootleggers even came to rely on the Baptists to monitor enforcement of the restrictions that benefit them!

Much the same framework can be used to analyse the current strident demand for strong regulation of the micro-finance institutions (MFIs) in India. Instead of alcohol, MFIs are the target of regulation. The Government has suddenly emerged as the moralizing Baptist in support of the exploited borrowers.

Who are the Bootleggers? In so far as the direct competitors of MFIs are the moneylenders, they stand to gain the most from any action that curtails the activities of MFIs. I cannot but avoid the feeling that the good old Shylocks are laughing all the way to the bank!

Regulating MFIs

Sriram and me have an article in this month's edition of Pragati that examines the issue of regulating micro finance institutions and its larger implications on the future of "social enterprises".

Analyzing interest caps on MFIs

The Government of Andhra Pradesh's proposed interest rate cap on rates charged by micro-finance institutions (MFIs) will in all likelihood, like similar price control decisions, generate its set of incentive distortions. I can think of three, as illustrated graphically.



1. A lowering of interest rates from the Re to Rc immediately reduces the number of people getting credit from Qe to Qs (this is indicated by the shaded triangle II).

2. However, the numbers willing to access credit at Rc increase from Qe to Qd (this is indicated by the shaded traingle III). In other words, Qd minus Qs is the number of people left without credit supply at Rc.

3. More worryingly, people accessing credit when the rates fall to Rc are most likely to be those with the highest ability to pay (those lying alongside the shaded area I) and also those more likely to have access to other channels of credit. This is because, those MFIs who are willing to provide credit at lower rates are likely to have better due diligence procedures that minimize their transaction (read recovery) costs. This ensures that those in the shaded area I are more likely to end up being given loans. Further, they also have the choice of picking from a large enough pool (demand is from Qd, whereas the supply is only for Qs) and hence are more likley to choose only the most credit-worthy of borrowers.

Prioritizing within the target group of borrowers for the provision of any subsidized credit, those people who are the most credit-worthy are also the least vulnerable and would therefore have to come last in any preference scale. However, assuming all the Qd are needy and willing to borrow at Rc, those lying in the shaded areas II and III are more vulnerable and are more likely to be prized out for all the aforementioned reasons and also not have access to alternative channels of credit. In Econspeak, the more credit-worthy and richer borrowers crowd out the less-credit worthy and poorer borrowers.

If a bank were to be in a position to be able to screen its borrowers and filter out the least credit-worthy and most vulnerable, then it would be operating in a seller's market and consider itself lucky. The MFIs (or atleast some of them) are in a similar market, thanks to the interest rate caps. Instead of helping the poor borrowers in dire need for credit, the interest rate cap ends up benefiting atleast some of the MFIs while helping none of the poor (irrespective of all this, the more credit-worthy ones would have anyway accessed their loans)!

The last-mile gap with microfinance and the way ahead for MFIs

In a country full of paradoxes, it should have come as no surprise that one of India's most profitable business sectors is also one that claims to provide a platform to lift its millions out of grinding poverty.

After a brief lull, microfinance institutions are back in the news with a big bang. First came the spectacular $354 million IPO of SKS Microfinance followed by an ongoing debate about the ethical concerns with making profits out of poor people. Then came the acrimonious ouster of the CEO of SKS under mysterious circumstances.

Now, following a number of high-profile suicides allegedly driven by harassment from usurious micro-lenders and mounting opposition, the Andhra Pradesh (AP) government has cracked the whip on microlenders. An ordinance has been promulgated capping the interest rates charged by micro finance institutions (MFIs) and introducing stronger regulatory requirements. In AP alone the MFIs are estimated to have given loans worth Rs 3500 Cr so far this year, against Rs 2358 Cr given by government banks (against annual target of rs 7500 Cr).

On the face of it, there should not have been any competition between MFIs and government-financed SHGs, especially in AP. The SHGs financed by the government of AP receive considerable interest subsidy, leaving them to pay an interest of just 1% if the group maintains regularity in repayment for six months continuously. The linkage amounts too are large, Rs 75000 for the first linkage (given to groups after six months of satisfactory thrift activity), Rs 2-4 lakhs for the second linkage, and so on.

In contrast, the MFI groups recieve smaller amounts and at usurious annual interest rates of 24-60%. The repayment terms are much more onerous - weekly repayment (as opposed to monthly for government SHGs) and the threat of force and public humiliation for recoveries. Despite these obvious disadvantages and attractions of the other side, women groups prefer MFIs in large numbers. What are the last-mile gaps that force poor people into making such apparently irrational choices?

Unlike the bureaucracy-layered loans grudgingly given by the scheduled banks as part of their priority sector lending to government managed SHGs, MFI loans come with the red-carpet rolled-out. While the group members are forced into making multiple visits to bank branch, the MFIs offer loans at the door-step. And the paper-work and other procedural formalities are minimal with MFI micro-loans. The repayment procedures too are convenient. The always-available nature of these MFI loans as opposed to the still-distant nature of bank microloans, also ensures that they fulfill the critical timeliness requirements of poor people.

There are also the attractiveness conferred by way of lack of regulation and absence of standard due-diligence requirements. MFIs encourage formation of groups followed by immediate sanction of loans, whereas the government banks insist on six months of continuous thrift activity to become eligible for the first round of loan linkage. The same group can access loans from multiple MFIs, without any questions raised about repayment capabilities.

In simple economic terms, thanks to all the aforementioned last-mile deficiencies, the opportunity cost of accessing micro-loans offered by government banks is much larger than the cost of the MFI loans, even with their usurious interest rates.

My argument that follows is neither in favor nor against MFIs. On the one hand, there is ample evidence that most MFIs indulge in unhealthy business practices that ends up exploiting the very people whom it intends to help. It is by now widely-known that apart from the downright illegal strong-arm tactics to recover defaulting loans, they also employ unethical practices that conceals the true cost of loans from their unsuspecting borrowers.

On the other hand, it is undoubtedly true that MFIs are only the latest in the long-line of businesses that have seized the opportunity to exploit the massive profits that characterize virgin markets. The only difference being that unlike their predecessors, MFIs have been making their super-normal profits even as they maintain pretensions of helping the poor and complementing the efforts of the government in lifting people out of poverty.

In simple terms, it cannot be denied that the MFIs are merely exploiting an extra-ordinary business opportunity. However, it can be argued that they are free-riding on public externalities (tapping into the existing SHGs and the social capital and trained field personnel created by the government microfinance movement) to run an exceptionally lean and low-cost business model. In the purest capitalist language, any business enterprise which, notionally atleast, purports to play by the rules of the game, and generates a return on investment far in excess of 50% is arguably efficient.

It cannot also be overlooked that MFIs, like money lenders, play an important role in meeting credit requirements of the poor. In recent years, MFIs have proliferated in response to the realisation of huge un-met credit demand among the poor, arising partially from the government's own inability to provide universal access to formal credit mechanisms. In other words, MFIs are a form of the cliched "necessary evil".

The challenge now is to ensure that the MFIs contribute towards meeting the credit requirements of poor people, without compromising on the their undoubted capitalist efficiency and entreprenurial drive. In other words, how do we get MFIs to shed their predatory and unethical business practices and start to function like normal businesses? The instinctive answer to such questions is stringent regulation - interest rate caps, severe punishments and so on.

I am inclined towards a more nuanced position. While regulations are essential, it needs to be borne in mind that they can be successful only if the state has the capability and commitment to enforce them. As is the case with similar regulations on a host of other sectors and activities, neither pre-requisites are available. In the circumstances, regulations have to be supplemented with strategies that can re-align the profit-maximizing incentives of micro-lenders with achievement of the desired public-policy objective of expanding access to formal credit mechanisms.

One way to achieve this is to formulate the market for micro-loans in a manner that makes borrowers effectively sub-ordinated equity partners in the enterprise. Profits beyond a pre-defined bound, and after accounting for the regular shareholder dividends, could be ploughed back into the respective accounts of the borrowers as bonuses that effectively lowers the final interest rates. This would enable an efficient form of price-discovery on interest rates which reconciles both the commercial imperatives of the MFI and the reasonableness of the interest rate borne by the poor borrower.

Another approach would be to have a sliding scale for appropriating some of the super-normal profits. In simple terms, a graduated system of taxation can be introduced that internalizes some of the earlier mentioned public externalities that have been captured free by the MFIs. Governments could then reimburse this as an interest subsidy to the borrowing groups.

The administration of both these strategies could become dramatically simpler with the coming of UID and the introduction of UID-linked bank accounts. It also becomes easier to enforce regulatory requirements on capacity-related eligibility norms for groups, on the number of separate loans a group can hold, and other factors.

In conclusion, MFIs may or may not have succeeded in their ostensible mission as social enterprises. It may also be debatable as to whether their activities will be to the benefit and long-term good of their customers. However, it is undoubtedly true that they have enormously enriched their promoters.

MFIs and their higher interest rates

In the past two decades, micro-finance (and self-help groups) has almost acquired a reputation of being the closest to a magic bullet in development policy-making. One of the distinguishing features of microfinance is the higher interest rates charged by microfinance institutions (MFIs). Esther Duflo and Abhijit Banerjee have an article in the Journal of Economic Perspectives that highlights this,

"These fixed costs of administering a loan can explain why interest rates for small loans are so high, why they vary so much across borrowers, and why the poor pay higher interest rates. Since borrowers with little wealth must get small loans, the fixed administrative cost has to be covered by the interest payment, which pushes the interest rate up. But high interest rates exacerbate the problem of getting borrowers to repay. Total lending therefore shrinks further, pushing up interest rates even more, and so forth, until the loan is small enough and the interest rate high enough to cover the fixed cost for even a small borrower. In other words, the presence of fixed costs introduces a kind of multiplier into the process of determining the amount lent and the rate charged... And if the borrowers are poor enough or the fixed administrative cost is high enough, the interest rate could become infinite: these borrowers will be unable to borrow at all."

The sequence of events goes something like as follows

1. The lender has to incur a fixed cost on maintaining a large recovery machinery and general administration of the loan. In view of the large numbers of these borrowers and the specific nature of such loans (no collateral loans to those without any prior credit history), the fixed enforcement costs (due to more enforcers, need to collect information on a larger number of people etc) are likely to be large. The larger fixed costs coupled with smaller loan amounts means higher interest rates.

2. Higher the interest rates, the less credit-worthy borrowers will "crowd-out" the more credit-worthy ones, and an adverse selection effect will be generated. The higher interest rates would attract borrowers who are intrinsically more likely to default. This too adds to the administration cost at the margins.

3. Higher interest rates will naturally lower the size of loans. This also means that the absolute interest repayments will form a larger percentage of the loan principal. In other words, smaller loans means that the fixed costs as a percentage of the loan amount will be higher, thereby driving the interest rates even higher up.

Here is a graphical illustration of how the high administration charges of micro-loans drives up the rates, crowds out the best borrowers, lowers average loan amounts, and thereby forces rates even further up.



The moral hazard is amplified by the presence of multiple and competing lenders. The cost of a likely default is often lowered by the possibility of another lender waiting in the wings to step up when the need arises again. In this context, it would be interesting to examine the moral hazard effect on private micro-lenders arising from the presence of government micro-finance (if they default there, they can always fall back on the government)?

The cost of default has to be higher than the interest payment so as to minimize the possibility of default. As Banerjee and Duflo point out, the incentive of a continuous relationship with the bank/micro-lender often provides the deterrent against default.

The fundamental issue being raised here is this. Micro-finance has emerged as one of the major sources of channeling credit to poor people. It is arguable that even as micro-finance has grown in importance, it may have had unintended effect of taking away the focus from penetration of conventional banking into rural areas and among the poor.

However, as the aforementioned reasoning/modelling suggests, micro-finance services only a specific category of customers among the poor. While regular consumption needs and business working capital requirements (with their focus on adequacy and timeliness) are optimally serviced by micro-loans, small-business capital investments (which need larger and longer tenor loans) would require conventional banking.

Conventional banking will always be the preferred choice for customers borrowing higher amounts with longer tenors. Further, there will be a large share of the poor who cannot afford the higher rates charged by the micro-financiers. Under the circumstances, the total consumer welfare among the poor can be maximized only if micro-loans complement, and not substitute, conventional banking sources.

Financial engineering for the poor

The last two decades have seen a proliferation of financial instruments that have had a dramatic impact on the global financial markets. While many of these instruments of financial engineering have played critical contributory roles to the current crisis, it cannot be denied that they have had considerable beneficial effects.

In the circumstances, it may be appropriate to borrow atleast some of the more obviously beneficial initiatives and instruments of financial engineering and use them to help the poor and lower middle class save more and efficiently and control their expenditures. Unlike the profit-driven nature of conventional financial market interventions, financial innovation for poor people should draw in on insights from behavioral psychology that point to numerous cognitive biases that forces them into sub-optimal spending and saving decisions.

Instead of providing inefficient direct assistance through revolving funds, interest subsidies and plain vanilla bank loans, it may be more effective to take a leaf out of behavioural economics and design instruments that incentivize savings, optimize consumption expenditures, and more effectively manage income flows for poor people.

In view of the large number of competing immediate consumption needs and their limited income, poor people experience very high opportunity costs on their savings. They also face self-control problems with managing their incomes and expenditures due to their dynamically inconsistent inter-temporal preferences. Recent research in behavioural economics have shown numerous examples of the aforementioned problems and offered suggestions on overcoming them.

In this context, in a classic paper, Shlomo Benartzi and Richard Thaler have advocated the use of instruments like "Save More Tomorrow", that commit savers in advance to allocate a portion of their future salary increases toward retirement savings.

In the present arrangement, the SHGs leave their thrift savings in the group savings bank account, which yields meager returns. Savings accounts, similar to the Corporate Liquid Term Deposit (CLTD) accounts offered to corporate clients, that automatically sweeps all the balances in the account into short term (say, money market) instruments and gives higher returns can optimize returns on their savings.

Apart from the issue of large numbers of competing needs, it is also commonly observed that a large share of the savings get dissipated in expenditures during festival seasons on "temptation goods". In order to overcome the self-control problem and disincentivize wasteful consumption expenditures, restrictions can be imposed on the periodicity and amounts (minimum balance requirements etc) that can be withdrawn at any time from an account.

Any exception to this should require an elaborate application process, including possibly multiple visits to the bank. Higher premiums (interest rate discounts or flat penalties) can be placed on withdrawls during a specific period, timed to coincide with, say festival season, or higher interest rate return for savings during that particular period ("festival offer" of higher rates for specified periods, complements nicely with the demand-supply dynamics, given that people tend to withdraw their savings in larger quantities during such times).

Savings instruments that combine features of a lottery (which are manifestly attractive for low income people) can be used to incentivize people to both save and keep their savings locked in for longer periods. Peter Tufano of HBS has designed premium savings bonds, that come with a lottery option, in which the buyer can particiapte only if he remains invested for a certain period of time. The Irish government has a unique form of tax and risk-free, state guaranteed savings instrument, Prize Bonds, offering people the chance to win big cash prizes in a weekly lottery.

There is also evidence to suggest that use-directed accounts, that are designed based on people's mental accounting choices, are effective at promoting savings. Accounts designed with pre-defined and use-directed escrows, can therefore be a very effective instrument in nudging people to both making savings for specific needs and limiting withdrawls from specific escrows. Further, sub-accounts like "education accounts" or "bike accounts" can be used to channel specific subsidies like student scholarships or even be linked up with commercial EMI based schemes for consumer durables.

Simple savings instruments that make annuity payments for children's educational purposes are effective means of chanelling savings for specific purposes. Besides, public policy can promote them by making matching or some pre-defined contributions to such accounts. The periodic (monthly/quarterly) contribution can be transferred by default from the savings bank account. Like Save More Tomorrow, the contributions can even be increased every year, in small increments, as a default option.

Appropriately customized (varying subsidies, depending on the size of house to be constructed), easy to access home loan products for the poor, can be designed and offered through private banks at varying commercial terms (tenor, rates and so on). The subsidies - direct cash, interest rate subsidy, etc - can be directly transferred into the account of the individuals.

Similarly, specific business investment products can funnel savings and government subsidies (like those under various self-employment schemes) to make capital investments in starting new or expanding existing businesses. Government support can be made conditional on achieving certain levels of savings, and can also be used to leverage further private bank loans.

In view of the volatile nature of inflation in developing countries, inflation-indexed savings products, especially those with longer tenor, can help mitigate inflation-induced erosion of the value of savings.

Agricultural income comes as harvest-time windfall inflows, which, given the self-control problems that afflict human beings, are liable to be inefficiently frittered away. It is therefore only appropriate that this one time inflow be converted into a stable revenue stream so that the farmers have access to an assured income every month. So how about a "harvest plan" annuity product offering by banks to attract these amounts as term deposits with gradual draw down? Such annuity plans can be offered to farmers groups, so that the banks can attract large deposits from the incomes of a group of farmers.

A share of these deposits can then be channeled into some of the various other savings products, including as default options. Payments on procurements by the FCI can be funneled into these accounts by default, including into a "fertilizer account", which can in turn be drawn down to make payments for fertilizer purchases for the next season. Such instruments can be used to make more efficient use of the proposed nutrient-based direct cash transfer fertilizer subsidy regime.

Or the subsidy can be given as dated vouchers which expire within specific period, timed to coincide with the mid-season, when application of fertilizers is most optimal.

Apart from promoting savings and containing excessive and even wasteful expenditures on "temptation goods" and immediate gratification, such financial instruments also help to more optimally and efficiently target beneficiaries with various direct and indirect subsidies. It also creates signalling platforms that simultaneously enables private companies to tap into the "fortunes at the bottom of the pyramid" and those consumers to access the products of this market.

Are MFIs and moneylenders complements?

Marginal Revolution draws attention to a WSJ article that appears to indicate an increase in traditional money lenders even in areas with heavy concentration of microfinance activity.

The RBI has reported that the number of registered traditional moneylenders increased 56% to 19,627 from 12,601 between 1995 and 2006. Another survey has estimated that the traditional moneylenders' share of total rural Indian household debt grew to 29.6% from 17.5% since the nineties when microfinance movement took-off.

Interestingly, WSJ sees moneylenders and microloans as complementing each other, in so far as SHG members may be drawing on moneylenders to help them keep their repayment deadlines and avoid the very powerful peer embarassment. The argue that since moneylenders may actually be helping SHG members repay their microloans in time, atleast some of the MFIs may have been bankrolled by moneylenders themselves. In this paradigm, moneylenders and MFI are some form of complementary services! Econ 101 defines two goods or services as complementary when they are bought and used together, the demand for one mirrors that for the other and vice-versa.

Speculating about the growth of moneylenders, as evidenced in the aforementioned figures, there are a few silver-linings -

1. It is possible that the proliferation of MFIs has forced moneylenders out into the open and made them register their activities. In other words, the growth of MFIs has generated a positive externality - competitive pressure on moneylenders to become more efficient (and thereby access formal sources of funding mechanisms) and transparent. Further, to the extent that older moneylenders are now getting themselves registered, the true numbers of newly enterant moneylenders may be exaggerated.

2. Even assuming that the numbers of moneylenders have been increasing, it may only underline the severe credit stress faced in rural India. One indication of this is the fact that official figures show the rate of banking credit and deposit growth as being much higher in villages than cities. A recent article in Businessline estimated the appetite for microfinance at about Rs 1.30-lakh crore a year, whereas microfinance disbursements were about Rs 28,000 crore in 2008-09.

In other words, thanks to the increasing penetration of economic growth into villages, the rural credit demand may be rising at a rate faster than what both the banks and MFIs are able to meet. And moneylenders may be only stepping in to fill in the vacuum. So we should be having more aggressive outreach of microfinance. It is also one of the most important arguements in favor of banking access and strategies like Total FInancial Inclusion (TFI).

Four problems with prevailing SHG model

That the existing Self Help Groups (SHGs) based micro-finance model has achieved remarkable successes is delivering both social and basic economic empowerment of women in many developing nations cannot be disputed. However, the prevailing model, especially in the government led micro-finance schemes, suffers from important limitations that come in the way of achieving goals that go beyond the modest initial objectives.

Here are four fundamental problems with the micro-finance based poverty eradication model of delivering development.

1. The rigidly structured (10-15 members and lack of flexibility with changing its composition and size) group account oriented micro-finance model does not have the required flexibility to accommodate the differential savings habits of members within the group. Since there is only one servicing account for the group, all the members generally save the same amount and equally share any benefits. Therefore, instead of need-based loan uptake, more often than not the loans are equally divided among the members and resultant sub-optimal utilization. This becomes critical, especially when the group has achieved a level of empowerment, and the differential credit needs of group memebers assumes importance.

2. In the absence of access to innovative and beneficial financial products, the SHG members may not be able to make the most efficient use of the inculcated savings habits and financial inclusion. In fact, currently the high opportunity cost (given the scarce income and multi-farious competing needs) thrift is being locked up in the low yielding savings bank account of the group. Unfortunately, even as the focus has been to get people to save and open bank accounts, important issues like the returns on their savings have been lost in the maze of priorities. Further, not enough attention has been paid towards leveraging the savings to minimize the risks associated with the universal and commonplace needs like health care and children's education.

3. The present arrangements also do not place the required premium on the vital forward and backward linkages like access to intermediates and capital goods, markets, and training required for making the most optimal use of the financing available for self-employment generation opportunities. It may be more appropriate if the financing, especially for starting new businesses or expanding existing ones, be bundled with all the required forward linkages.

4. It does not more explicitly acknowledge the reality that SHGs and microfinance are at best an entry-point activity that should be used to propel the group members into a higher growth trajectory. This would require that the groups leverage on the platform provided by the SHGs to access the formal institutions that support them and then its members get gradually equipped to chart out their fortunes independently. It needs to be acknowledged that while the strength of the group is an excellent platform to address the problems facing a group of poor people struggling to survive, it may not be the most efficient vehicle for addressing the challenges faced by those positioned to move up the economic ladder.

SHG membership as a signalling mechanism

In the last two decades, Self Help Groups (SHGs) and the micro-finance movement have emerged as one of the most important, if not the dominant, platform for addressing the challenge of eradicating poverty in many developing countries. The penetration of SHGs have been especially strong in many parts of India. However, there is a growing danger that these SHGs are becoming an end in themselves, rather than be instruments in fighting the scourge of poverty. I have blogged about this in an earlier post here.

These groups which started out as a means of empowering and inculcating thrift among women continue to remain stuck with the same paradigm and objectives. At best, the existing sets of policies have helped these groups start and expand on small, livelihood-based business activity. However, even in the specific activity of accessing formal sources of financing (for various purposes), the SHGs have not gone beyond traditional bank-loan driven group borrowings.

This post will seek to make a case in favor of a signalling role for SHGs in helping their individual members (and not as a group) access the broad spectrum financing options in the market. I will flag off one dimension - accessing all available formal financial/financing markets - in which SHGs, especially those with adequate capacity, can be invaluable in spurring more macro-level economic activity.

Now, a large number of these groups have gathered substantial capacity to deliver on outcomes beyond those intially envisaged. With some assistance and a different set of policy tools, many of them are capable of leveraging their capacity and built-up strengths in moving up into a higher trajectory of growth. More specifically, those SHGs can enable the transition of the SHG and micro-finance movement from addressing poverty alleviation to promoting vibrant entrepreneurship and economic development.

One of the most important dimensions of the utility of SHGs is in their role as an effective signalling mechanism. The poorer borrowers suffer from an especially acute risk aversion among lenders arising from the greater probability of adverse selection. The peer-pressure driven compulsion among SHG members to repay bank loans has become an effective credit guarantee for banks in making group loans to the SHGs. A logical extension of this argument would be to use the same credit-worthiness signal arising from SHG membership (atleast in the case of the stronger groups) to leverage loans for individual group members.

This would enable individuals to use their group membership to access/draw individual loans from banks for specific productive investments like business expansion or starting new businesses, constructing homes, purchasing consumer durables and automobiles, loans for education and health care, and so on. Presently, individual group members who want to make these purchases or investments access credit through the group loans, and then use it to incur their expenditures, thereby causing considerable transaction costs and duplication of activities.

Further, group loans generally involve equal distribution of the loan amounts among all group members. However, within a group, different members have varying levels of credit thresholds. Members use these loans for different purposes, move along varying growth trajectories, and have non-uniform credit needs and repayment abilities. In the circumstances, it becomes likely that those members who are more enterprising and have higher credit appetite gets constrained (in access to more credit) by their laggard compatriots. All these only highlight the importance of enabling individuals to access loans at their terms.

Here are a few examples of how this would work. Retailers (or their partner financing institutions) selling consumer durables on EMI can lend directly to poor customers, without the standard collateral requirements, by banking on the implicit guarantee provided by the individual's group membership. Typically, in the rural areas and smaller towns, there are likely to be only a handful (even only two or three) of retailers in the local market selling consumer durables or automobiles. It is easier and more efficient for them to administer these EMI sales of consumer durables and automobiles to the small numbers of local customers.

Poor people, looking to construct their homes, face numerous problems in accessing home loans in the regular financial markets. Given the large demand for home loans and the massive government spending on providing housing to the poor, it is natural that it offers ample mutually beneficial opportunities for both banks and the poor customers. The regular government housing programs for the economically weaker sections can be dove-tailed with direct bank lending to individual members of good SHGs, either by government providing the interest subvention subsidy (soft loans to beneficiaries) directly to the bank or the individual leveraging bank loan to top up the government assistance and construct a larger house with an additional loan.

Similarly, individual members should be able to access education loans by leveraging their membership of the SHGs, especially for higher education in professional courses. Here too, the regular government interest subsidies can be transferred directly to banks, thereby minimizing transaction costs and effectively addressing the targeting problem.

By encouraging the banks to lend directly to individuals using the signalling platform of SHG membership, and then transferring the interest subsidy directly to these banks, the government can reduce the considerable transaction costs and other numerous distortions associated with government subsidies.

It is true that there is nothing that prevents bankers today from providing loans to credit worthy individuals who are members of SHGs. But a formal recognition of provision of individual loans to the members of SHGs with good track record on the back of an implicit (not explicit) guarantee as a component of priority sector lending of banks, would go a long way in boosting the demand for such loans. It would encourage bankers to lend and borrowers to access formal financial institutions to meet their financial requirements. Bankers do not bear much additional substantive risks. Afterall, loans provided to SHGs were done so without any collateral backing and have borne impressive returns till date.

In the absence of credible signalling mechanism about the credit-worthiness of these individuals, such transactions would not have materialized. The banks benefit by increasing their loan portfolio without a disproportionate increase in the risk assumed, while the poor consumer gains access to the formal sources of credit provisioning, and government becomes able to more effectively target and deliver its assistance. We have a clear Pareto improvement, brought about by the signal emanating from membership of a credit-worthy SHG.

In order to avoid any moral hazard arising from this, it may be prudent to limit such lending to only those groups which have availed of and repaid atleast one or two tranches of loans in the recent period. The lending should be done strictly only after a resolution has been passed by all the members of the group permitting the specific individual to access the loan. Further, such lending can start off with small loans and the credit limits can be progressively loosened, both among group members and specific individuals availing of the loans. Also, the initial rounds of such loans can be limited to specific categories of expenditures like purchases of consumer durables, automobiles, student education loans etc.

Questioning the SHG led micro-credit movement

Despite breaking into the arena of development public policy making atleast two decades back and assuming the role of being the premier anti-poverty instrument in countries like India, there have been very few detailed studies on the impact of Self Help Groups (SHGs) and micro-finance as a poverty eradication tool. All the while policy makers have been increasing their exposure to SHGs as the "magic pill" to deliver on the objective of poverty eradication. This does raise very valid questions about whether we are putting all our "development eggs" in the single "basket of SHGs"?

It is in this context that two recent studies raises interesting questions about the micro-finance driven model of poverty eradication that has become the touchstone for all such efforts in India. From a randomized trial in 104 slums of Hyderabad, Esther Duflo, Abhijit Banerjee and Co find mixed results on economic activity and no impact on social dimensions like measures of health, education, or women's decision-making. From a field experiment on credit expansion for microentrepreneurs in Manila, Dean Karlan and Jonathan Zinman find no evidence of improvements in the well-being of those accessing micro-loans, and also results that are diffuse, heterogeneous, and not directly on the targeted group.

Karlan and Zinman find several indirect effects or positive externalities from micro-loans. They find that targeted micro-entrepreneur households shrink by shedding un-productive workers form their businesses; use loan proceeds to invest in human capital of their children, rather than in capital specific to their businesses; and male entrepreneurs appeared to benefit more than female ones from mico-loans.

The study by Duflo, Banerjee and Co about the micro-finance to SHGs in Hyderabad flags off several interesting issues. They find that those households with high entrepreneurship propensity exhibit the most positive response to microloans, as they use the micro-loans to finance the fixed cost and revolving capital requirements of running a business. Micro-loans are found to increase their consumption/purchases of durables (or investments), either for their businesses or for their personal use. It is observed that micro-loans crowd-in investments in starting the business or expanding existing businesses and crowds-out spending on consumer non-durables and temptation goods (alcohol, betel leaves, tobacco, gambling, and food and tea outside home). Further, existing businesses report a large and significant increase in profits after the micro-laons were provided.

The study indicates limited or no effect of the opening of MFI branches on education, health or women's empowerment. This appears to overturn the conventional wisdom that self-help groups and microfinance activity has much greater utility as a tool of social than economic empowerment.

The purpose of this post is not so much to question the utility of SHGs and micro-finance as to examine the possible changes in approaches and methodologies required to make more effective use of these anti-poverty policy instruments. I will first list out some of the general issues relating to the role of SHGs and the present approach and policies surrounding their functioning and development.

1. What should be the most optimal size of groups? Why should it be 10, as is the case with the majority (if not all) SHGs in the country? Does not the otpimal size vary with the backgrounds of the groups - urban-rural, very poor-poor, literate-illiterate etc? What should be the size of federations? Vary the numbers of members in treatment groups to study this.

2. Are smaller groups more effective for economic empowerment through capital investments, while larger ones are better for social empowerment and consumption smoothing? Does this mean that groups should split as they gather capacity to ensure that the varying requirements of the different members of the group are more effectively addressed? In other words, after the second or third linkage, should the SHGs be split into smaller groups so as to enable the members to move forward at raising credit and expanding their businesses at their choice?

3. What should be the most optimal size of initial and subsequent loans? What should be the repayment tenor and schedule? How should loans be packaged? Should loans be use-directed or left to the discretion of the group? Should loans, especially for business investments, be supported with backward linkage support - business literacy, training, helping to source their capital equipments, marketing etc?

4. Women of which age group are more responsive for each category of loans? Does it not make greater sense to target business loans to women of a specific age group? What should be the most optimal age range of group members? Which age group is the most effective target group for SHG activity and bank linkages? Treatment groups to be divided along different ages and studied.

5. What is the impact of financial literacy, group capacity built, general adult literacy, business training etc on how the loans are utilized? How should different categories of loans be packaged, so as to optimize their cost and effectiveness for the group members? Is it more effective to package different categories of loans as loan plus one of these aforementioned linkages or support? In other words, should some categories of loans be disbursed only as a bundled product?

6. Would any other intervention involving increasing financial access, like opening of bank branches and starting of no-frills accounts have also produced the same impact as SHGs and microloans? What would be their respective impacts? Treatment-control studies on these would be instructive.

7. What is the impact of presence of MFIs on moneylenders? Do they lower their rates in view of the reduced demand for their funds? Do MFIs inculcate market discipline into moneylenders? What other positive externalities do the presence of MFIs exert? This assumes important given the fact that moneylenders perform (and will continue to do so for the foreseeable future) an important credit provisioning role in such societies and the challenge is not to eliminate or drive them out, but to discipline them into moderating their lending practices and terms.

8. What is the comparison of the loan-use break up on loans given by money lenders and MFIs? Did MFIs change the loan distribution profile by encouraging new business or business expansion loans?

9. Which economic, social, and religious groups are most and least responsive to loans? It is important to supplement with other anti-poverty measures for those groups of people who take to SHGs with the least effectiveness. In such cases, it would also be important to identify the deficiencies and the reasons for the relatively poor uptake by these people. What is the treatment impacts of loans for consumption, paying off debts, starting business, expanding old business, and purchasing consumer durables, on different categories (economic and social) of SHG members?

10. Should we not explore getting consumer durables retailers/financial institutions that sell their products in Equated Monthly Instalments (EMI) into lending directly to individual SHG members (who would other-wise take loan and purchase consumer goods)? If need be, the government can then directly transfer the interest subvention differential to the respective bank or financial institution. Is it not possible to nudge established financial institutions to provide individual loans for expanding established business by leveraging the credit worthiness provided by the individual's membership of a good SHG?

11. Should we not have a detailed database which tracks the uses to which different groups and its members have used their share of loans for and their impacts, so as to more efficiently tailor and direct the next round of loans? For example, if one member in a group was repeatedly using a large share of the loans for children's education, it may be useful to help the student linked up with a scholarship provider. The information on consumption loans can be used to provide assistance to access alternate smoothing strategies like insurance etc.

And here are a few questions on the aforementioned Hyderabad study involving the MFI Spandana

1. I cannot but help feel that Spandana, being a commercial MFI, showed selection-bias in identifying the areas it proposed to set up its branches. This is evident in the criteria it used to select the slums - "poor, but not the poorest of the poor", smaller habitations/bastis within the slums, home ownership by 80% of the groups members etc. Did these not provide an implicit guarantee and distort the selected group? SHGs in rural areas may not fit into this profile.

2. Did the comfort provided by home ownership, among 80% of group members, provide an implicit guarantee for Spandana? If this were the case, would the individual members have accessed institutional loans by mortgaging their title deeds (assuming they had title deeds, which they should have had in Hyderabad)?

3. Was the decision of new MFI entrants on where (which places) to enter influenced by the presence of Spandana groups? Did Spandana's presence have spill-over effects which may have created an upward bias on the outcomes of the other groups? What effect did these new entrants have on Spandana groups themselves? Since MFI activity was virtually absent, the impact of Sapndana's entry may have been different from if there was already strong MFI activity.

4. Was there no government SHG activity in these sample areas at the baseline of 2005? I am inclined to believe that there was, more so given the fairly strong network of SHG activity in Andhra Pradesh. Has this effect been controlled for?

5. The quality of such household surveys are suspect, especially given the type of information solicited - asset ownership, decision making issues, expenditures, borrowings, savings etc. The households, especially in urban areas, have been socialized by government surveys to under-report their assets and savings, over-report their expenditures etc.

6. Is the increase in business openings in the aftermath of entry of Spandana due to the MFI loans or due to the fact that a few members who initially accessed these loans set off an emulation effect on their neighbours to start businesses? In other words, did Spandana's work exhibit spill-over effects on those who otherwise may not have taken micro-loans and if they did take it, would have used it to for other purposes? Did the new addition, due to this bring in an attrition bias into the sample, by adding newer memebers into the possible group of beneficiaries?

7. However,the selection-bias inherent in the choosing of Hyderabad, with its urban and relatively empowered socio-economic context, may have masked the cause-effect relationship between microfinance activity and social empowerment. One explanation for the limited assessed impact on the social empowerment dimension may be attributed to the fact that social changes take much more time than the two years of the study to have any noticeable impact. I am also inclined to believe that the effects would have been much more marked in the rural areas.

All these aforementioned issues can (and should) be examined extensively using randomized control studies, so as to re-design policies on SHGs and micro-finance to make them more effective and deliver greater bang for the buck.

Update 1 (20/6/2010)

Abhijit Banerjee argues that "there is now recognition that poor people and small firms have very limited access to capital and risk diversification"; they "do start a lot of firms, but these firms seem intended to remain tiny"; "the poor are not particularly well-suited to be entrepreneurs: They neither have the risk bearing capacity nor the human capital"; "nor will anyone give them enough capital to really grow the businesses". He therefore suggests that the main source of dynamism has to be growth of medium to large firms, though "there is evidence showing that these firms are too rare and too small in developing countries".