The main constraint on formal lending to the poor
“…is the cost of gathering information about them. It therefor makes sense that they would mostly borrow from people who already know them, such as their neighbors, employers, people they trade with, or a local moneylender.”
This high cost of due diligence for very small loans makes it financially infeasible for banks to lend to the poor.
Example: the effects of informal lending is high interest rates
“The sight of countless fruit vegetable sellers standing side by side on street corners is common to cities in most developing countries. Each of the sellers (usually a woman) has a small cart or just a sheet of tarp on the pavement on which she has pile tomatoes, onions, or whatever she happens to be selling. The vendors buy their stock in the morning from a wholesaler at night. Sometimes, the cart that they use to carry and display the vegetables is also rented for the day.”
“This is the way many businesses in rich countries operate too: They get a working capital loan to produce and purchase goods and then repay the loans out of their revenues. What is striking is how much the poor repay, compared to the rich.”
The interest rate in Chennai, India is such that a $5 loan left unpaid for a year would leave a debt of $100 million.
High Interest Rates Result from the Exploitation of Money Lenders
Moneylenders are the replacement for banks in informal economies, and are able to charge the poor with high interest rates for three reasons:
(1) Moneylenders hold a monopoly with borrowers because of the high-cost, low-reward of due diligence on the poor: if the borrower were to go to another lender, then that lender would have to do further due diligence, and would be skeptical of why the borrower switched lenders, which would both drive interest rates higher. Moneylenders exploit this monopoly by raising interest rates further.
(2) Unlike banks, moneylenders are not a place where people want to deposit their savings. Therefor, while moneylenders have the advantage in getting their money back, it is harder (more costly) for them to get money to lend out.
(3) the multiplier effect: “When interest rates go up, the borrower has more reason to try and find a way not to repay the loan. That means the borrower needs to be monitored and screened more carefully, which adds to the cost of lending. This pushes the interest rate up even further, which necessitates more scrutiny, and so on. The upward pressure feeds on itself, and interest rates can skyrocket.
The Necessity For Borrowing: the poor live with lots of risk
This risk comes from the lack of buffers against variation in food, income, political violence, crime, corruption, etc.
They protect themselves from risk through a diversified ‘portfolio’ (similar to hedge-fund managers): many total jobs held within a family, plots of land in different parts of the village, temporary migration of a family member, marriage to extend network of trusted resources. The only difference from hedge fund managers is that they diversify activities, not just financial instruments. However, diverse activities creates a lot of overhead (ex: its hard to become a specialist if holding multiple jobs).
This risk creates an inevitable need for informal resource networks as buffers/responses for when things go wrong.
Traditional Solution: Informal Insurance
Communities in poor areas have strong informal networks of tit-for-tat. They help each other not out of charity, but because they themselves run the risk of being in trouble in the future.
This mutual borrowing and lending did a lot to reduce the risk that any individual was facing.
However, informal moneylending in this context has its problems.
A More Formal Response: Microcredit is moneylending reinvented for a social purpose
“micro-finance is the idea of providing these lending opportunities with much smaller interest (an opportunity for both a profit mission and social mission). Compound interest causes this to be a great benefit to the clients’ lives. It provides a formal market to the underserved, where there was previously only informal sources of credit at high interest rates.”
A Peer Pressure Solution
MFIs keep a close check on their clients by loaning to a group a borrowers, who are liable fore each other’s loans. This gives the group reason to make sure others repay. The power of shame from peers seems to be sufficient to decrease defaults.
MFIs have gradually been able to move away from the formal requirement of joint liability. One reason for this could be a result of making repayment an implicit social contract such that the larger community ensures that loans be repaid so that the MFI continues to provide further loans.
“micro-finance is important because it gives the poor a way to map out the future in a way that was not possible for them before”
All quotes are from Poor Economics by Abhijit V. Banerjee and Esther Duflo