A.Importance of Micro Finance
A good definition of microfinance as provided by Robinson is, ‘Microfinance refers to small-scale financial services for both credits and deposits —that are provided to people who farm or fish or herd; operate small or microenterprises where goods are produced, recycled, repaired, or traded; provide services; work for wages or commissions; gain income from renting out small amounts of land, vehicles, draft animals, or machinery and tools; and to other individuals and local groups in developing countries, in both rural and urban areas’.
The goal of microfinance is a world in which as many poor and near-poor households as
possible have permanent access to an appropriate range of high-quality financial services, including not just credit but also savings, insurance, and fund transfers.(CGAP, 2004)Seen from a broader perspective, the development of a healthy national financial systemhas long been viewed as a catalyst for the broader goal of national economic development(see for example Alexander Gerschenkron, Paul Rosenstein-Rodan, Joseph Schumpeter,Anne Krueger ).
Gerschenkron (1962)postulated that the more backward an economy was at the outset of development the more certain conditions were likely to occur during growth: consumption would be squeezed in favor of investment (i.e., savings) in countries starting from farther behind, and there was likely to be a greater reliance on banks, state entities, and other means of directing investment, among other conditions. He never exactly defined how 'backwardness' was to be measured, though he alluded to a northwest-to-southeast axis within Europe, with the United Kingdom at the most advanced extreme and the Balkancountries at the least developed extreme.
Rosenstein Rodan(1943) is the author of the 1943 article "Problems of Industrialisation of Eastern and South-Eastern Europe" - origin of the “Big Push Model” theory - in which he argued for planned large-scale investment programmes in industrialisation in countries with a large surplus workforce in agriculture, in order to take advantage of network effects, viz economies of scale and scope, to escape the low level equilibrium "trap". He thus developed a theme laid out by Allyn Young in his 1928 article "Increasing Returns and Economic Progress", in which the latter himself expanded a theme formulated by Adam Smith in 1776.
Schumpeter (1934) thought that the institution enabling the entrepreneur to purchase the resources needed to realize his or her vision was a well-developed capitalist financial system, including a whole range of institutions for granting credit. One could divide economists among (1) those who emphasized "real" analysis and regarded money as merely a "veil" and (2) those who thought monetary institutions are important and money could be a separate driving force. Schumpeter was among the latter.
According to Anne Krueger liberalization of trade and payments is crucial for both industrialization and economic development.(Krueger, 1997)
B.Microfinance and Behavioral Economics
A growing body of research into decision-making reveals that people, rich and poor,consistently save less than they would like to. The problem is not simply impatience and a lack of “future orientation.” Instead, new explanations point to limits to complex decision making and weak internal self-control mechanisms on the part of individuals. The theory translates into innovative practice and products. Field studies, for
example, show the power of mechanisms like structured savings accounts that require regular deposits toward a fixed goal. Having the right mechanisms can make the difference between saving a little and saving a lot.( Armendáriz and Morduch 2010 p.17)
Mulainathan and Krishnan(2008) conclude in their article on Psychology and Economics:
“The psychological evidence presented suggests that planning for the future and sticking to that plan is difficult. The behavioral economic framework of these facts supports the idea that debt discipline is a good mechanism for microfinance clients. Given the liquidity constraints that many of the poor face, many are unable to save enough on a regular basis to meet their needs. For this reason, having relatively affordable access to credit can allow many clients and their families access to a range of items that will enhance their quality of life, from new consumer goods to the ability to pay for children’s school and college fees. The commitment to make weekly repayments to the MFI is something that many clients see as fixed, which helps them psychologically realize that saving for such payments cannot be delayed. In any case, given that mistakes are easier to make for the poor and carry much more weight, repayment discipline, implemented either through product design or group trainings, helps mitigate these self-control problems when it comes to debt.
At the same time, a behavioral perspective can be useful when thinking about common
accusations leveled at the microfinance sector, including the fact that clients borrow at high interest rates and may not be fully aware of the conditions to which they agree when borrowing from MFIs. With the example of the “leaky bucket,” where clients often find themselves unable to save up a large enough sum of money to purchase consumer durables for their homes, given the array of temptations and events responsible for the savings leakage, it is easy to see how microfinance clients are borrowing at relatively high interest rates because of behavioral reasons,rather than simply the lack of credit. In fact, this common behavior could be more of an illustration of the failure of savings markets, given that the cost of savings, at the expense of immediate need, may be so high that clients continually turn to both MFIs and moneylenders to meet their need for credit.
Lastly, in terms of consumer finance and policies to regulate the microfinance sector, it is
important to realize that development economists tend to emphasize the presence of institutions:
for instance, banking may need to be privatized to guarantee a more streamlined credit system that also ensures better savings facilities and smoother consumption. Behavioral economists take these ideas and examine them through a psychological lens, which often shifts the focus to how important the effects of human behavior are when thinking about how the poor deal with all aspects of their lives, from managing their finances to providing for their families. We see through the behavioral lens that institutional design in microfinance is not just about providing access to financial services but about solving these issues that microfinance clients—the poor— face on daily basis. Within the scope of this piece and the few examples presented here, it is the hope of the authors that principles of psychology as well as economics will provide greater intuition when formulating development policies that affect the poor in their everyday lives.”
Having given an introduction to the theme we plan to study we next look at the basic issues which we need to consider with regard to behavioral aspects of microfinance.
Mode/Mechanism of Microfinance
Are their certain behavioral anamolies specific to the poor? Does that affect the products relevant for them?Does that affect the mode of financing them?
A.)Are their certain behavioral anamolies specific to the poor?
Bryan, Karlan and Nelson (2010) define a commitment device as an arrangement entered into by an agent which restricts his or her future choice set by making certain choices more expensive, perhaps infinitely expensive, while also satisfying two conditions: (a) the agent would,on the margin, pay something in the present to make those choices more expensive,even if he or she received no other benefit for the payment; and (b) the arrangement does not have a strategic purpose with respect to others.
Much of the empirical work on Behavioral Anomalies in Credit Markets centres on the poor.This reflects a simple reality: behavioral anamolies may be costly to individuals, but the poor have less slack, ie; disposable income with which to absorb errors(Bryan, Karlan and Nelson, 2010;Mulainathan and Shafir, 2009)
Banerjee and Mullainathan (2009) formalize this idea in the context of commitment, putting forward a temptation model that helps explain the existence of poverty trapsAt higher levels of income, however, only a small portion of marginal saving will be spent on temptation goods. Therefore, those with low income donot save and those with high income do save, leading to polarization of income. If this model is correct and temptation does in fact represent a smaller cost to the rich, then commitment devices may provide a means of pulling the poor out of poverty.
B.Do the behavioral features of the poor affect the products relevant for them?
Ashraf et.al(2003) examine savings products in developing countries designed to promote commitment behavior. The desire for clients who require liquidity and also want help committing to a savings plan, but these two desires are often at conflict with each other.
Summarising from this paper:
Savings products with a commitment property can be more suitable to meet long-term goals and anticipated events, such as purchasing a house or paying school fees. Whereas simple flexible savings products aims to offer low-income and poor communities safe and convenient access to their funds to meet non-discretionary spending needs.( Ashraf et.al(2003)
C.Do the behavioral features of the poor affect the mode of financing them?
“Group liability” and “Group lending” both are very distinct from one another." “Group liability” refers to the terms of the actual contract where individuals are both borrowers and simultaneously guarantors of other’s loans. “Group lending” merely means there is some group aspect to the process or program, like the sharing of a common meeting time and place to make payments.
Giné and Karlan (2010)
Group liability in microfinance purposes to improve repayment rates through peer screening, monitoring, and enforcement. Sometimes it may create excessive pressure which may discourage reliable clients from borrowing.( Armendáriz and Morduch, 2000)
Group liability is often described as a key innovation responsible for the expansion of access to credit for the poor in developing countries. Under group liability structure clients have an incentive to screen other clients so that only trustworthy individuals are allowed into the program.(Adverse Selection avoided) In addition to that clients have incentives to make sure that funds are invested properly and effort exerted.(Moral Hazard mitigated). Finally the enforcement could be enhanced because clients face peer pressure, along with legal pressure to repay their loans. Thus shifting the responsibility of certain tasks from the lender to the clients, group liability claims to overcome information asymmetries typically found in credit markets, especially for households without collateral. Giné and Karlan (2010)
The basic question about the relative merits of group versus individual liability has still remained unanswered for many reasons. Merely comparing performance of one product with another within or across lenders does not establish a causal relationship between the contract terms and outcomes such as repayment, selection, or welfare. There are countless unobserved characteristics that drive individual selection into one contract or the other, as well as institutional choices on what to offer, and how to offer. Lenders typically chose the credit contract based on the context in which they operate. Giné and Karlan (2010)
Quoting Armendariz de Aghion and Morduch (2005),
“The best evidence would come from well-designed, deliberate experiments in which
loan contracts are varied but everything else is kept the same.”
This is precisely the goal of the paper by Giné and Karlan.(2010)
Quoting from their conclusion:
“The choice of group or individual liability is perhaps one of the most basic questions lenders make in the design of loan products in credit markets for the poor… The results are striking, however, in three respects. First, we find that individual liability compared to group liability leads to no change in repayment but did lead to larger lending groups,
hence further outreach and use of credit, for pre-existing groups. Second, in new areas, we found bank officers less willing to open groups despite no increase in default. Thus the supply constrained the growth of the lending program, whether for good cause or unwarranted fear by the employee is outside the scope of our data to assess. Third, we do find statistically significant evidence of some of the mechanisms discussed in the group liability literature, such as screening and monitoring, but we simply do not find that it adds up in an economically meaningful way to higher default…… In sum, the recent trend of microfinance institutions expanding their individual lending products (or in some cases, shifting from group liability to individual liability but maintaining group meetings) may help deepen outreach and provide more flexible microfinance products for the poor.” Giné and Karlan (2010)
1. Robinson, Marguerite S, ‘Microfinance: the Paradigm Shift From credit Delivery to Sustainable Financial Intermediation’, in Mwangi S Kimenyi, Robert C Wieland and J D Von Pischke (eds), 1998, Strategic Issues in Microfinance, Ashgate Publishing: Aldershot.
2.Gerschenkron, Alexander (1962), Economic backwardness in historical perspective, a book of essays,
: Belknap Press of Harvard University Press. Cambridge, Massachusetts
3.Paul Rosenstein Rodan“Problems of Industrialization of Eastern and South- Eastern Europe”, Economic Journal v 53, No. 210/211, (1943), p 202-11.
4.Joseph Schumpeter"The Nature and Necessity of a Price System", 1934, Economic Reconstruction.
5.Anne O. Krueger Trade Policy and Economic Development: How We Learn The American Economic Review, Vol. 87, No. 1 (Mar., 1997), pp. 1–22
6.The economics of microfinance / Beatriz Armendáriz and Jonathan Morduch.—2nd ed. 2010 Massachusetts Institute of Technology
7.Psychology and Economics: What it Means for Microfinance,Sendhil Mullainathan & Sudha Krishnan,April 2008, The Financial Access Initiative and Innovations for Poverty Action.
8.Armendariz de Aghion, B. and J. Morduch (2005). The Economics of Microfinance, MIT Press.
9. Group versus Individual Liability: (May, 2010),Long Term Evidence from Philippine Microcredit Lending Groups, Xavier Giné and Dean S. Karlan
10. A Review of Commitment Savings Products in Developing Countries, Economics and Research Department Series Number 45.Nava Ashraf, Nathalie Gons, Dean Karlan and Wesley Yin; Asian Development Bank, July 2003.