If we want to conceptualize the relationship between the MFI and a microfinance client as a principal-agent relationship, the MFI would be the principal delegating tasks (e.g. using the loan for the agreed upon entrepreneurial project) and the client would be the agent who has to deliver the tasks23. PA-relationships are characterized by the problem of
23
Principals and agents are both equipped with their own utility functions (Drazen 2000, 23).
imperfect information. The agent, fulfilling the task, will always have more information about how accurate she is going to fulfill that task. Analogously, the microfinance client, although claiming to use a loan according to the agreed upon purpose, might not live up to this promise and will use the loan for something else (e.g. repairing the house, consumables). Situations of imperfect information between the MFI and its clients may cause inefficiencies like under- or overestimating the riskiness of a client and might even culminate in market failure (Akerlof 1970, 490). The specific problems arising from asymmetric information between a principal and an agent are adverse selection and moral hazard, which are explained in more detail in the following. How MFIs try to mitigate these asymmetries by the means of specific lending methodologies is presented when discussing particular group and individual lending techniques.
5.3.2.1.1.1
Adverse Selection
The most noticeable example of explaining adverse selection is „The Market for Lemons: Quality Uncertainty and the Market Mechanism” by George Arthur Akerlof (1970). Akerlof shows that the combination of diversity in quality and information asymmetries between the seller and buyer leads buyers to choose bad quality cars over good quality cars. As a consequence, good quality cars are squeezed out of the market.
What are the underlying considerations Akerlof makes to come to that conclusion? Whereas the seller of a used car knows exactly what kind of hidden characteristics (e.g. future repairs, defects) the respective car entails (Akerlof 1970, 489), the buyer faces the problem that a used car cannot be easily inspected and defects of a used car mostly stay undiscovered due to a lack of knowledge about cars in general or also due to a lack of time the buyer wants to invest into buying a car. Imagine a car park where different vendors want to sell used cars. A buyer walks up to vendor I. Although car I is of low quality, vendor I will describe this car as of high quality and well maintained. The buyer looks at a different car from vendor II. This model is actually a perfectly maintained used car without
any defects. Vendor II explains proudly that he took good care of car II and that the buyer would not have to expect any repairs in the near future. The buyer is confused. Car I is USD 1000 cheaper than car II. Since he evaluates both offers as bona fide, he decides to buy the cheaper car. Akerlof transfers this situation to the big scale and shows that as a result of asymmetric information vendors will pass off their low-quality cars as higher-quality cars. After some time all of the vendor II types leave the market because they are not willing to sell off their cars to a price below their acceptance limit. In the end the buyer can only purchase ‘lemons’ (i.e. bad cars) for a relatively high price (Akerlof 1970, 489–491).
Analogously to the above-described, imperfect information between the MFI and its client prohibits the MFI from categorizing its clientele into riskier and safer borrowers24. Setting accurate incentives is key in order not to end up with a pool of clients that consists only or merely of risky clients. The traditional banking sector also faces similar problems; however, a bank would not face exorbitant losses if, for example, some of their clients would not be able to repay their loan. Why is that? Traditional banks only disburse collateralized loans. Borrowers can show securities, such as land, a house or a business, which may be seized by the bank if the loan is not repaid. It follows that, due to the collateral that is at stake, the borrower is incentivized to rather pay back the loan than to shirk. With a contractual agreement that is enforceable, the bank (i.e. principal) can effectively minimize its agency costs because losing the collateral is incentive enough to repay. No additional endeavors have to be undertaken in order to elicit a sufficient repayment behavior from the borrower. In contrast, MFIs have higher agency costs due to the uncollateralized loans they disburse. If there is no collateral to seize, the MFI has to create a system of incentives, which enhances the probability of the borrower to repay (Armendáriz and Morduch 2010, 41–48). Microfinance tries to create this system of incentives by means of group lending and costly individual lending schemes, which are discussed after the next chapter (Armendáriz and Morduch 2010, 101, 140).
5.3.2.1.1.2
Moral Hazard
Besides adverse selection, two manifestations of moral hazard are prevalent in microfinance (Armendáriz and Morduch 2010, 39–53): ex ante and ex post moral hazard. The incertitude an MFI has about its client’s actions after the loan is disbursed but before net returns on the entrepreneurial project are realized is explained by ex ante moral hazard. Due to insufficient information the MFI is in the dark regarding the borrower’s undertakings. She might indicate putting the loan to the agreed upon cause; however, it is characteristically for PA relationships that the agent (i.e. borrower) in contrast to the principal (i.e. MFI) has the advantage of knowing her exact agenda. The lender is moreover not in power to entirely monitor the actions of the borrower. This would be too cost intensive.
After net returns on the entrepreneurial project are realized, MFIs face another incomplete information problem, which is called ex post moral hazard. It depicts situations where borrowers confirm to have failed in their business idea. In some cases it might not be straightforward whether a business project succeeded. As a consequence, lenders struggle to enforce contracts and face the risk of not being paid back. This is particularly difficult in developing countries with weak legal systems. As argued above, there is no or only negligible collateral to seize after a client has defaulted on her loan. If MFIs cannot elicit an adequate repayment behavior from their clients, they are confronted with losses.