Universität Hohenheim, Institut 490a

Universität Hohenheim, Institut 490a
M5101: Prof. Heidhues + Tom Rural Finance Prof. Dr. Manfred Zeller Prof. Dr. Franz Heidhues Thomas Dufhues Tom Dufhues PhD-Student of Prof. Heidhues It was planned that Prof. Heidues is taken part in the lecture for supporting macro-economics. Unfortunately, he is busy today. However, if there are questions which i an not solve we can arrange a meeting with him next week (Monday 8:30). Research Focus on microfinance in Northern Vietnam, within the SFB „Sustainable land use and development in mountainous regions in southeast Asia“ If I am talking too fast or unclear or if do not understand me you can interrupt me at any time. Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Structure of the lecture 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal credit 2. New Institution Economics (NIE) aspects in rural finance 3. Financial services 3.1 Credits - Traditional agricultural credit - „Micro finance revolution“ 3.2 Savings 3.3 Insurances 3.4 Safety net of MF (credits, savings, insurances) 4. Financial innovations 5. Models of Rural Financial Institutions 1. first the rural financial system will be described and we will have a short look into the formal and informal sector The formal and informal sector are compared with special emphasis on credit 2. Then some theoretical aspects of New Institution Economics; very important for rural finance 3. The third part of the lecture will focus on the most important financial services in rural finance Here we will have the closest look on credits and savings Insurances are only slightly discussed At the end of section three we shortly discuss the microfinance safety net 4. Finally we look into financial innovation which have implications on the rural financial system Universität Hohenheim, Institut 490a

The rural financial subsystem
M5101: Prof. Heidhues + Tom The rural financial subsystem Rural infrastructure Agricultural sector Extension system Off-farm activities Government, Central Bank Insured party Financial market policy Monetary Trade Exchange rate relations Financial intermediaries Formal Semi-formal Informal Saver Borrower 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Middle: In the middle the financial intermediaries; around the the clients financial intermediaries do allocate funds from one party to the other In an ideal market they compete with each other among the clients However, in most developing countries the rural financial market is very fragmented e.g. the formal market serves the better of and the informal the poor and the poor do not have the chance to receive formal credit Left side (policies): The rural financial market is of course influenced by the government and the central bank through their policy interventions e.g. financial market policies have direct influence on the rural financial market for instance by setting interests ceilings or monetary policies: e.g. an hyperinflation will discourage savers to save in bank deposits, but rather in kind to secure their deposits Exchange rate relation do also influence the rural financial market, particularly when most farmers cultivating cash crops for export. Right side (infrastructure): The rural infrastructure and the agricultural sector do influence the demand and supply of financial services, e.g. in subsistence farming financial services are much more less demanded than in market-oriented farming systems Also the agriculture extension system influence the demand and supply for financial services; farmers who are supported by extensionist for modernization their farms do much more likely demand credit and FFI are more willing to disburse credit to farmers who are supported by extentionist as they are percived as a less risky borrowers. Rural financial market Source: Adapted from Buchenrieder, Heidhues, and Dung (2000) Universität Hohenheim, Institut 490a

Major functions of the formal financial system
M5101: Prof. Heidhues + Tom Major functions of the formal financial system Regional intermediation Sectoral intermediation Social intermediation Size transformation Time transformation Information transformation Risk transformation Intermediation Financial asset transformation Financial Depth Width of financial instruments Diffusion Promotion of financial asset accumulation Effects: Functions: Increase in the efficiency of resource allocation Promotion of factor mobility Provision of a financial infrastructure Setting monetary policy Enforcement of financial discipline in the enterprise sector Framework for structural adjustment Economic stability Form of Implication: 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Intermediation function: Regional: e.g. savings are collected in the urban areas and credit are disbursed in rural areas Sectoral: e.g. collecting of funds in the agricultural sector disbursing of credits to SMEs Social: e.g. few rich savers, many poor borrowers of micro loans Asset transformation function: Seize: Many small savings turned into few big loans Time: e.g. short-term deposits into long-term loans for investment Information: the bank does assess the investment of the borrower and the his credit worthy; this can usually not be done by the average small saver Risk pooling: credit defaults are split on to many savers Diffusion of financial services: width of services: This implies that a whole range of financial services is supplied, not just one service like credit but also savings and insurance and in each category different types of services. the depth : This means that many people using financial services, pparticularly in the area of savings. This means that the share of liquidity that is kept in savings instruments increases. The more savings the more money is available for investment lending. Financial infrastructure: refers to the different types of financial intermediaries, savings banks, commercial banks, credit unions and alike, insurance agencies. The better developed the institutional network (infrastructure) the more likely it is that a greater share of people will participate in the financial market. Source: Adapted from Geis (1975) Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom The traditional reason for formal agricultural credit S  Y  P  I  Vicious cycle of capital formation - A descending spiral - Source: Heidhues and Schrieder (1999) Y = Yield/income S = Savings I = Investment P = Productivity 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Who knows the reason for the traditional agriculture credit? It is the vicious circle of capital formation The rural population was believed to be too poor to save at all or too poor to save sufficient capital for investment as their income is considered as very low. Low savings etc... Traditional approach assumes that savings are not sufficient: a capital injection should boost investment Traditional approach towards agricultural credit Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Formal financial intermediaries (FFI)? Next Definition of formal finance: All intermediaries under control of the central bank Usually all banks and institutions which are collecting savings Semiformal = village banks, solidarity and self-help groups promoted by NGOs Informal sector: Family members or friends ROSCAS Traditional money lenders Deposit collectors Pawnbrokers Landlords, employers  Interlinked contracts } Non-profit segment = “moral community” Profit segment = outside moral community Forward 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Does anyone now the definition for formal finance? Formal finance is under direct control of the central bank Semiformal: Under government control e.g.often credit cooperative are under control of the Ministry of agriculture however, for simplification reasons, we are talking later only about formal and informal sector Informal: Under no control Who are the informal lenders? two segments, profit and non-profit ASCAs = Accumulating Savings and Credit Associations; RoSCAs = Rotating Savings and Credit Associations RoSCAs are the most spread form of informal finance around the world we can find them in almost any country in the world under different local names, e.g. in Nigeria Ususu, in Cameroon Njanggi or Tontine and in Vietnam Hui or Ho Universität Hohenheim, Institut 490a

RoSCA members and their contribution  of individual contributions
M5101: Prof. Heidhues + Tom Rotating savings & credit associations (RoSCAs): RoSCA members and their contribution A B C D  of individual contributions 50 200  of contributions received by individual member  of net loan received by individual member 150 100 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations This example is a very simplified RoSCA; there are existing a broad range of different varieties; it should just explain the principle The person who is receiving the at finally does actually not need the RoSCA as he saved all the money by himself AsCAS: Credit amount will be given away within an auction to the person who is willing to pay the highest interest rate. Note: All RoSCA members contribute the same amount at their periodic group meeting (Four members: A, B, C and D) Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom RoSCAs pros and cons Back pros cons + low cost + high repayment rates + need orientation + unbureaucratic, quick loan decision process + no collateral + mutual insurance system generally relatively short-term oriented cumulative credit need and no interregional inter-mediation (fragmentation) 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Pros: Low cost: No administration, no forms or transport, only opportunity of time for the meetings high repayment rates due to close social contact need orientation: few people come together with a similar need and adjust the RoSCA to their need in terms of amount, time, etc. quick: once the decision is made on the terms the loan is disbursed very quick no collateral: due to the social connection no physical collateral is needed Mutual insurance scheme: Often the groups not only have a credit function, but in addition, the members pay fines for indecent behavior during meetings or separate fees for a so-called mutual insurance funds. These funds pay out financial aid without interest in case a member is in need. The eligible needs are pre-defined. Insurance can also be in-kind, like working on the fields of a member when he/she is sick and alike. Cons: short term: the social collateral is probably not strong enough to finance long term loans; the longer a loan, the higher the risk of default; sums are rather small and long term investment usually require bigger sums cumulative credit need: cumulative credit need: often all members are from the same village and profession, like farmers. Then of course all of them will have at the same time in the year the demand for credit. The amount of credit needed is then higher than the credit fund can provide. As ROSCAS have no inter-regional intermediation: one of the advantages in the formal system is the inter-regional intermediation, which means that banks collect their savings not just in one region but in several, therefore, if people dis-save because there is a crisis like a drought and they need cash, it is unlikely that the dis-save in all regions at the same time. Similarly, if people need credit, it is not likely that the people in all regions need credit at the same time. fragmentation: operate outside central bank and the law: default is possible and happens more often than thought, e.g. cashiers flee to another region or country. Credit default can not be brought forward at a court, only informal pressure, sometimes not sufficient. Universität Hohenheim, Institut 490a

credit worthiness (3 essential Cs)
M5101: Prof. Heidhues + Tom Credit worthiness Credit disbursement is the process of the temporary allocation of resources (financial means) to a person or legal entity (firm, government) with the expectation that principal, interest and fees will be fully repaid. Lenders assess … credit worthiness (3 essential Cs) 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Collateral Character Capacity to repay In the following we will compare the formal and informal sector in the case of credit; but most of the following statements are also valid for formal and informal savings or insurance services the lender can never be 100% sure that the borrower will be able or willing to repay Therefore, every lender has the freedom and the obligation to select the borrower this means that the borrower‘s credit worthiness will be assessed by the lender this are the essential three Cs Collateral: (comes into play when the borrower defaults) Goods: this can be all physical assets which can be seized Persons: This can personal guarantees Character: (looking for indicators of the willingness to repay) Credit history: How was the performance of the last loans Personal background: the person committed any crime Capacity to repay: (looking for indicators of the ability to repay) Profitability of investment: Income: how are the income streams; how much debt can the household repay legal obligations: Are there any outstanding loans? Physical and financial capital Human and social capital Credit history Personal background Return on investment Income Debt / Expenditures Universität Hohenheim, Institut 490a

Cost of credit extension
M5101: Prof. Heidhues + Tom Cost of credit extension For the credit institution For the borrower Costs of finance: costs of procurement of funds Transaction costs  staff remuneration  material costs  reserves = Total costs for the credit institution + profit margin + risk margin = Market rate of interest (including fees etc.) Costs of finance: interest payment to the credit institution Transaction costs  transport  opportunity costs of time  costs of advice and procurement of information  securities, guarantees  certificates (certificate of residence, employment, good standing etc.) - discounted cost of future reciprocal commitment, informal market only = Total costs for the borrower 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Lender Cost for capital: Usually formal lenders are borrowing money either form the population, and/or other banks and/or from the central bank, thus they have to pay interest rate on their capital Transaction costs; of course the formal lender has to pay the staff and material, e.g. all cost fixed and variable e.g. transportation cost for the credit officers or computer for the office all formal lenders are enforcement by the law to build reserves for the cases of bad loans, this is to protect the institution from collapsing and to protect the deposits of the saver Profit margin: of course commercial lenders have to make a profit; this must be also added All this cost add up to the market rate of interest Borrower has to pay the interest rate plus the before mentioned transaction costs TC can become the major part of the cost for the borrower In many countries the total cost for the borrower are that high that at the end the cost for formal and informal loans are often equal How can that be? Informal interest rates are immense? Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Informal vs. formal finance Informal financial sector Formal financial sector Advantages Disadvantages Disadvantages Advantages closeness to clients/members little bureaucracy flexibility low TCs short-term financial products savings eventually insecure low, locally limited capital mobilization, fragmentation (social, sectoral, geograph) Monopolistic supply little cost efficiency little closeness to clients political influence possible bureaucratic procedures monetarisation, i.e. systemic savings mobilization economic development High volume and long-term loans possible Please name the advantages or disadvantages of formal and informal finance Advantage informal Closeness to clients: no transportation cost; clients fell not inhibited by formal procedures or different looking persons in large buildings (no entry barriers) little bureaucracy: quick disbursal of loans; illiteracy is not a problem flexibility: loan term are adapted to the situation of each client; all term are potentially renegotiable TCs: because of the other advantages the TCs are very low Disadvantages informal: only short term credits are or saving products are available; due to high risk lending and no collateral or legal bindings savings are relatively insecure; deposit collectors can disappear, can be robbed, money can be stolen or burnt, animals can die, ASCAS people can default low and locally limited savings: No allocation of savings to the most profitable investment; all need people in one region often need at the same time credit or do dis-save at the same time disadvantages formal: not cost efficiency: often dependent on government or donor funds; bad repayment rates etc. little closeness to clients often products are not adapted to the need of the clients; loans are to big or to small terms are too long etc political influence is often possible. during election years sometimes government given debts relief buerocratic procedure: takes time; cost money; makes it often impossible for illiterates to gain access Advantages formal: bigger loans/savings possible; long term products full transformation functions; positive effects on the whole economy; 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Definition of Transaction Costs (TCs) The cost that arise when individuals exchange property rights (PR) to assets and enforce their exclusive rights. TCs include all expenses and opportunity costs, fixed and variable, which arise in the exchange of PRs, except the price of the PR itself. Large share of transaction costs is fixed per transaction (irrespective of its size) Importance of TCs in Development (Micro)-finance 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Higher TCs decrease the efficiency of exchange relationships. The legal and regulatory framework and institutional innovations may reduce TCs and raise the efficiency of exchange. ( TCs  institutional change) Definition: We start with Transaction costs as they are a big issue in rural finance In case of credit or savings, what is the price? (interest rate) Please name some Transaction costs? (e.g. traveling costs, costs for the paperwork, bribes, opportunity cost of time) Importance: Why are transaction costs are important for development finance? In general Transaction costs can be an barrier for outreach and access in developing countries TC can be very high due to to the bad infrastructure For instance traveling costs are too high for borrowers to reach bank, and thus hampering access (access). TCs can be too high for MFIs to improve outreach to low income borrowers (outreach) Universität Hohenheim, Institut 490a

Classification of TCs Arise before the transaction Mostly related to
M5101: Prof. Heidhues + Tom Classification of TCs Arise before the transaction Mostly related to searching for and screening of potential trading partners and obtaining price information Arise during the transaction Including costs of arranging the transactions, physically transferring the product or service, and drawing up contracts Arise after the transaction Including costs of monitoring the terms of the transaction and enforcing liability Information costs Negotiation costs Enforcement costs MFIs 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Clients classification MFI-clients Who can tell me transaction costs for the client and for the MFI? e.g. for the client transportation costs to reach the bank e.g. for the financial institute: collecting of information on the borrower Classification Information, negotiation, Enforcement Information: e.g. client looking for an financial institute with the cheapest interest; e.g. Financial institute: collecting information on the creditworthiness of the borrower Negotiation: e.g.client: paying for contract forms or fees; e.g. Financial institute: Time of setting up the contract Enforcement: e.g. client has to show the credit officer around on his farm to prove whether he spent the credit on the right purpose; e.g. financial institute: call in a lawyer to force the borrower to repay. The big question in rural finance is: How can an organizations reduce transaction costs? Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Selection of borrowers towards bigger farmers/ wealthier clients Back average transaction cost per lent unit of money average cost per loan 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations I mentioned it before, but wee can clearly see it in the figure, the average costs per loan are equal for small and big loans As funds from government were not secure and often not enough to compensated the subsidized interest rates, the institutes tried to reduce their cost besides, ssometimes governments set interest ceilings, this means it is forbidden to charge higher interest rates then set by the government thus credit institutes could not cover their costs over the interest rate, thus they had to reduce the cost one very effective way was sorting out all small loans thus the originally target group was crowded out and instead few big farmers received very large loans small-scale-farmers medium-size-farmers large-scale-farmers Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Relational contracts Financial services contracts (savings, credit, insurance) are relational contracts (I.e. incomplete contracts where some future verifiable actions are specified but not all contingencies are and can be negotiated, thus the contract also depends on personal relations) The transaction takes place over a long period of time, there is a premise that partners enter into repeating transactions Transaction is based on promises of contract partners  enforcement problem Trust is an important factor in relational contracts Information asymmetry TCs MFIs HHs Information cost One party to an agreement has better information on the matter of contract then the other Example: creditworthiness of borrower (STIGLITZ), quality of used cars (AKERLOF) 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Relational contracts: Financial contracts are different to daily business contracts E.g. buying bred in the bakery, the transaction takes place immediately Information asymmetry: A borrower knows from the beginning of the credit contacts whether he is willingly to pay back the credit or not. The bank does not. What can you do against this? banks usually require collateral to secure their loans. What is the problem in micro-banking with collateral? Most MF clients do not possess collateral. a costly process of screening and monitoring replaces collateral. Most of the costs are related to gathering information due to information asymmetry. The costliness of information is the key to the costs of transacting. If we are able to reduce the cost of information we can improve access and outreach. All relational contracts face information asymmetry Most of TCs are due to costs of acquiring information. Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Information asymmetry  adverse selection and moral hazard Adverse selection implies unwanted, suboptimal market equilibria. Akerlof showed this first for the market of used cars. Suppliers of above-average cars only get average price, whereas suppliers of bad cars receive an unjustified premium. Because of adverse selection, the volume of market transactions and quality of cars is lower (STIGLITZ credit). Responses: Signaling, screening. adverse selection moral hazard ex-post ex-ante Transaction Moral hazard 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Moral hazard occurs, e.g. when a buyer in a relational contract changes her behavior after the purchase of a service in that way that the change increases the likelihood of defaulting on the contract and harming the business interest of the supplier. Example: borrow credit for fertilizer  spent on leisure; buying theft insurance, then not locking the suitcase. Adverse selection: Adverse selection is a major problem of insurance contracts. For instance a person with very dangerous occupation, deep sea diver, will rather take an insurance on industrial accidents than lets say a secretary. Credit institutes may face an adverse selection e.g. when offering too high interest rates. The riskier an investment is, the higher is the profit. When offering very high interest rates only persons with a risky investment can afford the credit. Therefore, adverse selection does in fact also has a positive influence as it gives lending institutes a strong incentive not to demand usury interest rates. Moral hazard: Some one buys a car insurance and drives afterwards like a mad man because he thinks that the cost of an accident are covered by the insurance anyway The buying of an insurance can effect people to care less and thus raise the cost of the insurance company Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Financial market Credit Savings Insurance The product triangle of rural finance Vogel‘s (1984) forgotten half of microfinance in the 1980s Zeller et al. (1997) termed insurance as the forgotten third in the 1990s Financial market Credit Savings Insurance The product triangle of rural finance Vogel‘s (1984) forgotten half of microfinance in the 1980s Financial market Credit Savings Insurance The product triangle of rural finance The product triangle now we are looking at the services provided by the formal sector in the area of rural finance Credits: During the 70s the main focus was on agricultural credit, it was believed that credit would be the only financial service demanded by necessary for the rural population; as the rural population was considered as too poor to save therefore, the first rural financial organizations had a very strong focus on supplying credit to the population Savings: However during the 80s researchers and development aid community proved with empirical studies in many countries all over the world that even the poorest of the poor are able and willingly to save Besides, in times of decreasing donor funds and government funds the mobilization of funds became a big issue for rural credit institutions since that time the importance of offering savings is acknowledged. However, this unfortunately true only for the research community, Still, many donors and governments in developing countries are still in favor for disbursing credits only or are giving credit the main priority; Insurances: this is a very recent product development and not yet very spread; however the organization offering formal insurance in rural areas is growing every day. Product triangle: we start with discussing the credit services as this is still the most spread financial service in rural areas and we will begin with the traditional agriculture credit, which is still offered in many developing countries 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Source: Buchenrieder, Heidhues, and Dung (2003) Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom The efficiency of informal finance 1. Are the services provided by informal lenders "valuable" for their clientele? The answer is a strong “yes“. 2. Are the services provided by informal lenders "sufficient," from the perspective of their clientele? Under many circumstances, the answer in this case is possibly “no“. 3. Are informal financial services "efficient" from an economic perspective? The answer here is a strong “no“ (in a first-best sense), but yes in a second-best sense. 4. Can informal financial transactions be replaced and/or complemented with formal financial intermediation? The answer is “potentially yes“, but the task is not easy at all. The repression of informal financial services should be opposed. They are not "evil" but valuable services actually demanded by their clientele. Without those informal arrangements, these services would not be provided at all. Informal service or no service Informal lenders typically do not provide a sufficiently wide collection of the services for which a demand exists (e.g., deposit facilities, money transfers, certain types of loans). Several of these "missing" services, however, are demanded by the poor and if they were available they would also be welfare-improving. Moreover, informal financial services are either a part of a larger network of relationships (friends and relatives), which carry particular (but difficult to measure) costs, or are quite costly (money lender). It is not surprising, therefore, to observe a demand for those semiformal and formal financial services that are cheaper and that are at the same time permanent and reliable. Increasing access to less costly services will also be welfare-improving. Particular informal insurance reaches quickly its limits in case of covariate shocks, eg. droghts. Informal financial arrangements are competitive mostly within small market segments, for financial transactions among agents who are in close "proximity." Beyond the local boundaries, informal finance is "prohibitively expensive" The information costs for screening and monitoring borrowers are too high. In consequence, informal finance cannot contribute to the allocation of resources. In this sense, informal finance is not socially "efficient" and cannot contribute to economic growth as much as formal finance (wider in scope). Since the provision of formal financial services is very costly, the process takes a long time and requires major improvements in infrastructure and institutions. To reach the poor one would require, in addition, innovations in financial technology. Are these innovations possible? There are a few examples that suggest that this is the case, under certain circumstances (which may not be present in every country). On the other hand, informal finance will never disappear, but it will occupy an increasingly less important niche as formal finance is developed. Valuable financial services are provided by informal arrangements. Economic development will require, however, the provision of additional (also valuable) formal financial services (to replace or complement the former). While understanding the role of informal finance, the real challenge is to discover the appropriate combinations of technologies, organizations, and policies needed to develop formal financial systems at the national level. But the worst case woulod be when informal fiancial arrangement are crwoded out by insustaianalbe fomal instituions, which after breaking down leave the rural popalation in a much vulnerable position then before. 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Key features of the traditional agricultural credit supply External (to the rural sector) financing by government and external donors (Short-term) production credit (supervised credit, credit targeted to certain crops/animal husbandry activities) Strong focus on (production) credit; no savings mobilization, no insurance or insurance substitutes Subsidized credit (low interest rate)  providing opportunities for seeking rents that tend to be captured by the wealthy/powerful Collateral to overcome information asymmetry (systematically screening out the poor) Policy of “Give and forgive” (Zeller et al., 1997) 1. The traditional agriculture credit was extend by institutes usually finance by the government and/or external donor agencies therefore, those institutes had very seldom a commercially oriented focus and were usually non-profit oriented 2. As we could see in the vicious cycle of capital; the solution was to boost investment, therefore, only production or investment loans were were approved; Consumption loans were generally not given. As it was assumed that consumption is not income generating and thus not contributing to economic development However, nowadays, also consumption loans are recognized under certain circumstances as an important financial service; for instance, consumption loans can be used to sustain the capital which most poor only possess, namely the human capital; To excluded consumption credit, the credit was supervised with very high cost; besides, money is fungible, thus you can never be sure what the money it actually used for; another way to control the credit purpose was to target it to certain professions, e.g. only credit for paddy rice; leaving all without access to credit who do not possess paddy land; little room for innovative investments 3. savings were considered as unimportant for development It was believed that the rural population could save if at all only an insignificant amount of money as long as external funds were flowing the agricultural credit institutes had no need to collect savings anyway. 4. The credit were usually subsidized as it was believed that the rural population and particularly the poor were unable to afford market rates of interest And it was believed that the interest rates demanded by informal lenders were usury and antidevelopmental and solely based on the monopoly of the money lenders In some rare cases this was true but in general this assumptions have proved false 5. The agricultural credit institutes applied traditional credit technologies and their only way to secure loans and to overcome information asymmetries was to require collateral, usually land titles/wages/ or capital assets 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Why was the traditional agricultural credit approach not successful? No capital mobilization (savings) lack of independence Gov. influence undermines institutional independence Uncertainties of external funding (government, donors) Linkage between government funding and repayment performance Did not reach the target group Market distortions caused by subsidized credit Did not respond to the full demand for financial services by rural households (poor and non-poor) Many reasons lead to the failure of this approach 1. No Savings as the institutes relied solely on the external funds mostly from government the were not independent and were in the mercy of the government often they had to implement government decisions, which were lead by political reason rather then economically sensible (e.g. interest rate ceilings) 2. Funds no one of these Agricultural development banks has been working economically sustainable, there were depending on continuous funds from outside However, even those government funds have proved as being not reliable, leaving the credit institutes without funds behind; particularly when governments find out that the traditional agriculture banks were an immense drain of publicc resources (no peanuts) when those funds stopped from flowing this banks broke down immediately 3. Linkage History has proven a strong link between government involvement and repayment rates; often funds were directed to political cadres, those cadres usually refused to repay. 4. Not reached the target group a) the target group was not reached as products were not adapted to the need of peasants or the rural poor and thus were not demanded loans were too big, terms were too long massive paper work was required, leaving all illiterate without access B) most small farmers were excluded by the bank they did not possess any collateral, as property rights are often unclear in developing countries fix cost for handling a loan are usually the same for huge and small loans; this means the cost per unit money lend out are smaller with bigger loans, therefore, banks did automatically selected bigger farmers to save costs 5. subsidized interest rates This point is of enormous significance for the failing of this Approach and will be discussed on the next transparencies 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

Effects of low interest rate policy
M5101: Prof. Heidhues + Tom Effects of low interest rate policy Next Weakening of rural finance institutions Adverse allocation effects Forward Weakening of rural finance institutions The subsidized interest rates prevented the institutions from becoming independent, as the were in a continuously need of external funds after some time they get get addicted to these funds and cannot exist without continuous injections of money 2. Adverse allocation it was assumed that the low interest rates would result in an increased economic growth, however these effects are questionable and probably negative Non-market (non-price) rationing in market economies usually the price is the rationing factor, which brings demand and supply to an equilibrium if subsidized interest rates are applied the price does not work anymore this has two negative affects a) lending towards bigger loans b) lending to key-persons with economical and/or political power 4. Income distribution apart from the fact that most funds were lead to few people the subsidization of interest rates has in itself a regressive distribution effect What does it mean?: First, does some know what is progressive taxation? This is actually the opposite effect. The more some one earns the more he is paying tax. This means that richer people are paying more tax in absolute terms but also in relative terms. But if you subsidies interest rates, the one who takes the biggest loan gets also the biggest subsidy and the biggest loans are usually taken by rich people Low savings interest rate some credit institutes were also offering savings, trying to full fill full intermediation function or just trying to be more independent however due to the subsidized interest rates on credit the interest rates on savings were set very low very often the interest rates were that low that they lying below the inflation, this means you are actually loosing money when you are depositing your money at the bank of course such a policy does not attract many savers 3. Non-market (non-price) rationing lower cost/ larger loans economic and political power 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations 4. Distribution effect, regressive 5. Low savings interest rate (often negative, below inflation) Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Misallocation of funds i i* Economic rent i** 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations You can clearly see in the figure, that with subsidized interest rates investments will be financed, which were under market interest rates not profitable. Once the interest rate subsidizes are removed those business will break down This led to a misallocation funds in the whole economy, which has negative effects of growth and development Investments i* = market interest rate i** = subsidized interest rate Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Adverse employment effects Labor Isoquant Lopt 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations This figure shows the optimal factor combination under a specific cost function. The isoquante is a curve with the same output for different factor combinations For example this curve is the production isoqunate for 10 tons of paddy rice, this tons of paddy rice can be produced with a lot of labor and little capital or vice versa; I can use 10 family members for ploughing or I buy tractor the cost line is a function of interest rate and wage at the point where is meets the isoquante we have the optimal factor combination This means under the current wages and interest rate the farm will use Iso-cost-function Copt Capital Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Adverse employment effects Back Labor Isoquant Lopt Lopt* Copt* 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations If we lower the interest rate the cost line is less steep and it touches the isoquante at a different point this means that the optimal factor combination is changing the cheaper the capital is the more of it will be used and the more capital I use the more labor will be replaced now in most developing countries we have lots of unused labor in rural areas and a big unemployment problem the off-farm sector is still very small thus, subsiding interest rates will aggravate this problem as farm labor will be replaced by capital with cheap capital the farmer might by a tractor instead of using 10 workers for the land preparation Iso-cost- function* Copt Capital * = subsidized interest rate Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Effects of an imbalance in supply and demand Back i S i* i** D 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations you can see in this figure, that when the price in this case the interest rate is not working anymore you will receive a market disequilibrium The low artificially low set interest rate has two effects: 1. the demand is rising and in case of interest ceilings the supply is decreasing that means we have a higher credit demand than loans funds are available This situation leads to rationing of credit according to non-economic reasons Corruption nepotism are a wide spread phenomena under this circumstances farmers with the greater economic power could pay higher bribes and received the bigger loans besides, history has shown that political cadres used their influence on the credit institution and served their own clientele with huge cheap loans Both clientele the political and economical powerful used their influence not only in receiving huge amounts of the cheap loan, but also in delaying or refusing repayment these resulted in very bad repayment rates; in some cases 80% of the funds were not paid back Another very negative aspect was that these huge funds misused by powerful individuals were not invested locally but usually brought abroad S** E* D** Credit i* = market interest rate i** = subsidized interest rate E* = equilibrium Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Nominal and real rate of interest The real rate of interest is equal to the nominal rate of interest minus the effects of inflation. The real rate of interest (r) is derived from the nominal rate of interest (i) and the inflation rate (p) according to the following formula: Example: i=18%, p=12% 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Reasons for high costs in agricultural lending “As a rule, lending to agriculture is more expensive than lending to commerce and industry and lending to small farmers is more expensive than lending to others” Riskier because of relatively undiversified loan portfolio, mainly agriculture Riskier because of the productive risk of agriculture, droughts, floods, diseases etc. Usually thinly populated areas with bad infrastructure Small amounts of loans are required Vulnerable clientele (smallholders often poor, women play major role in farming systems) See Zeller, 2003 (paper on rural finance institutions for D.C. conference) 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Therefore, artificially low interest rate are particularly a problem in rural lending as the gap which has to be filled with government funds is even wider why is rural lending more expensive? 1. riskier portfolio It is riskier for the institution as the portfolio is relatively undiversified, mainly agriculture. this means that many people are at the same time in credit need or do save or unsave at the same time. 2. riskier when a region is hit by a natural catastrophe it is very likely that the agricultural investment of many borrowers was also hit this means that many loans at the same time can not be repaid 3. bad infrastructure The institution has very high transaction cost; credit officers have to travel far distances from borrower to borrower roads are bad and traveling takes time and is expensive 4. small loans as we already said, small loans are more expensive Finally: rural lending must be more expensive, must require higher interest rates then other lending Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom The new approach to rural finance - The microfinance revolution - Next Financially sustainable and independent financial organizations 2. Ensure outreach to the whole spectrum of the rural population 3. Implementation of client adapted financial services (see last chapter) 4. Implementation of savings instruments 5. New forms of collateral, e.g. group credit, savings, leasing... Forward after the disaster of the traditional agriculture lending first micro finance institutes appeared during the 80s so what is so different about the micro finance approach? They learned form the mistakes of the formal agricultural lenders and learned from the strengths of the informal sector it is now recognized that sustainable and independent financial organization are a key factor for serving rural clients After the disastrous outreach of the traditional credit institutes outreach became a major issue in rural and micro finance. However, many MFIs went in the exact opposite direction and do serve the poor only, which is also suboptimal 3. Product design was recognized during the 90s as another important issue in rural finance many of the financial services offered were not adapted to the needs of the rural clients besides, the rural population was long time seen as a homogenous crowd with similar needs, nowadays, the rural population is recognized as very heterogeneous, with different needs and thus blueprint products or one-fits-all-products are considered as insufficient (we will discuss this issue in more detail in the last chapter) only products adapted to the needs of the rural population will be demanded It is now clear that savings are a valuable service to the rural population in addition to that savings are considered as essential for any viable MFI traditional lenders relied solely on traditional collateral as land titles; this left many rural households without access to credit as they usually do not possess such certificates MFIs did develop a variance of collateral substitutes ehr. Forward 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Forward Forward Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom 1. Sustainability Back Why sustainability? The poor value secure but more expensive access to credit higher then cheap but uncertain access Unsustainable FFI are a drain of public resources Non-performing loans leaving behind a burnt soil for any viable rural financial intermediation How to achieve sustainability? Savings collection for being independent from external funds which tend to end at some point of time (also lower costs of capital than commercial borrowing) Full recovery of costs of lending is essential: a) cost covering interest rate greater than opp costs of capital plus admin costs plus risk premium b) achieve high repayment rate (> 95%), and c) organizational efficiency (low hierarchies, de- central decision making  lower administrative costs) Why sustainability: 1. many poor households use credit as a mechanism to cope with disasters or they are waiting for good chance to invest therefore, it is very important to them to have a reliable access to credit in times of need; 2. nowadays public resources and donor funds are rare; there is no room left anymore for wasting money 3. Once a borrower has defaulted he is actually out of the game for any future loan. When the bad repayment behavior has been set in the head of too many people it is impossible to implement any sustainable financial institution; this can leave whole areas without access to formal credit for a very long time But how can sustainability be achieved? 1. first of all: Collect savings right from the beginning it make the institution independent from donor or government funds; besides when offering savings institutions are usually subject to much stricter external control, (this is written down in most financial laws, to protect the savers); But is has also very positive effects on the institution; as they are also controlled externally they usually do perform much better 2. Services must be cost covering There are many reasons: The poverty lending approach is still very common among some NGOS, which believes that the poor are not able to pay high interest rates Often NGO staff is not educated to perform financial operations Then for some donor agencies the flow of capital abroad is the success criteria; Many governments still use cheap credit to keep rural population quiet in the sort term instead of making had reform etc. 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations BUT: For the few sustainable MFIs, see Microbanking Bulletin Universität Hohenheim, Institut 490a

Administrative Expense Ratio
M5101: Prof. Heidhues + Tom Benchmarking EFFICIENCY Administrative Expense Ratio Provides an avenue for best practices to emerge Gives practitioners, board, funders, and regulators a comparative picture of MFI performance Helps coordinate efforts and efficiency to help MFIs increase outreach Chart: Administrative Expense Ratio = (administrative expense + in-kind donations)/ average total assets Data source: MBB Issue 7, November 2001: Focus on Transparency, Table Dc The MicroBanking Bulletin (MBB) is the lead benchmarking source for the microfinance industry. Its benchmarks are widely used by investors, donors, and service providers to facilitate greater standardization of the microfinance sector. Originally an output of the MicroBanking Standards Project, the MBB is now one of the principal products offered by the MIX (Microfinance Information eXchange). The MIX is a not-for-profit private organization that supports the growth of a healthy microfinance sector through increasing standardization and facilitating information exchange. The MIX is supported by CGAP, Citigroup Foundation, Deutsche Bank Americas Foundation, Open Society Institute, Rockdale Foundation, and others. To learn more about the MIX, visit the MIX website at The MBB’s Objectives: The MBB collects financial and portfolio data provided voluntarily by microfinance institutions (MFIs), organizes the data by peer groups, and disseminates the results. The MBB plays a critical role in: Assisting MFI managers and board members in understanding their performance in comparison to peers Establishing industry performance standards Enhancing the transparency of financial reporting Improving the performance of microfinance institutions Overview of the MBB Toolkit: The MicroBanking Standards Project has developed a toolkit to assist local MFI networks to more effectively serve their members in establishing performance standards and comparing their results to similar institutions. The toolkit is also appropriate for apex organizations or central banks that monitor the financial performance of MFIs. This toolkit guides users through a step-by-step process of performance monitoring and benchmarking. Figures: Averages for All MFIs by Region Data source: Microbanking Bulletin (MBB) Issue 7

M5101: Prof. Heidhues + Tom 2. Outreach While outreach is used from the perspective of the financial program and access is used from the point of view of the potential client, they both refer to the same thing: who is getting the credit (Vaessen 2001). supports rural growth and food security it improves an equitable income distribution it enhances portfolio diversification of the rural finance institution and reduces risk Depth of outreach: high share of women, poorest, etc. Breadth of outreach: reaching huge numbers of target group people Why is outreach supposed to be important? a broad access to financial services supports growth in rural areas as it pushed up investments and it improves food security as financial services can be used for consumption and income smoothing a broad access also improves the income distribution as assets are not accumulated with few people not only risk at the household level is reduced, but also for the institution; when an institution can spread its products among a huge numbers of people few defaults can easily be coped with We have to kind of outreaches: depth of outreach; this refers to the quality of outreach, which means that you clients also include many poor and marginalized groups, for instance, ethnic minorities or women and we have the breadth of of out reach which refers to the number of clients in total There is still a discussion going on which is more important: some people say breadth is enough. If you reach huge numbers of people you will automatically also reach the poor even if in relative numbers their share is small others say unless you actively include the poor into the institution and measure your success by depth of outreach, the institutions will skip those people; however, it will include some cost, because the institution might have to measure the poverty level of their clients 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom 2. Outreach - How to reach the target group? Targeting – Ex ante Potential clients are assessed ex ante by short-cut poverty indicators, e.g. wealth, assets, farm size, type of house, occupation etc. Problem Usually quite expensive and time consuming, as every new customer has to be assessed (But Geo-targeting, Housing index, PWR, poverty assessment tools) Potentially open to corruption Product design Designing of financial services exactly tailored to the needs of the target group and thus, are not demanded by other groups of the population This requires extensive market research before the product design Problem Critics say, that with product targeting alone the very poor can not be reached How can we ensure outreach and particular the depth of outreach? there two ways of reaching the target group and both ways are still discussed among scientist and practitioners Exante – Targeting Different ways of targeting: 1. Family income via standardized questionnaires (quantitative), 2. Indicator methods – Principal component analysis (quality of housing, number of animals, etc.), 3. Participatory assessment through the target group or village meeting, 4. Assessment via key-persons nevertheless, all ways are more or less cost intensive and using a lot of time and resources besides it gives the person who is in charge of determining the access to the financial service of a certain household the possibility to take on bribes 2. Product design The financial services are designed in a way, that they are specifically constructed in a way, that they will be demanded only by the target group However, this requires an extensive market research before the implementing the products; nevertheless, market research is important anyway to offer good products anyway Products are taken by the rich just of the expectation to receive in the future larger loans 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom 2. Outreach vs. Sustainability Back Some argue there is a trade-off between sustainability and outreach (see e.g. Zeller and Meyer, 2002)  the costly information collection on the credibility of potential clients and long distances in sparsely populated regions Counter example: e.g. BRI (Bank Rakyat Indonesia) has an enormous breadth of outreach and is covering its operational costs (however: depth of outreach not clear) Sustainability enables rural MFIs to serve significant/more numbers of low-income clients over time MFIs try to operate in a so called ‘win-win pro-position’: The poor benefit from the financial services provided, willingly to pay high interest rates/fees to obtain them, which permits the MFIs to provide the services on a sustainable basis. Sustainability is based on the reasoning that sustainability today will mean more outreach and impact tomorrow 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations We also have a discussion going on about outreach and its effects on sustainability the cost for ensuring outreach to the very poor are supposed to be very high and some believe they are that high that the institution need financial support to supply the poorest with credit First: we have some example of financial institutes which have an enormous outreach and are financial sustainable e.g. the BRI) Second: Usually a MFI should be in a win-win situation; the poor benefit from the access to loans which they formerly not had and are willingly to pay high interest rates to obtain them; this allows the MFI to provide services on a sustainable basis Third: always keep in mind, that some HHs are not able to handle credit anyway; they should be rather reached with savings or in really bad cases with grants but these grants of course should not be given by an organization which is related in anyway to a credit institution Finally: sustainability today means more outreach and impact tomorrow if you have an unsustainable institution which reaches a certain number of people in a shot period; this number can surely be outdone by a sustainable institution which works on a long-term basis. Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom 4. Reasons for MFI to offer savings Back Achieving independence from external funds Improving the internal organizational efficiency Close contact to the target group Gathering of relevant information for granting credits Improving outreach Collateral Why is so important for an MFI to offer savings: Independence they become independent form donor and government funds and thus independent form policies which affect their profitability of sustainability the tapping a source of funds which will not dry up after some time or policy change Internal efficiency offering savings is more complicated than disbursing credits it needs a much better organizational structure; the improvements gained though the supplying of savings will positively effect all other business activities closer control form external auditors close contact to the target group when offering savings you will automatically have more contact to your target group, thus both sides reduce cultural barriers collecting information the closer contact allows the credit officer to collect more insider information thus he can assess the creditworthiness of people much better outreach: offering more products will of course also improve the outreach (usually much more people save then taking a credit) Collateral the accumulated savings can also be used as a collateral, securing certain parts of the credit and/or give information about the income streams of a borrower 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom 5. Collateral Why are banks asking for collateral? Relational contracts, information asymmetry, moral hazard problem Collateral insures the lenders’ loan portfolio in case of borrowers’ default. It represents an incentive of the borrowers’ willingness to repay. Traditional collateral Land titles, wages, capital assets (car with title) FFIs typically resort to legal options, such as seizing property or wages directly from the employer. MFIs lend to low-income clients who usually have very few assets. Consequently, traditional collateral is often not available, and collateral substitutes (similar to the informal market) are used. 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations First why do lenders need collateral? because credits are relational contracts and therefore information asymmetry and moral hazard play a key role All lenders are hit by this: formal, informal, traditional, innovative etc. Therefore collateral is used to insure the lenders’ loan portfolio in case of borrowers’ default. Besides, the collateral represents an incentive of the borrowers’ willingness to repay. Traditional collateral as we discussed already land titles, wages, capital assets FFIs typically resort to legal options, such as seizing property or garnishing wages directly from the employer. but: in many developing countries either there is no legal infrastructure to seize property, (laws are missing, maybe too few judges, thus it takes years, etc.) or there are simply no sizeable assets the particular problem of MFIs is that they tend to lend to low income clients who own of course, if at all, only few sizeable assets; Thus traditional collateral is not available What can be done if there is not traditional collateral? Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom 5. Collateral Back Substitutes of traditional collateral Joint liability groups Compulsory savings Social collateral or character-based lending Credit history Any kind of valuable property, e.g. animals, furniture Joint liability:in joint liability the groups are responsible for the single borrower, usually the group has to repay the loan of the single borrower if he defaults and/or the group is excluded form future credit; thus the group keeps peer pressure on its members not to default Compulsory savings: before someone group or individual receives a loan he must proof his/her ability of repaying; thus he must save in regular time intervals a certain amount of money; this amount will also later on be used as a collateral to secure part of the credit and the lender can see how much the borrower is able to repay and thus estimated the amount of the credit Social collateral: the borrower needs references form certain people who proof his honesty: in Vietnam people only receives credit when the local party head gives agreement assessment of the investment: if the investment is considered by the credit officer as profitable and of low risk nature sometime this might be enough to grant a loan Credit history: punish bad borrowers and reward good ones; if some fails future loans are denied, if some one repays late he will receive less credit in the future; if someone always pays back in time grant him bigger loans or pay him even some money back Seize any kind of property: carpets, toys of the children, everything can be seized which is not absolutely necessary for surviving Why does it work to seize property which has even less value then the loan works? sometimes people are so afraid to deal with officials or the police it is simply enough to know that they will be in trouble with the law or it very embarrassing to them when the neighbors get to know the the bank seized their carpet, because they are bad borrowers sometimes those assets have little actually value but have a high emotional or religious value to the borrower, one could size e.g. the cross form the wall because of the embarrassment few instance should be enough when collateral is actually sized, people talk about it and will spread the news to other borrowers The mechanism of collateral Often, simply the risk of legal repression is enough to encourage repayment. Regardless of the actually value of the asset, the act of pledging assets and the consequent realization that they can be lost causes the client to repay the loan. Even if the collateral is almost never collected, this does not signal its lack of importance. Few instances when collateral is actually collected are sufficient. 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Reasons for households to save Next Income smoothing Safeguards against uneven income streams due to seasonal variations Insurance Provisions against disability, disease, retirement, sudden income losses and other contingencies Wealth accumulation Financing household’s long-term goals (social and religious purposes, heritage, consumer durable) Future investments Financial reciprocity or social reciprocity The possibility of using savings to gain access to credit or other services Forward 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations SAVINGS: 1.Income smoothing particular agriculture production is a high seasonality of income, this means you have a lot of money after harvesting time, which is usually a short period of time about or two month depending on the crops and this money has to be saved to finance all expenditure over the year Insurance many poor people save to make provisions against future shocks, e.g. if the income earner gets sick the savings can be used for the treatment, thus they do not need to lend form the money lender or at least not such a big amount Wealth accumulation people save for durable consumer goods, e.g. I always wanted to have side car and thus I saved my money for it But more important for many rural people in developing countries is that they save for social or religious purposes, e.g. heritage, or wedding parties; in India many people get very indebted only to finance the wedding party of their daughter; 4. future investments one can of course also save for an investment, small investments are usually financed by savings 5. financial reciprocity one might save in the hope to get a loan in the future Universität Hohenheim, Institut 490a

The need for income and consumption smoothing (Morduch, 1995)
Cash flow within the lunar year of an ethnic minority in Northern Vietnam Back 6 5 4 3 Monetary unit 2 1 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations 1 2 3 4 5 6 7 8 9 10 11 12 Lunar month Expenditure Income Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Formal and informal savings Formal savings Bank accounts Certain insurances Stocks What are formal savings? time deposits, checking accounts capital life insurances, most forms pension funds, buying stocks at the stock market What are informal savings? We have two kinds 1. In kind animals are a common source of in kind savings; they even give an interest (off-spring) and this interest is even often higher then the interest rate paid in the formal sector Grain and other cash crops are often stored and sold in case of demand for cash; immediately after the harvest prices usually are down and thus a better price can be gained construction material is often stored as it lasts very long; thus one can build or collect the material for the housing step by step; particularly in cases of strong inflation this is a very common event; the money looses its value very quickly, thus people trying immediately to convert it into goods; wood, bricks, and iron can be stored for years Jewelry or gold: usually, rather rich people do save in this form in the absence of formal savings or in the presence of high inflation; the advantage of the form of saving is that is easily converted back into money with almost no loss 2. Cash Money collectors; many market traders use this form of saving; the money collectors comes by every day and people deposit with him or withdraw; for his service of keeping the money safe he demands a small fee ASCAS/ROSCAS: As I already explained before, rreciprocal lending schemes function not only as a source of informal credit but also as a form of saving; in cases of ASCAS even with an interest rate Pillow: of course the is the most simple form of saving; however is is also the most accessible form All forms of savings have certain advantages and disadvantages. which saving option is actually used depends on the households decision matrix. The next transparency shows some decision parameters. Informal savings In kind: Animals (cows, goats, pigs, chickens etc.) Grain (maize, rice etc.) and commodities (beans, coffee etc.) Construction materials (bricks, wood, etc.) Jewelry or gold In cash: Money collectors Reciprocal lending (e.g. RoSCAs) Under the pillow 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Decision parameters for choosing a saving option Transaction costs TCs incurred on transforming available surplus into a specific savings option or on liquidating it Liquidity Time of liquidating the saving option in case of need Real interest rates Remunerations of the saving option Divisibility Possibility of parting of the savings in different sizes Safety How secure are the savings stored? Trustworthiness and confidence Piggy bank Locking money away from relatives and friends The household decision to use a certain saving option or a mix of them depends on specific features and cost that arise TCs: These are the cost that occur during the process of saving or liquidating: in case of formal savings the transport cost to the bank and back or incase of saving in animals the transport to the market liquidity: How quick can the saving be turned into cash? Particularly, if the HH is saving for insurance reasons it is necessary that the saving can be turned quickly into cash, e.g. in case of an traffic accident; in such cases time deposits of several month are inappropriate Real interest rate: Do I lose money when I save or do gain some; if people refrain on consumption today, most of them want to be paid for this renunciation; especially the poor „Zeitpräferfenzrate“, „Grenznutzen“ Divisibility: Cash has the highest divisibility; in kind savings are different; if you only have to pay for some fertilizer it is not appropriate to sell a whole cow and you cannot sell a leg of a cow; therefore, if people save in kind or particular animals usually they different kinds of animals at different sizes Animals can die, house can burn down, people might get robbed; therefore, safety can be of big concern in choosing the saving option; E.G. bank accounts are safe in terms of robbery (banks are insured) or fire or other catastrophes, but HHs do not know whether the bank invest the money carefully; it might happen that the bank goes bankrupt or in case of deposit collector he may just disappear or in case of the bank; the bank passes information on to a third party, government etc. and if you do not want to pay tax you might not use the bank Piggy bank: particular when women save cash at home it is often taken away by the husband or children beg until they get some small amount to buy sweets; for some people it is important to secure the savings from their own weakness or from the desire of relatives 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Importance of savings “For the poor, access to saving products may be more important than credit (Zeller 2001).” “In institutions which offer unbiased savings and credit services, the number of savers exceeds the number of borrowers by a wide margin (Seibel 1999).” The most successful saving product: - voluntary - close proximity to the clients - positive real interest rates - (quickly accessible in case of need) BUT: Locking away of savings in formal deposits may decrease the depositor’s access to financial support from the social environment in times of scarce resources. Social cohesion as well as individuals’ safety nets may be disrupted Finally we can say that savings are a very important service for the financial institute and for the HHs particular for the poor many HHs are simply too poor to borrow but they can safe Thus it is not surprising that empirical evidence has shown that savings are more demanded then credit how should a saving product look like to be successful: Again as I said before there are no blue prints but research has shown that the following key feature are the basics for successful saving products: Voluntary: compulsory savings are seen by the clients as cost of the credit and in almost all cases clients withdraw their money after they did repay the credit close proximity: a close proximity reduces the transaction costs and creates an environment of trust which is essential for savings; positive real interest rates: as I said before especially the poor want to be rewarded for their renunciation different types of time deposits need to be offered however, to reach the very poor a quickly accessible checking account is of particular importance 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Micro-Insurance “Many households borrow, more save, and all insure (Zeller 2000).” Formal insurance schemes in most developing countries not available, particularly not for the rural population Particularly poor households enter into various forms of informal self-insurance or co-insurance arrangements Informal insurance arrangement are important but at the end not sufficient Insurance in rural finance: Relatively new product in rural finance During the 80s many experiments in developing countries with crop insurance schemes BUT: All failed and immense public resources were wasted Today many MFIs also offer micro-insurances, e.g. life insurances, disability insurance, health insurances MFIs sometimes offering a compulsory investment insurance to secure their portfolio the importance of insurance services for ru7al development is coming more and more into the mind of development aid organization and researchers formal insurance is not available for the rural population in most developing countries Nevertheless, poor households use the informal sector insurances quite intensively; self-insurance and co-insurance What kind of insurance schemes are available: we have formal and informal savings (reducing the power of shocks) then we have different kind of credit resources (for coping with shocks) income diversification is a common way of mitigating with risk keeping a broad social network with relative friends social organization etc. is also an important source to be taped in terms of need Nevertheless, all these schemes are important but at the end not sufficient for instance, when it comes to shocks hitting a whole region, as then social network collapse Insurance in rural finance Micro insurances are relatively new product in rural finance during the 80s many governments tried to provide crop insurance schemes to farmers; however, these schemes were even a greater waste of money than the traditional agriculture banks, moral hazard went out of control today the micro insurances offered by some MFI are mostly life or disability insurances or health insurances; these kind of insurances are relatively easy to sell as moral hazard is comparatively low; if you try to sheet a life insurance, you have too kill yourself in a way that it looks like an accident, this of course only few people are willing and able to do and surly nobody gets sick voluntarily Some MFIs offering a compulsory insurance scheme for their borrower to secure their loan; this however more a protection for the MFI then for the rural HH; that is why they made it compulsory otherwise people would not demand this service; nevertheless it can be useful as it functions as a collateral and thus gives HH access to credit which they without not would have had 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Challenges of micro-insurance in MF Moral hazard problems, particular for crop insurance Totally different business compared to credit and savings Danger of bankrupting an MFI in a single catastrophic event Professional expertise from insurance companies and reinsurance is inevitable as many risks in rural areas are covariate (HIV/AIDS, drought, pests, animal diseases) The absence of insurance possibilities limits the households’ ability to reduce consumption fluctuations, but this does not necessarily imply that the most effective intervention would be to set up insurance programs Providing open access to savings and (emergency) loans may be a preferable method for helping clients to manage risk. If potential MFI‘s clients do not yet have access to flexible savings and credit, providing insurance may be premature. 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations The main challenge of insurance schemes is to cope with moral hazard problems, this makes it so difficult to offer property insurances, as fraud is very common either you have a lax monitoring process then the cost of moral hazard will explode or you have a strong monitoring system then the cost are so high of the premium that nobody will demand the insurance product the future task will be to find new ways of controlling moral hazard However, insurance is a very complicated business and totally different to credit and savings services; in some countries it is even forbidden to mix up those services in a single institute Insurances have the potential to bankrupt the whole institute in one single catastrophic event, therefore, protection of savers is of great importance When MFIs are thinking of entering into the insurance market, they must seek advice from professional insurance companies Besides the absence of formal insurance scheme does not necessarily mean that this is the best intervention to help households coping with risks for many events open access to savings and credits is more appropriate way besides, if households do not yet have access to flexible, client adapted savings and credit services offering of insurance might be premature Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom The safety net role of microfinance? Next Open access savings and emergency loans act as a form of insurance (people may choose not to borrow to their full credit limit, see Diagne and Zeller, 2002, Malawi research report of IFPRI) Credit and savings products cannot provide complete protection against risks resulting in a loss greater than what a household can save or repay  at this point, insurance becomes a more effective method of risk management Some risks cannot be economically insured and there are some risks where insurance is technically possible but may not be the most appropriate tool Different risks require different financial services with specific features: There is no „one fits all“ solution!!! Forward 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations The different financial services are all closely related to each other in their function and can be exchanged among the other However, this can be done only to a certain degree, financial services have their specific limitations for instance: Open access to flexible savings and credit function as a form of insurance, Thus a household may protect itself by taking a loan to cover significant medical expenses, but this protection is ineffective if the payments are greater than the household can afford to repay. Similarly, savings products offer only partial protection against risks causing large losses relative to household income. Some risks can not be insured against at all; Losses that occur in some particular period cannot be insured against; one can only accumulate savings before the loss occurs, e.g. school fees. some events that cause financial stress but occur with greater uncertainty, e.g. dowry) can be technically insured but are better served by savings rather than insurance. Different risk require different services, the best safety net for a rural household would be a combination of formal and informal savings, credit and insurance services one of the major statements you should take from this lecture is that there are no one-fits-all solutions and that there are no blueprints; everything must be adapted locally according to the different needs of the rural population Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Cash flows of different financial products Back 4 ‘ Saving up ’ out - ‘ Saving through ‘ Pay ‘ Saving down ’ 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Who can tell me which of these three figures present savings, credits or insurance? In case of credits the money is collected after the disbursal of the lump sum, in case of savings before, and in case of insurances continuously this figure should show the similarities between the financial services it explains very well too people who are able to pay back a credit are also able to save (even today many government officials in developing countries do believe that rural people can not save, but at the same time maintain the statement that they are able to repay there loan) in - Pay Source: Rutherford (2000) Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Categories of financial innovations „The Schumpeterian qualification, that innovation must be cost reducing, separates change from innovation (Von Pischke 1995 p.121).“ Innovations in the macro-financial system Innovations at the level of the financial intermediary Innovations in organizing financial intermediation Financial product innovations 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations First what is actually a innovation? innovation must be cost reducing Why are financial innovations important for the rural financial market? Innovations do lower cost in general which then will be rolled over to its customer which means reducing cost for the borrower, either reduced interest rate or reduced transaction cost lower cost mean better access and better outreach Financial innovation can occur at different stages of the financial system: 1: e.g. new banking laws 2: e.g. transformation from NGOs to banks 3: e.g new management information systems 4: e.g. innovative savings products Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom (1) Innovations in the macro-financial system Innovations at this level change the system as a whole. They may contribute to the outreach of financial intermediation and are generally applied at the policy level. Examples:  Changes in the legal and regulatory framework  Establishment and acceptance of new organizational forms of financial intermediaries 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Examples: 1) Innovation in the regulatory framework can and did in some countries, allow NGOs to offer saving services. Usually the regulations or laws on financial institutes are very strict and too strict for most of the NGOs (minimum reserves, etc.). Thus people can be reached with savings which formerly had no aces to them. for instance due to lowering the minimum reserve condition or through exceptional regulation the establishment of so called village banks became possible (west Africa). finally: Innovations within the macro financial system can not be influenced by a single organization, as it concerns political decisions of a sovereign state However, through creation of lobby groups or representation offices decisions can be influenced  Innovations in the macro-financial system allowed NGOs to take up financial intermediation activities in many countries which was illegal before Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom (2) Innovations at the level of the financial organization Innovations at the level of the financial organization refer to changes in their legal form or organizational form. These innovations may increase access to financial services through economies of scale and specialization; mistrust may be reduced through a better organizational compatibility with existing organizational forms. Examples:  Transformation of an informal into a registered (NGO) or formal financial institution (bank)  Changes in the hierarchical structure, decentralization, two- tier models  Market differentiation through the creation of specialized outlets which, e.g. cater particularly to SMEs 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Examples: 1. the so called upgrading. an informal financial NGO will be upgrade to a formal financial intermediary with fully integration into the formal financial market with all transformation functions for instance: Financieria Calpia in El Salvador 2. implementation of decentralized decision structures and creating independent profit centers for instance in Vietnam credit officer have no decision power art all all loans must be signed by two superior officers, however, they never decide against the recommendation of the credit officer, thus why not give them the power to decide own their own, at least for small loans the BRI created independent profit centers, thus each credit officer can be easily evaluated whether he is making loss or profit of course this approach require a lot of training and education of the field staff 3 Calpia El Salvador did establish special branches for rural people and thus were able to move from urban area only to the country side this special branches or windows were constructed to take away the reservations of the rural population against formal banks (small rooms, informal cloth of the staff etc.) Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom (3) Innovations in organizing financial intermediation Innovations in the areas of administration, monitoring, and management of financial contracts may increase efficiency through a reduction of transaction costs. Often, technical progress plays a role when adopting productivity increasing innovations. Examples:  Monitoring Software specifically for small-scale clientele  Simplification of used forms  Participatory marketing approach 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations technical progress: for instance, the inventing of management information systems, faster and cheaper notebooks for field staff etc. Examples: 1. Special software was developed for handling small borrowers 2. forms were simplified in term of handling the form for the customers, complicated phrases were eliminated; access to the forms was improved, people can get the forms at places not far away from their homes at special stations, e.g. the village retail store keeps this forms 3. implementation of Marketing tools: e.. the promoting of savings through the combination with lotteries, or advertisements slogans etc. The use of market research tools to adapt the products to the need of the clients came into use A chance took place from the ‘product-driven’ development to the demand-driven approach. Nowadays it is recognized that is not enough to produce something and then try to sell it. The ‘demand-driven’ approach has succeed. Under this approach they identify and meet customers’ needs on a profitable basis. Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom (4) Financial product innovations Innovative financial products reflect new or modified products. They may improve the operational and financial sustainability of the financial intermediary and may be better adapted to the demand of the clientele. Gaining new market segments and improving outreach Examples:  different forms of savings contracts  supply of insurance contracts  consumption loans, input loans, loan volume and time horizon of loans according to market rates 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations It is very important to make an cost-benefit analysis for the new products, and regional limited pilot phase is essential, thus a flop can be prevented and enormous cost can be saved, only after this the product should be established in all branches Examples: 1) Checking-Accounts in rural areas,Lottery savings, Saving for school fees or wedding parties 2) Life insurances, combined savings and insurance products, e.g. capital life insurance; combined insurance and credit products,e.g. in case of death of the borrower the insurance will pay the rest of the debt, thus relative will not need to pay back the loan Saving for funerals leasing products 3 abolition of one credit product for all; individually adapted credit products  Rural Credit Project of the Bangladesh Rural Advancement Committee (BRAC) offers life insurance policies Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Building of rural financial markets Dos Don'ts (innovative approaches) 1. Mobilization of savings; savings as collateral 1. Start from the beginning with cold money, i.e. (exclusively) 2. Implementation of alternative forms of collateral, e.g. joint-liability groups funds by the government or international donors 2. Subsidizing of interest rate Credit/saving allocation at the local level (decentralization) 3. (but support of institution building often indispensable) 4. Integration of women (outreach) 3. Credit as appendage to a 5. Building of guarantee and emergency funds production project 4. Politically motivated debt 6. Unconventional enforcement of repayment (exclude group from access to further loans, seizing of group savings, etc.) relieve 5. Use of extension workers as 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations debt collectors 7. Cover costs (sustainability) 6. Do not use blue prints, especially not from other countries 8. Credit/savings/plus approach, i.e. offering of agricultural extension in addition to savings and credits Market research 9. Integration or connection to the formal financial market 10. Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Recommended literature for first steps in the field of rural (micro) finance Ledgerwood,J Sustainable banking with the poor - Microfinance handbook - An institutional and financial perspective, Washington DC, USA: The World Bank. Robinson, M.S The microfinance revolution - Sustainable finance for the poor. Washington DC, USA: The World Bank and Open Society Institute. Rutherford, S The poor and their money. New Delhi, India: Oxford University Press. Pischke, von, J.d Finance at the frontier – Debt capacity and the role of credit in the private economy. EDI Development Studies. Washington DC, USA: Economic Development Institute and The World Bank. Pischke, von. J.D, Adams, D.W. and G. Donald Rural financial markets in developing countries. EDI Series in Economic Development. Washington DC, USA: Economic Development Institute and The World Bank. Universität Hohenheim, Institut 490a

Models of Rural Finance Institutions
M5101: Prof. Heidhues + Tom Models of Rural Finance Institutions Manfred Zeller Presentation made at the International Conference on Paving the Road Forward for Rural Finance, June 2-4, 2003, Washington, D.C. Download papers at Thanks. The objective of my paper is to discuss different institutional models for rural finance, and to highlight their comparative advantages. Following the structure of my paper, I begin my presentation (next slide).... Universität Hohenheim, Institut 490a

Outline of presentation
M5101: Prof. Heidhues + Tom Outline of presentation Renewed interest in rural and ag finance: Why? Changing paradigms and policy objectives in development finance. What is specific about rural and ag finance: environments, ag production, clientele. Types (or models) of rural finance institutions. Micro-finance best practices: Transfer? Policy recommendations: Towards sustainable rural financial systems. 1. Give examples that indicate new interest and hope (The title of this conference, IFAD-FAO-IDB strategy papers, among others). 2. Wrong assumptions about the poors‘ ability to repay, save and pay risk premiums  Learning from informal demand and supply Changes in paradigm, leading to new policy objectives of Financial sustainability, outreach, and welfare impact 3. Highlight differences between urban and rural areas and between agriculture and other economic sectors - implies that building sustainable rural finance institutions and systems is more difficult 4. In view of specific characteristics of rural areas and of agriculture, make differentiation of models, and discuss their comparative advantages. Focus is on micro-banks, member-based institutions (credit unions, village banks), and other institutions (state-owned rural/agri development banks, downgrading of commercial banks, contract farming). Leasing covered in a presentation by Frank Höllinger, FAO. 5. Most best practices done/pioneered in urban/semi-urban environments. Can they be transferred to rural finance? What needs to be adapted? 6. The major models of rural finance institutions discussed in the paper all have comparative advantages that need to be exploited within a financial systems framework that supports vertical and horizontal integration for sustainability and increase in breadth and depth of outreach. Universität Hohenheim, Institut 490a

Renewed interest in rural and ag finance: Why?
M5101: Prof. Heidhues + Tom Renewed interest in rural and ag finance: Why? Decline in formal rural and agric credit after justified collapse of subsidized ag credit systems. Role of rural finance for agric and economic growth, food security and poverty reduction. Hope of doing better this time because of our enhanced knowledge on: - market and government failure  improved macro-economic, financial and ag sector policy frameworks - demand for financial services by rural population - best practices in (urban-based) micro-finance and financial systems building One may see three principal motivations, as listed below 1 to 3. Do not wrongly understand me here. The Decline was for the very right reasons– dismantling of state- and donor-supported institutions (better projects) that were doomed to fail and had negligible outreach to the poor, and we do not want a new push into donor- and government funded rural finance. The policy environment is right now (SAP, financial market liberalization) – However, learning from past failures of directed, subsidized credit still important so as to NOT repeat past mistakes. Most of the poor live in rural areas. Ag sector the backbone of the economy (major employer) in many developing and transformation countries. But role of ag in econ development declines as development proceeds. Access to finance is often a structural constraint for increased growth and poverty reduction but impact studies show that finance needs to be seen complementary to other inputs (technology, market access, education, etc.) There is market failure (see Stiglitz work on credit rationing, information asymmetry,etc.). Also, because of that private sector may underinvest in institutional and technological innovations geared towards rural finance. However, there is also government (or donor) failure. Poor households (also those below the poverty line) can be creditworthy, are able to save, and willing to pay premiums for insurance. The words beneficiaries (instead of clients), and need (instead of demand) are completely outdated, and should be erased from all policy documents on finance. Universität Hohenheim, Institut 490a

Old versus new paradigm
Old paradigm of sector-directed, supply-led and subsidized credit: faulty assumptions about demand (i.e. “need”) focus not on financial sustainability of institution, but on (depth) of outreach. Impact was assumed. New paradigm: focus on institution and systems building liberalization of financial markets as necessary but not sufficient condition for deepening financial systems  need institutional and technological innovations to reduce transaction costs Demand orientation, three objectives Universität Hohenheim, Institut 490a

Outreach (Breadth and Depth) Financial sustainability
M5101: Prof. Heidhues + Tom The triangle of finance: Synergies and trade-offs Outreach (Breadth and Depth) Welfare impact (Direct/Indirect) Financial sustainability Explain the three objectives. Financial sustainability ((of rural finance institution/system), a must-be strategic objective. Outreach (depth and breadth) Welfare impact: Explain direct effect when targeting the poor, and indirect effect (e.g. employment creation, food prices). Link with MDGs/economic growth and poverty reduction. Give examples of synergies and trade-offs (both from the welfarist and institutionalist camp). - Whether public investment in finance is worth it (be it technical training, equity capital injections, or pilot testing of new technologies), needs to be assessed with ALL three objectives in mind. At least in theory, to consistently unite the trade-offs and synergies between the three objectives, full assessment of a public investment in financial institution requires cost-benefit-analysis (comparing to alternative policy instruments). But unlikely to be done in policy practice. No proof who (institutionalist versus welfarist) group is right (But that should not be the issue). Both camps have good arguments, and donors as well as national governments differ in their relative emphasis on the three objectives. The call for financial sustainability (as a strategic goal to be reached for financial institutions) is universally recognized but policy-makers (and the two camps) differ in their patience to reach that goal. Inner and an outer circle.graph Second recommendation of paper: Different institutions have different comparative advantages in pursuing the three objectives. Thus, a mix of competing institutions appears to be best. This gives sufficient room for innovations which is much needed for rural finance. This second recommendation will be more substantiated when we compare the advantages of different models of rural finance institutions against the specific characteristics of rural areas and agriculture. next slide. Source: Zeller, M., and Meyer, R.L The triangle of microfinance: Financial sustainability, outreach, and impact. IPPRI/John Hopkins Univ, Dec Universität Hohenheim, Institut 490a

The Urban-Rural Dichotomy
M5101: Prof. Heidhues + Tom The Urban-Rural Dichotomy higher transaction costs for FIs and their clients (irrespective of the institutional model) higher systemic risks, more volatile cash flows, and complex, heterogeneous legal frameworks lower risk bearing ability and higher vulnerability of rural households lower policy commitment to rural areas Rural finance is more difficult Comparing urban with rural areas within the same country, we see characteristic differences that lead to (compared to urban areas): See bullets Each bullet is explained with examples from the paper Universität Hohenheim, Institut 490a

Specific characteristics of agriculture
M5101: Prof. Heidhues + Tom Specific characteristics of agriculture Location-specificity (ag is production in space). Unfavorable terms of trade for agriculture. Production depends on natural conditions (covariant risks!), gestation periods of several years e.g. tree crops, dairy. Seasonality (production, food and factor prices). Significant role of women in ag, especially food crops. High incidence and depth of poverty among population dependent on agriculture. High volatility of prices in ag commodities.  Serving ag clients is EVEN more difficult. Comparing agriculture with other economic sectors, we see characteristic differences that again lead to higher transaction costs, more risks, and lower scope for sustainable financial intermediation. Focus is on developing and transformation countries, e.g bullet 2 does not apply to developed countries that protect their agriculture. See bullets Each bullet is explained with examples from the paper To 2: But has much improved thanks to SAP and market liberalization, but US-EU and other ind. Countries still protect their domestic agric) To 5: Gender discrimination (especially pronounced in rural areas) makes it more difficult to reach women farmers, and their food crop production generates less cash or cash that is controlled by men. Universität Hohenheim, Institut 490a

Creating inst. innovations
M5101: Prof. Heidhues + Tom Creating inst. innovations Institutional innovations in rural and microfinance are rarely the PURE product of market forces seeking to maximize profit. Successful innovations were done conform with market principles. Yet, they were fostered by public investments (example BRI) or by private altruistic action (1. coop movement in Germany started by Raiffeissen and Schultze von Delitzsch, 2. Grameen Bank: Yunus 3. Many other leaders in the industry supported by donors. State has a role to invest in innovations and related learning and multiplication of best practices (free-rider problem)– Much of investment (and learning) can and needs to be done together with other stakeholders (private firms, NGOs, clients). Let us look back historically: What created major breakthroughs in rural and micro-finance no need to make it artificially difficult. 1. If these statement were false, we would not be here today, and we would pursue our profits (with the nice add-on social benefit of serving rural areas and the poor). Similar logic than the other 100-dollar bill in the curbside (Old Chicago economists joke). The bill is not there because somebody already must have picked it up). 3. BECAUSE private market forces fail to sufficiently invest (from a social point of view). Can be copied by others so there is a free-rider Problem. There is no patent on institutions. Universität Hohenheim, Institut 490a

Models of rural finance institutions: Overview
M5101: Prof. Heidhues + Tom Models of rural finance institutions: Overview Credit projects and revolving credit funds  NOT a model Member-based institutions: (1) Credit unions (2) Village banks Micro-banks Lending technologies: Individual and solidarity group lending, and linkage model (with pre-existing self-help groups). Other: (1) State-owned ag/rural dev banks (2) downscaling commercial banks (3) contract farming (4) supplier credit/leasing and other To first bullet: Credit projects linked to rural dev programs (No view on sustainability). But: credit projects as pilots with a view on sustainability are fine. Dismal performance with revolving funds, some NGOs and governments still do them with cold and easy money. To second bullet: (often supported by international NGOs such as WOCCU, Societe Desjardins, and Raiffeissenverband in the case of credit unions) and in the case of village banks: CARE, FINCA, CRS, CIDR, etc. To lending technologies: Not a model of an institution, but important to mention. I skip linkage banking in following presentation. Too little evidence (mainly from sources promoting the thing) to say much on cons and pros. To fourth bullet: Do not say much on downgrading commercial banks (see paper by von Pischke). Also less on leasing and other private-public partnership models in rural finance (see e.g. presentation by Höllinger, fAO, on this topic). Mention, that in your view, that contract farming is a viable, but heavily under-exploited and under-researched commercial option for agricultural finance in developing and transitioning countries. Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Credit unions (CUs) Formal institutions owned and controlled by their members, regional networks and (coop) banks facilitate transformation of term, size, and risk. Larger CUs managed by professionals (if not interfered by state), technical assistance and supervision important. Number one (rural) MFI  large breadth, some depth, proven sustainability over many years. Comparative advantages: Proven ability to service many rural depositors and provide diversified range of individual loans. Governance structures tend to protect saver. Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Village banks (VBs) Semi-formal institution owned and controlled by its members – often promoted by international NGOs such as FINCA, CARE, CRS, Freedom from Hunger, etc. The Pros are: In comparison with a credit union, a VB is much smaller and less complex in structure, thus enabling less educated/poorer members to manage/ participate. Member-driven interest rate policy for internally generated savings deposits (and loans) can adapt to segmented rural financial markets  interest rates often set much higher than in other MFIs. Cons: Small size of bank and homogeneity of members limits scope for term, size and risk transformation. Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Microbanks Formal, profit-oriented institutions that use microfinance technology. Examples: Unit banks of BRI, BancoSol, IPC-supported banks. Heterogenous ownership structure in practice: Private, NGO, equity stakes of public dev banks, or municipal gov’t. Pros: (1) Focus on profit/ financial sustainability. (2) Agribiz/SME-Promotion/Larger farmers: Growth and indirect welfare impacts (3) Critical substitutes for commercial banks that ignore MF technology. Cons: Ownership structure may not call for depth of outreach. Social commitment of owners? Risk of mission drift? Why make compromises between profits and depth? Universität Hohenheim, Institut 490a

State-owned rural/ag dev banks
M5101: Prof. Heidhues + Tom State-owned rural/ag dev banks Need to be transformed (based on business principles), or, if not possible, liquidated. Successful transformation is possible even if STATE OWNERSHIP is retained (BRI, BAAC)  depends on political will, suitable macro-economic and ag sectoral framework, and on mgt that is independent and has incentives to perform A number of donors are involved in reform of state-owned banks (IFAD/GTZ/IDB/USAID): No reason to write them off. Liquidation (even if possible) is often not the best option. Universität Hohenheim, Institut 490a

Micro-finance best practices
M5101: Prof. Heidhues + Tom Micro-finance best practices Knowledge on best practices in micro-finance are relevant, but not sufficient because of specific characteristics of agric finance Agricultural lending: See FAO, Table 3 in paper Savings: CGAP working papers. Insurance against idiosyncratic risks such as sickness, accident: Innovations by SEWA and others, see ILO and other publications. Adaptation to rural and farm households is needed. But this is nothing new: Best practice means to develop demand-oriented products and delivery technologies. Adaptation for example with (e.g. w.r.t. repayment schedules, timing of loans), or savings products responding to seasonality. Universität Hohenheim, Institut 490a

Conclusions/recommendations
M5101: Prof. Heidhues + Tom Conclusions/recommendations Learn from past failures of rural/ag finance. It is too costly to repeat them. No (model) blueprint but promote institutional diversity/innovation. Each institutional model has its comparative advantages, and diversity enhances competition, outreach, and impact. Promote rural finance institutions within a financial systems perspective. Stand-alone retail rural financial institutions are doomed to vanish  need horizontal/vertical integration. To 2: These comparative advantages arise because of (1) heterogenous socio-economic and agro-ecological contexts, (2) different emphasis by social investors on any of the three objectives justifying more than one model. To 3: is First-tier: Village banks, credit unions, and micro-banks. Second- and higher tiers: Commercial and state-owned banks, as well as coop banks. Village banks and stand-alone credit unions unlikely to survive without horizontal and vertical integration. Microbanks, ag dev banks, and commercial banks as second- or higher-tier institutions. Greater exposure to rural areas, or to agriculture in general, and to specific crops in particular, all raise the need for horizontal and vertical integration of village banks, credit unions and micro-banks. To 4: Role of NGOs as well as private-public partnerships in experimentation. Universität Hohenheim, Institut 490a

Conclusions/recommendations
M5101: Prof. Heidhues + Tom Conclusions/recommendations 4. Do the relatively “easy” things first, while gradually experimenting with the more difficult ones. Rural and ag finance is more difficult than urban finance, and many environments are too hostile without preceding improvements in other sectors (infrastructure, ag tech, ag policy…). Rural finance follows rather than precedes… 5. Be patient. Building of rural financial institutions and systems is a labor-, knowledge-, and time-consuming process. It is technical, not financial assistance that matters. More of capital can do more harm than good. To 2: These comparative advantages arise because of (1) heterogenous socio-economic and agro-ecological contexts, (2) different emphasis by social investors on any of the three objectives justifying more than one model. To 3: is stand-alone retail rural financial institutions are doomed to vanish once public support is phasing out. First-tier: Village banks, credit unions, and micro-banks. Second- and higher tiers: Commercial and state-owned banks, as well as coop banks. Village banks and stand-alone credit unions unlikely to survive without horizontal and vertical integration. Microbanks, ag dev banks, and commercial banks as second- or higher-tier institutions. Greater exposure to rural areas, or to agriculture in general, and to specific crops in particular, all raise the need for horizontal and vertical integration of village banks, credit unions and micro-banks. To 4: Role of NGOs as well as private-public partnerships in experimentation. Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Literature used for this lecture Buchenrieder, G., Heidhues, F., and P.T.M. Dung Rural finance and sustainable rural development in Northern Vietnam - Research proposal submitted to Deutsche Forschungsgemeinschaft (DFG). Stuttgart, Germany: University of Hohenheim, The Uplands Program. Buchenrieder, G., Heidhues, F., and P.T.M. Dung Risk management of farm households in Northern Vietnam. Research proposal submitted to Deutsche Forschungsgemeinschaft (DFG). Stuttgart, Germany: University of Hohenheim, The Uplands Program. Geis, H.G Die Rolle der finanziellen Infrastruktur bei der Kapitalbildung. In: Priebe, H. (ed.): Eigenfinanzierung und Entwicklung. Berlin, Germany: Duncker und Humboldt. Heidhues,F. and G.Schrieder Rural financial market development. Research in Development Economics and Policy Discussion Paper No 1. Stuttgart, Germany: Grauer Verlag. Pischke, von, J.D. Analytical and public policy issues in promoting innovation in rural financial markets. In Special issue: Innovative approaches to rural financial market development. (ed Heidhues, F). Quarterly Journal of International Agriculture 34 (2): Rutherford,S Raising the curtain on the 'microfinancial services era'. Small Enterprise Development 11 (1): Seibel, D Outreach and sustainability of rural microfinance in Asia: Observations and recommendations. Rural Finance Working Paper No A5. Rome, Italy: International Fund for Agriculture Development (IFAD). Vaessen,J Accessibility of rural credit in Northern Nicaragua: The importance of networks of information and recommendation. Savings and Development 25 (1): 5-32. Vogel, R., Savings mobilization, the forgotten half of rural finance. In: Adams, D. W., Graham, D., Von Pischke, J. D. (Eds.): Undermining rural development with cheap credit. Boulder, USA: Westview Press. Zeller, M Promoting institutional innovation in microfinance - Replicating best practices is not enough. Development and Cooperation (1): 8-11. Zeller,M. and M. Sharma Many borrow, more save, and all insure: Implications for food and microfinance policy. Food Policy 25 (2): Zeller,M., Schrieder,G., Braun von,.J., and F. Heidhues Rural finance for food security of the poor: Concept, review, and implications for research and policy. Food Policy Review No 4. Washington DC, USA: International Food Policy Research Institute (IFPRI). Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Literature used for this lecture Lapenu, Cécile, and Manfred Zeller, Distribution, growth, and performance of the microfinance institutions in Africa, Asia and Latin America: A Recent Inventory. Savings and Development, Vol. 26 (1), pp (a longer version of this paper can be downloaded at under discussion papers) 1. Zeller, Manfred Determinants of repayment performance in credit groups in Madagascar: The role of program design, intra-group risk pooling and social cohesion. Economic Development and Cultural Change, Vol. 46 (1), pp , January 1998, University of Chicago Press. Sharma, Manohar, and Manfred Zeller Repayment performance in group-based credit programs in Bangladesh: an empirical analysis. World Development, Vol. 25 (10), pp October 1997. Adams, D.W The conundrum of successful credit projects in floundering rural financial markets. Economic Development and Cultural Change 36 (2): Feder, G., R.E. Just, and D. Zilberman Adoption of agricultural innovations in developing countries. Economic Development and Cultural Change 22(2): Hulme, D., and P. Mosley Finance against poverty. Routledge: London and New York. Universität Hohenheim, Institut 490a

M5101: Prof. Heidhues + Tom Assessment of strengths & weaknesses of selected rural finance issues: Implications for the future Steps to select a topic for a seminar paper: Germans select a country (developing or transition) of their choice, all others should take their home country You may select a rural financial service (see rural finance triangle) or an FFI of the country Select the sector (formal or informal) and/or specific financial institution Discuss strengths and/or weaknesses of sector and/or financial institution Use the templates of the institute Not more then five pages (incl. tables, figures & references) Financial Market Credit Savings Insurance If you have questions while preparing the seminar-papers you can contact me under: or you can find me in the office of Dr. Gertrdu Buchenrieder. Source: Buchenrieder, Heidhues, and Dung (2003) Universität Hohenheim, Institut 490a

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