“This is not charity. This is business: business with a social objective, which is to help people get out of poverty.” – Muhammad Yunus on Microcredit (Founder of Grameen Bank; Nobel Laureate)
Microcredit is a concept established to assist the poorest of the poor break out from the cycle of poverty. It provides small uncollateralized loans to help individuals and families make productive investments – for example to buy a cow so that they can sell milk, to buy a sewing machine so that they can set up a tailor shop, etc. These are usually informal economic activities that have low return and low market demand. Hence, these individuals, prior to the emergence of microcredit, were considered “not bankable” by the formal financial sector.
The impact of microcredit/microfinance on poverty has been mixed. The emergence of microcredit in the 1990s, with Muhammad Yunus and Grameen Bank, was a source of hope for a solution to global poverty. Jonathan Murdoch in his 1999 paper wrote “… the promise remains that microfinance may be an important aid for households that are not destitute but still remain considerably below poverty lines.”[1] Although Murdoch saw opportunities, he was also skeptical of the high costs associated with lending small loans to many people compared to lending large amount to few. By early 2000s hope had turned to celebrations. Microcredit was considered the panacea to solve global poverty. It was poverty fighting at two fronts: helping the really poor escape poverty and at the same time empowering women within these poor households. Like many, Khandker for his World Bank 2005 paper, found that microfinance contributes to poverty reductions, especially for women, both at a personal level and also at the local village level.[2] But, by the late 2000s, effectiveness microcredit/microfinance was being challenged by a host of researchers. Banerjee et al.(2015) conducted a randomized trial in Hyderabad, India, providing microcredit to one group of households but not to another; they did not find any significant changes due to this microcredit on health, education, or women empowerment among the households that received this credit.[3]
Despite the fact, there are merits to microcredit in the developing world where poor households face stifling credit constraints. As a result, there has been a mushrooming growth of microcredit lending institutions over the last 20 years. One of the byproducts of increased access to microcredit is the growing heterogeneity in the market for lenders and the differentiated products.
In one of his trips to Colombia, Jose, ever curios about this market, started asking people about the interest rates on these microcredit loans. To his surprise, he got a universally coherent response. No matter whom he asked, the answer was ‘usury rate’. Usury rate is the highest rate that can legally be charged by regulated financial institutions – mostly traditional banks. Unregulated Micro Finance Institutions (MFI) and Non-Government Organizations (NGO) are exempt from the cap. Colombia, one of many countries, issues an interest rate cap. Intrigued, he and his coauthor, Luca G. Deidda, started exploring the effect of this interest rate constraint on the market for microcredit. In particular, he wanted to understand the mechanism by which traditional banks entered the microcredit market and the effect of interest rate caps on this credit market. Described below is his ongoing project:
Today the lending market for microfinance is very heterogeneous. The lenders not only include traditional MFIs and NGOs but also traditional banks, who have been induced into the microfinance market by its apparent profitability. Although the philosophy of microcredit has changed, from helping the poor to making a profit, the argument for increased competition is that they lend at a lesser cost to the poor reducing interest rates that are on average as high as 30% from the traditional MFI/NGO channel.
Banks, ‘downscaling’ into the microcredit market, need an efficient method to screen the previously unbanked microcredit lenders.
José and Luca explore the coexistence of microcredit lending for a bank alongside its standard loan practices, in a model of a competitive credit market characterized by adverse selection. Potential borrowers are heterogeneous both with respect to their ability to repay loans and to the degree of informational transparency about such ability. Lenders (banks), while not informed about borrowers’ type, have access to a costly screening technology such that – by devoting enough time to screen applicants – they can extract an informative signal about their ability to repay. The authors identify the characteristics of economic environments where (i) both types of credits are offered by the bank, (ii) only traditional credit is offered, and (iii) only microcredit is offered. According to José and Luca’s model, the emergence of bank microcredit always results in a higher degree of participation in the credit market, provided that adverse selection is not too extreme, and microcredit is viable.
The authors empirically test the main predictions of their model using three comprehensive data sets. The first of the data sets is an international cross-section of bank MFIs, the second is a panel of bank-level data from the Colombian banking sector, and the third is a panel of individual loan data from a Colombian bank which downscaled into microcredit. The estimated results from analyzing the data sets show a significant impact of bank microcredit and financial liberalization on the broader population’s access to formal credit along the lines predicted by the model.
– Nishant Yonzan
[1] Murdoch, Jonathan. “The Microfinance Promise.” Journal of Economic Literature (1999): 1569-1614.
[2] Khandker, Shahidur R. “Microfinance and poverty: Evidence using panel data from Bangladesh.” The World Bank Economic Review 19.2 (2005): 263-286.
[3] Banerjee, Abhijit, et al. “The miracle of microfinance? Evidence from a randomized evaluation.” American Economic Journal: Applied Economics 7.1 (2015): 22-53.
