Rethinking banking
- Development experts, entrepreneurs, social activists and academicians from around the world have been drawing lessons about retail banking of microfinance on four accounts:
- How micro lenders’ risks are compensated
- How information problems of microlenders are addressed
- How microfinance can be used to reduce poverty, and gender inequality and foster social change
- How to use markets in low-income economies to supply insurance and pay for utilities such as water and electricity instead of using inefficient parastatals (public) companies
- Microfinance has created economic opportunities for a variety of communities as diverse as villages along the Amazon in Ecuador and Brazil and inner-city residents of Los Angeles in the USA.
- Well established programs are also to be found in Bangladesh, Bolivia and Indonesia, with others gaining momentum in Mexico, China, India and Kenya.
- Out of the 67.6 million microfinance clients served by over 2500 microfinance institutions by the end of 2002, it was established that 41.6 million, were in the bottom half of people living below their country’s poverty lines, i.e. the poorest.
- If microfinance is proving that successful today, why did it not start earlier than in the 1970s?
- Or to put it in another way, why doesn’t capital flow naturally to the poor as suggested by economic theory?
- One of the first lessons in Introductory Economics is the principle of diminishing marginal returns to capital.
- Economic theory predicates or states that enterprises with relatively little capital should be able to earn higher returns on their investments than enterprises with a lot of capital.
- By the same analogy, poorer or micro-enterprises should be able to earn relatively higher profits on their investments and therefore be able to pay higher interest rates than richer or larger enterprises.
- The diminishing returns principle is derived from the assumed concavity of the production function.
- The assumption of concavity works on the premise that the more you invest, the more output you get but at the decreasing rate at the margin i.e. each additional unit of capital invested will earn a smaller incremental return.
- For example, when a tailor buys his first Ksh 10,0000/= sewing machine, his production will rise quickly relative to the output generated before, when he was using only a needle and thread.
- The next Ksh 10,0000/= investment, used to rent a better premise and buy electric scissors, will also bring in gains, but the incremental rise in production is unlikely to be like one of the sewing machines.
- After all, if renting a premise and buying electric scissors added more output than a sewing machine, a rational tailor would start with the former, not the latter (sewing machine).
- The size of the incremental gains matter because the marginal returns to capital determine the borrower’s ability to repay the loan.
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- What this implies is that the small entrepreneur earns a relatively higher return on his smaller capital investment, and therefore is more able to repay the lenders investible funds, including at a higher interest rate, than a larger entrepreneur.
- It also implies that financial institutions should be more attracted to lend to the smaller entrepreneurs, because of the expected higher returns, than to the larger ones.
- To extend the argument further, capital investments in poor/developing countries should be expected to earn a higher return per unit of capital invested than they would in rich/advanced economies.
- If this theory is correct, why do global investors prefer to put their money in New York, London, Tokyo and Hong Kong and not Kenya, Bangladesh and Bolivia or other low-income countries where according to theory capital investment should earn relatively higher returns?
- In general, why doesn’t capital investment move from the North (the wealthy nations) to the South (the poor nations) and not the other way around as is the case today?
- According to Nobel Prize winner, Prof. Robert Lucas (1990), based on his estimates of marginal returns to capital, borrowers from India should be willing to pay 58 times as much (in interest) as borrowers from the USA.
- Prof. Lucas’s research findings were supposed to highlight this puzzle or paradox: Given that investors are rational (prudent and self-interested) why has the theory of diminishing returns on investment got it so wrong in practice?
- Or why are capital investments more likely to flow from the poor to the rich countries or why is it easier for large companies like East African Breweries to obtain financing from banks than self-employed cobblers or carpenters?
- One of the explanations for this is to be found in risk: Investments in poor countries like Uganda, Kenya and Tanzania carry higher risks than investments in the rich countries of the USA, Britain or Germany.
- The same is true of risks associated with commercial banks’ attitude to lending to cobblers and carpenters compared to DT Dobie or Safaricom LTD companies in Kenya.
- Other than risk, the second explanation for poor people’s failure to access loans is their lack of collateral.
- The third explanation is a dearth of information about the performance of small enterprises, since few of them keep records.
- The fourth explanation is economies of scale: banks face higher transactional costs handling many small borrowers than one large borrower.
- The starting point with microfinance is that new ways must be found to advance loans to poor borrowers because they are too poor to offer collateral, and/or provide information that can be analyzed for purposes of providing loans.
- The issue, therefore, is whether microfinance can find a way to combine traditional banks resources with the local information and cost advantages of money lenders, neighbours or relatives, who are the traditional lenders to the poor.
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