Microfinance metamorphosed and expanded from the narrow field of microcredit (Mago, 2013; Helms, 2006). Although several practitioners and scholars use both words interchangeably, they differ in meaning due to the scope of services they offer. Microcredit involves the provision of loans of small amounts often less than $100, by banks and other institutions to poor and other borrowers excluded from conventional financial institutions (Sengupta & Aubuchon, 2008). Microfinance includes microcredit in addition to the provision of other services like savings, money transfer, insurance and training (CGAP, 2012). Essentially, the main difference is that microcredit supports one product (small loans) and is provided by both formal and informal institutions as oppose to microfinance that supports many products provided by registered and regulated financial institutions (CGAP, 2012). Nevertheless, both microcredit and microfinance are focussed on assisting borrowers exit poverty by providing financial services to the poor (Garikipati, 2017;Ghalib, 2017; Roodman & Morduch, 2009) Informal credit facilities have been a common source of finance for the poor before the advent of microfinance (Helms, 2006). Factors such as its easy, convenient, fast and flexible access to informal credit services make them attractive to the poor (Mahmood, et al., 2014). Usually, the poor sourced informal finance from family, friends,
2014 2014 2014 2014 2014 2014 11,634,442.51 5,437,463.69 5,630,312.55 70,983,634.31 28,356,577.66 11,290,517.20 0 10000000 20000000 30000000 40000000 50000000 60000000 70000000 80000000
Africa East Asia and the Pacific Eastern Europe and Central Asia Latin America and The Caribbean Middle East and North Africa South Asia G R O S S L O A N P O R T F O L I O B Y R E G I O N Series1 Series2
27 | P a g e landlords and moneylenders. However, moneylenders have been criticized for exploiting the poor by charging excessive interest rates to poor borrowers, whose limited credit options constrain their bargaining power (Rosenberg, et al., 2009). According to Tucker and Lean (2001), one reason for the high interest rate is information asymmetry as lenders have less information about the borrower’s ability to repay loans. Both authors argue that lenders spend financial resources in screening loan applicants and monitoring borrowers to mitigate default risk; thus, these costs are transferred to borrowers as the interest rate. A study (Aleem, 1990) of fourteen moneylenders in Pakistan found that monopolistic competition exit s in markets with imperfect information. The study further suggested that interest rate charged by moneylenders is equivalent to their average cost of lending but exceed their marginal cost and these are incurred through screening of loan applicants, overheads, loan drive and bad debts. Therefore, moneylenders charge high-interest rate due to the high cost of gathering client information to ensure the safety and efficiency of loans and prevention of fraud (Huang, et al., 2014). Moreover, the moneylender has also been criticised for its harsh treatment of defaulters. Aryeetey & Udry (1995) noted that moneylenders perceive litigations against defaulters as expensive, thus, they prefer to confiscate collateral or threaten to cause harm to the body of the borrower or his property. Although other informal sources of finance like friends and family presumably have good information concerning the characteristics of potential borrowers, they are unable to provide adequate finance for microenterprise expansion or savings facilities (Aryeetey & Udry, 1995).
Other types of traditional informal savings and credit sources are rotating and non-rotating association, credit unions and credit cooperation. Rotating savings and credit associations (ROSCAS) comprise one of the most commonly found informal and indigenous financial institutions particularly in Asian and African countries (Evuleocha, 2011). In ROSCA, member’s contributions are collected at the agreed regular interval (weekly/monthly) and given to a member in a rotation format until the cycle is complete. Comparatively, non-rotating association follow similar contribution interval, but deposit’s money collected with a treasurer. At the end of the agreed contribution cycle, members receive their total contribution (Iganiga & Asemota, 2008). In some non-rotating associations, interest is paid to members from their lending and in others, they are not. Dagnelie & LeMay-Boucher, (2008) pointed out that the number of members, amount of contributions and frequency of meetings varies widely amongst different ROSCAs. The presence of ROSCA in many developing countries indicates its usefulness to the poor. However, these credits and saving associations are called various
28 | P a g e names in different countries or communities. Table 2.1 below presents the various names associated with ROSCAS in developing countries.
Table 2. 1 Rotating Saving and Credit Associations in West Africa
Rotating Savings and Credit Associations in West Africa (ROSCA)
Country Local Names
The Gambia Osusu
Sierra Leone Asusu
Senegal Tontine
Ivory Coast Diaou moni, Wari moni
Ghana Nanemei akpee
Nigeria Esusu, Isusu, Dashi, Adashi, Oha, Bam
Niger Asusu
Cameroon Njangi, djanggi, tontine, credit rings
Kenya merry-go-rounds
Mexico Tandas
India Chit
Tanzania Kibati
Source: Adapted from Nwanna (1996) and Helms (2006)
Members of Rosca are primarily poor individuals with little access to formal financial service markets due to high transaction costs (Dagnelie & LeMay-Boucher, 2008). Critics have questioned the reason behind joining ROSCA as oppose to personal saving since ROSCA does not offer interest on contributions. Besley et al., (1993) argue that on average, members of ROSCA receive a lump sum amount of money to buy indivisible goods earlier than through individual savings. The inability of individuals to adhere to self-disciplined to commit to personal savings have been cited as a condition for joining ROSCA. Dagnelie & LeMay- Boucher, (2008) stressed that many individuals suffer from short-term temptations and are aware of the inconsistency problem, hence, would turn to ROSCA. ROSCAs have many advantages: they are efficient and cost little to run, they are transparent and easy for members to understand, no outsiders are involved, no cash is stored since it passes from member to another, and the risks of misappropriation are low (Helms, 2006). Generally,
29 | P a g e ROSCA serves as a saving mechanism that supports members in purchasing indivisible goods (Anderson & Baland, 2002). However, with such an appealing and useful credit and saving mechanism available to the poor, some may wonder why the poor still lack finance. In his contribution, Helms (2006) pointed out that ROCASs are often rigid as it requires regular deposits of equal amounts, an individual’s money is tied up until it is their turn to access the funds. More so, members are at risk of default from other members, which could lead to loss of money and eventually the breakdown of the ROSCA (Dagnelie & LeMay-Boucher, 2008). This system cannot provide money to members in need but are not due for collection. Due to these limitations, ROSCA could not fully meet the ever increasing and dynamic finance needs of poor borrowers. Similarly, all informal financial networks are vulnerable to collapse or fraud: whether due to corruption, financial indiscipline or collective shocks like a natural disaster or a bad harvest leading to loss of funds by participants (Helms, 2006).
Formal financial institutions have robust resources and expertise in lending compared to informal financial sources, hence should be expected to fill the finance gap. Basu (2006) suggest that lending to the poor pose high repayment uncertainty. Banks are profit oriented and risk-averse; therefore, any doubt in the loan applicant’s ability to repay loans creates legitimate grounds for concerns. Basu (2006) indicated that because the poor are mostly involved in agricultural activities, they tend to be highly exposed to cyclical fluctuation such as crop failures or a fall in commodity prices and therefore may face real difficulties servicing loans. The absent of detailed records showing the credit history, sales, income and expenses of loan applicants is another factor hindering banks from lending to the poor. A study (Mbroh & Attom, 2013) of small and micro enterprises found that business owners lacked basic accounting knowledge; hence do not keep proper accounts of business activities. Lack of useful financial information makes it difficult for banks to ascertain the creditworthiness of loan applicants.
However, banks can overcome the issue of lack of information by collecting collateral to hedge default risk. Amiram et al., (2017) and Weill & Godlewski (2006) noted that collateral solves the problem of information asymmetries; the problem of moral hazard after the loan is granted and reduces the risk of the loan in the event of default. Collateral creates a cushion that improves banks propensity to lend to applicants without a credit history. Feder et al., (1988) suggested that lands and buildings are the major types of collateral assets accepted by banks in developing countries. However, the poor do not possess such kind of assets, thus, due to the lack of acceptable collateral, millions of poor people cannot access the formal
30 | P a g e banking system (Yuqing, 2007). Fafchamps (2013) argued that lack of collateral is not the reason why the poor are often credit constrained but lack of regular income. He stressed that in developed countries, unsecured credits such as credit cards, overdrafts and mortgages are given to clients who have a steady flow of income but without collateral. This tends to suggest that a steady flow of income improves the borrower’s ability to repay debt, hence increases their creditworthiness. Meeting these criteria is practically impossible for most poor people in developing countries as they suffer from acute deprivation and lack of income. Donaldson et al., (2014) argued that poor households in developing countries are unable to meet basic needs in the form of clothing, food, healthcare and even the education of their children. Generally, the lack of collateral and income information still borders on the effect of information asymmetry on banks wiliness to lend to the poor. Adverse selection is another critical problem faced by banks due to information asymmetry. Adverse selection occurs when banks are unable to differentiate risky from safe borrowers due to lack of information; thus, banks use either high-interest rate or collateral as a selection criterion. The high interest rate may deter safe borrowers from taking loans due to fear of not been able to repay, which leaves the risky borrower to accept loan facility. This situation may cause the moral hazard problem as borrowers may undertake riskier projects than the bank would have preferred since they will not face the full consequences of failure (due to limited liability) (Armendariz & Morduch, 2004). Ghatak & Guinnane (1999) argued that in some cases, banks may offer two different contracts, one with high-interest rates and low collateral and the other with the opposite, but stressed that poor people by definition do not have assets that make useful collateral, hence, will be discriminated upon. Therefore, for various reasons such as asymmetry information, lack of useful collateral, adverse selection and moral hazard, formal financial institutions are always hesitant about lending to the poor in developing countries. Armendáriz de Aghion & Morduch, (2005) contends that due to the inability of the formal and informal financial sectors to provide robust financial access to the poor as highlighted above, a finance gap had ensued that needs to be filled. The consequence of this finance gap is that the poor are starved of the required funds to improve their economic conditions and well- being. Figure 2.1 below illustrates the failure of both the formal and informal financial sources to meet the financing needs of the poor, which in turn has created a persistent finance gap in developing countries. Mahmood et al., (2013) stressed that in order to fill this gap there is a need to relax the loan application requirements of the formal sector and remove constraints associated with the informal credit sector.
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Figure 2. 2 Factors that Create Persistent Gap in Financing the Poor
Formal Source of Finance Banks
Do not provide loans to the poor due to the following problems faced by banks: • Asymmetric information • No Collateral • High Transaction cost • Adverse Selection • Moral hazard Informal sources of Finance
Family, friends and relatives /Moneylenders/ ROSCA, Credit Unions. Provide loans with the following limitations:
• Exploitative interest rate/ inhuman behaviour
• Limited loan size and repayment time • Limited available local resources Government Finance Programmes:
Failed due to the following reasons:
• Market failure due to subsidized loans benefiting rich landlords • Corruption
• Diversion of funds from its intended purpose
• Lack of a consistent programme delivery
GAP IN FINANCE TO THE POOR IN DEVELOPING COUNTRIES
Source: Adapted from Mahmood et al., (2013) and Armendariz de Aghion and Morduch, (2005).
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