The Economics of Microfinance – a must read

Participating in the growth microfinance (even if it is not the commercial growth) is one thing, and knowing why one should do that is another. After all, one is bound to ask sooner or later, does this really work. And if it does, what are the various challenges in the field and if it doesn’t work, then why is it so. It is not just about the execution of randomized trials and saying that there is a positive or no impact. It is everything from, how much interest should one charge the lender, should loans be given only to women, and if so, does that model create a positive impact, what should be the funding model – should it be based on subsidies or would it be a self-sustaining MFI, and more. Questions like these are the ones that are tackled in this book. The authors – Beatriz Armendàriz and Prof. Jonathan Morduch are well known in the field of microfinance.

Warning: long read. For starters, this is not a general read. It feels like a textbook and I guess it might be a textbook in some schools. So expect a little dry read. That doesn’t mean that the book is boring. On the contrary, each chapter lets the reader on one of the aspects of the field. There are instances where the reader is left with an a-haa ! moment, understanding why certain things are difficult from an institutional perspective (like for example, does group lending always work ? How does one model returns for lending in such a scenario).

There are 10 chapters in the book

  1. Rethinking banking
  2. Why intervene in credit markets
  3. Roots of microfinance : ROSCAs and credit cooperatives
  4. Group lending
  5. Beyond group lending
  6. Savings and insurance
  7. Gender
  8. Measuring impacts
  9. Subsidies and sustainability
  10. Managing microfinance

The first chapter is an introduction to the traditional banking model and how it needs a big shift in processes when it comes to microfinance. The usual model of – have collateral – get debt – repay it – get the collateral back doesn’t work with microfinance. Also, the traditional model is not used for consumption . And like Stuart Rutherford mentions, consumption ((did not read Rutherfords’ book yet) as an end for microfinance is not necessarily a bad idea.

The second chapter is about how to and more importantly, why, intervention into the traditional credit markets is important. And by traditional credit markets, you can think of either the (evil ?) moneylender or the banks. This chapter also covers, among other things, the adverse selection (the asymmetry of information, wherein the bank knows very little about the riskiness of the project), the moral hazard (ex ante – how motivated are the borrowers to allow for a good return, ex post – how motivated are the borrowers to payback after the realisation of returns). Not only are these issues dealt with, the authors also model these issues into nice mathematical equations (ok, may be not so nice sometimes 🙂 ). This provides a good grounding into the interest level and return calculations.

The roots of microfinance talks about how this field was operational long before Prof. Yunus made it famous, albeit in a different form. The idea of credit cooperatives and the various auction models for getting the loans are discussed. On a personal note, I kind of understood how the credit society that my dad used to be associated with operated and how they’d determine the interest rates and distribution mechanism (of course, in his case it was a very limited audience and there wasn’t as much an asymmetry of information and risk involved. I digress.). The authors also design a simple model for a random ROSCA, and even though I must admit the equations do look intimidating, it is worth the effort to bend your mind to understand it because it gives an idea into the functioning of the ROSCA.

The next two chapters go in depth into the well-known and possibly the prevalent model of microfinance these days – group lending. Borrow in a group, mitigated risk and peer monitoring comes free ! Hmm, that sounds like a marketing campaign 😉 !  These two chapters discuss the various flavours (if you will) of group lending.

The chapter of savings and insurance discuss the lesser known (or is less famous !) aspect of microfinance – micro-savings and micro-insurance. Both of these areas are still growing areas (growing – with my limited sphere of knowledge). The authors don’t  spend too much time in the specifics of either of the fields.

The chapter of gender is about whether women are better customers of microfinance and if there is a larger impact (what Prof. Yunus calls the double bottom-line) by lending to women than to men. Again, this possibly is a topic onto itself, so the authors don’t get too much into specifics.

Measuring impacts is a chapter on the various ways to measure the impact of microfinance. Apart from the recent interest in randomized trials, there are other ways to measure the impact of microfinance. These are not dealt in depth, but the reader is given enough to understand how an impact study happens. Like the authors write in the section titled Addressing the selection problem in practice

In the following sections, we consider a series of related approaches to impact evaluation. The overview is not exhaustive and we do not aim to provide a full survey of impact surveys to date. Rather, we aim to point to key methodological issues and to gather several important results. The results to date are decidedly mixed, with some evidence of modest positive impacts of microfinance on income, expenditure, and related variables, while other studies find that positive impacts disappear once selection biases are addressed.

And this seems to be still an open issue, with recent studies still not being very conclusive, but giving enough evidence that there is a positive impact if not uniformly across households.

The chapter on subsidies is about the MFIs. It tries to answer a very simple (well, not so simple) question – should the MFI rely on subsidies or should they operate on a commercial basis. How does the MFI become sustainable ? This is an interesting topic and the authors do point out the open questions in this area. Questions that need more research to find the answers.

Managing microfinance is about managing the MFI. Managing how the loan officers evaluate the potential borrowers, setting expectations, devising incentives for the staff. Irrespective of the microfinance becoming the poster-child of relatively risk-free returns, there are issues in the management of the MFIs which are very important, like the story of Corposol.

So, how does this book stand. Well, it is a must-read if your interest is more than as a lender / borrower. A 9 out of 10. Each chapter has quite a few open questions which still need answers and the authors clearly mark such areas (like interest calculations, measuring impacts, ‘mission-drift’ in subsidies’ cost-benefit analysis).

The book is like a textbook, so it does require some amount of patience. One problem I had was the usage of non-standard symbols in the mathematical equations. They might be standard symbols in Economics, I am not sure, but I found it little-to-lot annoying. The explanation for the equations though, is crisp, and the authors do mention the reference if you really want to get to the gut of the result. Oh, by the way, the reference list is amazing. I guess one can spend a life time just with the reference list :). Like always (sigh!) I didn’t work on the exercise problems. I am hoping that I will do that when I start re-reading individual chapters. Yes, I think this is a book which will require more than one read. Pick your area of interest, or if you don’t have any, solving the exercises and the reference should let you find it. So, go ahead and get the book. And looks like the second edition is out !

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