Assignment #2 Microfinance

Money and Banking Fall 2012

Big Banks Draw Big Profits from Microloans to Poor
In recent years, the idea of giving small loans to poor people became the
darling of the development world, hailed as the long elusive formula to
propel even the most destitute into better lives.
Actors like Natalie Portman and Michael Douglas lent their boldface names to
the cause. Muhammad Yunnus, the economist who pioneered the practice
by lending small amounts to basket weavers in Bangladesh, won a Nobel
Peace Prize for it in 2006. The idea even got its very own United Nations year
in 2005.
But the phenomenon has grown so popular that some of its biggest
proponents are now wringing their hands over the direction it has taken.
Drawn by the prospect of hefty profits from even the smallest of loans, a raft
of banks and financial institutions now dominate the field, with some
charging interest rates of 100 percent or more from their impoverished
customers.
We created microcredit to fight the loan sharks; we didnt create microcredit
to encourage new loan sharks, Mr. Yunnus recently said at a gathering of
financial officials at the United Nations. Microcredit should be seen as an
opportunity to help people get out of poverty in a business way, but not as
an opportunity to make money out of poor people.
The fracas over preserving the fields saintly aura centers on the question of
how much interest and profit is acceptable, and what constitutes
exploitation. The noisy interest rate row has even attracted Congressional
scrutiny, with the House Financial Services Committee holding hearings this
year focused in part on whether some microcredit institutions are scamming
the poor.
Rates vary widely across the globe, but the ones that draw the most concern
tend to occur in countries like Nigeria and Mexico, where the demand for
small loans from a large population cannot be met by existing lenders.
Neil MacFarqhar, The New York Times, April 13, 2010

Lifting People Worldwide out of Poverty

We are not trying to create a non-profit. That was not our intention. Our
intention was to persuade the bankers to lend money to poor people, so my
struggle was always with the bankers. Initially, I offered myself as a
guarantor, and then took the money from the bank and gave it to people. So
it was an extension of the banks activities. When we saw that it was
working well and the banks were not as enthusiastic as we were, we thought
maybe we should have a separate bank created for this purpose. Finally we
did that in 1983 called Grameen Bank or the village bank. So we became
a bank because it is a banks activity. We lend money to the poor. People
sometimes refer to us as an NGO. We have to explain that we are not an
NGO. Its not that we are belittling NGOs . . . Im simply stating that people
get confused, thinking that because we work with the poor, we must be an
NGO. I say, no, we are a bank and it is owned by the poor people. The
owners of the bank are the borrowers of the bank. Thats the distinction that
we want to make, to clarify what we are.
Another aspect that I want to draw attention to there are many microcredit
programs going around advertising themselves saying, Oh, this is a great
opportunity to make money. And the encourage people who want to make
money to join in and do that. Again, we say, Look, our purpose is not to
excite people about making money. Our purpose is to help people get out of
poverty. Those who are seeing this as an opportunity to make money have
to raise their interest rate to the extent that they make a lot of money. The
interest rate issue becomes a sensitive one. We are saying interest rates
should be kept as low as possible, preferably to cover costs. If you want to
make a little profit on top of it, it should be a very modest profit, so that it
doesnt look like this was your intention. Those who are doing thatusing
microcredit, microfinance, to make a lot of moneywe keep saying that this
is not microcredit in the sense that we do it. We came here to fight the loan
sharks, not become loan sharks ourselves. This is their moving into the
direction of loan sharks. We want to disassociate ourselves from them.
Muhammad Yunnus, interview in Knowledge@Wharton, May 27, 2009.
Lets first define what microfinance is. Its lending money to the
poorest women for
income-generating
activity, without
Muhammad
Yunnus, September
2010 collateral, so
they can help themselves out of poverty. If you cross that boundary,
then use another term because when you use the term microcredit,
you confuse people.
Muhammad Yunnus, September 2010

Im not opposed to profit. Grameen Bank is a bank. But ownership

is the question. Grameen Bank is owned by the borrowers and the
profit goes back to them. We oppose the money of the poor people
going to someone else; [or at least] is there a rule restricting the
percentage of profit that goes to someone else?
Muhammad Yunnus, September 2010

Economics Focus: A Partial Marvel

Broadly speaking, neither study found that microcredit reduced poverty.
There was no effect on average household consumption, at least within a
year to 18 months of the experiment. The study in the Philippines also
measured the probability of being under the poverty line and the quantity of
food that people ate, and again found no effects. Microcredit may not even
be the most useful financial service for the majority of poor people. Only one
in five loans in the Hyderabad study actually led to the creation of a new
business. Providing people with safe places to store their (small) savings
may help the more in the long run.
That said, microcredit did have discernible effects. In India, people in the
slums that had access to microcredit were more likely to cut down on things
like tobacco and alcohol in favour of durable goods (particularly items such
as pushcars or cooking pans that are used heavily by traders and food-stall
owners). One reason average consumption failed to increase may therefore
be that more people were diverting some of their own income into starting or
expanding their businesses. Microcredit clearly allowed more people to
overcome the barrier posed by start-up costs. The MIT researchers found
that as many as one-third more businesses had opened in slums which had a
microcredit branch. This may mean that even though there was no
measurable impact on poverty during the study period, there may well be
some over a longer time-frame as these businesses prosper.
Tiny loans are unlikely to be enough to allow these businesses to grow to an
efficient scale, of course. But the role of microcredit in allowing people to
signal their creditworthiness is valuable, especially if their success makes
banks more willing to lend them larger sums and leads to even more
economic activity. By being willing to take a risk on entrepreneurial sorts

who lack any other way to start a business, microcredit my help reduce
poverty in the long run, even if its short-run effects are negligible.
The Economist, July 16, 2009
The textbook says:
Asymmetric information occurs when buyers and sellers are not equally
informed about the true quality of what they are buying and selling. The
asymmetry typically runs in the same directionthe seller knows more than
the buyer.
Adverse selection arises before a financial transaction is consummated. For
example, adverse selection is related to information about a business before
the bank makes the loan. All small businesses tend to represent themselves
as high quality (that is, low risk) despite the fact that bankers know that
some are good and some are bad.
Moral hazard arises after a financial transaction is consummated. It arises
because borrowers covertly engage in activities that increase the probability
of poor performance. For example, a small business borrower may
deliberately choose riskier projects after receiving a bank loan.
Ritter, Silber and Udell, pages 192-194

Is Microfinance Building or Exploiting Social Capital?

A huge part of microfinance institutions use commitments of
groups in absence of collateral. Namely, peer pressure from
groups is seen as one of the main reasons why microfinance
works. Supporters claim that the most important issue is to
provide the poor with access to capital. By using social
relations as collateral a market failure is resolved. Critics,
nevertheless, argue that thereby microfinance exploits social
relationships to obtain higher repayment rates and to reduce
administrative costs This is especially true in the minimalist
approach, where cost-effective measures are used to become
financially sustainable. Rankin argues that under these
circumstances the health of the financial system rather than
the welfare of the poor becomes the main objective of
microfinance.
A. Vanroose, Solvay Business School, June 2007

Microfinance Is Down, But Not Out

Microfinance leverages financial access to give the poor one of many tools needed to take
control over their own lives and navigate the myriad routes out of entrenched poverty.
Microcredit started out as the provision of small loans, usually without collateral, to individuals
with limited access to other sources of capital. In a world where the poor, especially women,
were deemed un-creditworthy, this in itself was a significant innovation. Microfinance became
larger, however, with the provision of additional financial services such as savings, remittance
transfer, and specialized loans. While many started out simply as lending and deposit-taking
institutions, some microcredit lenders have now expanded their services to insurance provision
and other services, leading regulators to get more involved in their activities.
Microfinance regulation might have murky motivations and unintended consequences. Was it a
spate of borrower suicides that led to a government crackdown in Andra Pradesh, India, bringing
micro-lending to a halt in 2010? Or was it competition with state-run savings programs? The
answer is not entirely clear.
In July 2011, caps on microcredit interest rates in Bangladesh were meant to protect poor
borrowers but may have had the opposite effect. As interest rates are lowered, the supply of
lending capital tightens, which forces lenders to cut costs. The danger is that this will mean fewer
loans to the poorest. Some may stop lending the smaller sized loans usually made to those with
the least access to capital. Others may stop lending in disadvantaged, hard-to-reach areas that are
more costly to serve. It can also drive out lenders lacking the cushion to absorb the costs of
servicing smaller loans, leaving only the largest MFIs in place facing less competition.
One criticism of microfinance is relatively high interest rates. But the costs for servicing a
microcredit loan can be quite high. Many non-profit providers maintain loans in under-orunserved areas which have no other options. Loan officers travel to their clients and can be
expected to work at all hours providing the hand-holding their clients need. Let's be clear:
microcredit must at least meet its costs in order to be sustainable. And it must be sustainable to
have a long-lasting, positive effect. Despite higher interest rates, demand for microfinance
services remains strong at the base of the economic pyramid.
Microcredit should neither be credited with ending poverty on its own nor held responsible for
promising more than it can deliver. It is simply one way to enable more people to participate in
the capitalist system, not the magic bullet guaranteeing prosperity. In this regard, information is
as essential as capital in ensuring that all parties understand and share expectations related to
microcredit.
Moushumi M. Khan
Huffington Post
5

August 13, 2012

Discussion Questions
Answers should be typed in paragraph form. Points may be deducted for
incorrect spelling, grammar, and punctuation.
1. How is Grameen Bank similar to Bank of America? How is it different?
2. Muhammad Yunnus believes that microlending institutions should make a
profit, although not an excessive profit. Why might making a profit be a
good thing? What determines an acceptable interest rate for microlending?
3. How do microcredit institutions deal with asymmetric information and
such problems as adverse selection and moral hazard?
4. In addition to microloans, what other types of financial services and
products might be provided to the poor in order to reduce poverty and
encourage economic development?
5. Do you think microfinance will be successful in reducing poverty over the
long run?