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Jan Feb 2008 Review

  1. 1. Federal Reserve Bank of St. Louis REVIEW J A N UA R Y / F E B R UA R Y 2008 V O LU M E 9 0 , N U M B E R 1 Thinking Like a Central Banker William Poole The Microfinance Revolution: An Overview Rajdeep Sengupta and Craig P. Aubuchon A Primer on the Mortgage Market and Mortgage Finance Daniel J. McDonald and Daniel L. Thornton Changing Trends in the Labor Force: A Survey Riccardo DiCecio, Kristie M. Engemann, Michael T. Owyang, and Christopher H. Wheeler
  2. 2. 1 REVIEW Thinking Like a Central Banker William Poole Director of Research Robert H. Rasche Deputy Director of Research 9 Cletus C. Coughlin The Microfinance Revolution: Review Editor William T. Gavin An Overview Rajdeep Sengupta and Craig P. Aubuchon Research Economists Richard G. Anderson Subhayu Bandyopadhyay James B. Bullard 31 Riccardo DiCecio A Primer on the Mortgage Market Michael J. Dueker Thomas A. Garrett and Mortgage Finance Carlos Garriga Daniel J. McDonald and Daniel L. Thornton Massimo Guidolin Rubén Hernández-Murillo Kevin L. Kliesen 47 Natalia A. Kolesnikova Christopher J. Neely Changing Trends in the Labor Force: Edward Nelson A Survey Michael T. Owyang Riccardo DiCecio, Kristie M. Engemann, Michael R. Pakko Michael T. Owyang, and Christopher H. Wheeler Rajdeep Sengupta Daniel L. Thornton Howard J. Wall Yi Wen Christopher H. Wheeler David C. Wheelock Managing Editor George E. Fortier Editor Lydia H. Johnson Graphic Designer Donna M. Stiller The views expressed are those of the individual authors and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis, the Federal Reserve System, or the Board of Governors.F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W J A N UA RY / F E B R UA RY 2008 i
  3. 3. Review is published six times per year by the Research Division of the Federal Reserve Bank of St. Louis and may be accessed through our web site: research.stlouisfed.org/publications/review. All nonproprietary and nonconfidential data and programs for the articles written by Federal Reserve Bank of St. Louis staff and published in Review also are available to our readers on this web site. These data and programs are also available through Inter-university Consortium for Political and Social Research (ICPSR) via their FTP site: www.icpsr.umich.edu/pra/index.html. Or contact the ICPSR at P.O. Box 1248, Ann Arbor, MI 48106-1248; 734-647-5000; netmail@icpsr.umich.edu. Single-copy subscriptions are available free of charge. Send requests to: Federal Reserve Bank of St. Louis, Public Affairs Department, P.O. Box 442, St. Louis, MO 63166-0442, or call (314) 444-8809. General data can be obtained through FRED (Federal Reserve Economic Data), a database providing U.S. economic and financial data and regional data for the Eighth Federal Reserve District. You may access FRED through our web site: research.stlouisfed.org/fred. Articles may be reprinted, reproduced, published, distributed, displayed, and transmitted in their entirety if copyright notice, author name(s), and full citation are included. Please send a copy of any reprinted, published, or displayed materials to George Fortier, Research Division, Federal Reserve Bank of St. Louis, P.O. Box 442, St. Louis, MO 63166-0442; george.e.fortier@stls.frb.org. Please note: Abstracts, synopses, and other derivative works may be made only with prior written permission of the Federal Reserve Bank of St. Louis. Please contact the Research Division at the above address to request permission. © 2008, Federal Reserve Bank of St. Louis. ISSN 0014-9187ii J A N UA RY / F E B R UA RY 2008 F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W
  4. 4. Thinking Like a Central Banker William Poole This article was originally presented as a speech to Market News International in New York, New York, September 28, 2007. Federal Reserve Bank of St. Louis Review, January/February 2008, 90(1), pp. 1-7.E veryone looks at the world through System but also may not reflect the views of any- lenses colored by his or her own expe- one else at the Fed, past or present. I thank my riences and background. Over my nine colleagues at the Federal Reserve Bank of St. Louis plus years at the Fed, I have been struck for their comments, but I retain full responsibilityby misunderstandings of why the Fed acts as it for errors.does—misunderstandings from vantage pointsthat are quite different from that of a Fed official.Those with Fed experience do know things that ASSESSING THE ECONOMYothers do not. Some of what we know is confi- An area where Fed practice and market prac-dential, but such information is in most cases tice are essentially identical is in assessing thedisclosed with a lag. There are few permanent state of the economy and the outlook. Privatesecrets. Still, there is a central-banker way of sector and Fed forecasters use similar methodsthinking that can be described and analyzed; and rely on the same statistical information.doing so may help others to avoid mistakes in Obviously, there are professional differences ofassessing Fed policy. That is my topic in these opinion and of approaches, but these do not createremarks. a divide between Fed and private forecasts. As I Obviously, all I can do is to describe how one have often put it, economists inside and outsideparticular central banker with the initials W.P. the Fed studied at the same universities underthinks about what he does. And my perspective the same professors and read the same journalis that from a particular central bank, the Federal articles. There is substantial movement of econo-Reserve. My Fed colleagues might put things dif- mists into and out of the Federal Reserve System.ferently and might believe that I am off base with Fed economists attend many university seminars,some of my comments. Nevertheless, I think the and academic economists attend Fed seminars.effort is worthwhile, for the degree of success of Disagreements about forecasts are similar insidemonetary policy is positively correlated with how and outside of the Fed.completely the market understands the Fed. My There is a difference in the informal or anec-disclaimer is that the views I express here are dotal information available inside and outsidemine. These views not only do not necessarily the Fed. The Fed has a large network of businessreflect official positions of the Federal Reserve contacts and relies on them to augment the fore- William Poole is the president of the Federal Reserve Bank of St. Louis. The author appreciates comments provided by his colleagues at the Federal Reserve Bank of St. Louis. The views expressed are the author’s and do not necessarily reflect official positions of the Federal Reserve System. © 2008, The Federal Reserve Bank of St. Louis. Articles may be reprinted, reproduced, published, distributed, displayed, and transmitted in their entirety if copyright notice, author name(s), and full citation are included. Abstracts, synopses, and other derivative works may be made only with prior written permission of the Federal Reserve Bank of St. Louis.F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W J A N UA RY / F E B R UA RY 2 0 0 8 1
  5. 5. Poolecasting effort. However, some private forecasters up to an FOMC meeting. Thus, I ordinarily dohave access to data and information the Fed does not give detailed answers to questions on thenot. Large financial firms in particular have access precise implications of the latest data for theto data, such as credit card activity and prospec- economic outlook. In many cases, I just haven’ttive borrowing by major clients, that the Fed does studied the implications thoroughly, although Inot have. Retail firms have extremely current certainly do so by the time the FOMC next meets.information on sales and orders. Of course, theFed may obtain some of this information throughits business contacts, but private companies often DEALING WITH RISKmake much more systematic use of their owninternal business information than the Fed does. A private firm, especially a financial firm, Forecasters continually provide updates based must have robust policies to address risk. To anon the flow of current information, both statisti- economist, risk is a two-sided concept. Outcomescal and informal. In this regard, Fed and market may be above or below prior expectations. Thepractice is essentially identical. possibility of an outcome far below expectation There is, however, a difference between the deserves special attention, for such an outcomeFed and the market in the use of forecast informa- may force a firm into bankruptcy. A financial firmtion. Traders and portfolio managers base their models risk quantitatively, to the extent possible,trades on the current flow of information, which and then examines with great care the extent toneeds to be updated throughout the trading day. which formal models may miss key risks, perhapsFed policymakers, on the other hand, do not con- because they were not observed during the sam-tinuously adjust the stance of policy in the same ple period used to fit a model or because the eco-way managers adjust portfolio holdings. For this nomic environment may be changing. A centralreason, my own practice is not to worry much as bank has a similar task. Quantification of risks toto whether I have correctly absorbed the import the economy should be taken as far as possibleof each day’s, or each hour’s, data. I know that and then careful thought applied to risks beyondsome information will be irrelevant to my policy those that can be captured in models.position because it will be superseded by new One important difference between a financialinformation by the time of the next FOMC meet- firm and the central bank is that a firm has a muching. For example, I do not need hour-by-hour wider array of strategies available to mitigate riskinformation on security prices. When I get to than does a central bank. A financial firm canthe next FOMC meeting, I’ll have the latest data, make careful calculations of the extent of durationcharts of how security prices have behaved mismatch between assets and liabilities and cansince the previous meeting, and analyses of price adjust its positions continuously to control thebehavior over a much longer period—indeed, for extent of mismatch. A financial firm can deal inas far back in time as I find helpful. Given that many derivatives markets to control risk. A finan-the FOMC does not adjust policy continuously, cial firm has wide latitude in choosing how muchupdating my forecast with every data release risk to accept.would not be an efficient use of my time. A central bank pretty much has to accept A consequence of the fact that FOMC meet- policy risks to the economy arising from theings occur at six-week intervals, on average, is economy’s institutional structure and marketthat when I give a speech and take questions I may environment. Market sentiment, bullish or bear-not be completely up to date on the implications ish, can change quickly. Analytically, the centralof the latest data. In my speeches and discussions bank can explore implications of various possibleof policy with various audiences, I try to concen- scenarios and can engage in special informationtrate on longer-run issues and general principles. collection to try to understand as quickly as pos-I emphasize that I will be studying all the data sible what is happening in the economy. Beyondand anecdotal information in the days leading that, what a central bank can do is to adopt from2 J A N UA RY / F E B R UA RY 2 0 0 8 F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W
  6. 6. Pooletime to time a somewhat asymmetric policy directly in market prices, especially in the federalstance in an effort to control risk, especially by funds futures and options markets and the similarguarding against particularly costly possible out- markets in eurodollars. There is an importantcomes. When inflation risk is the dominant con- policy purpose for the Fed to study these marketcern, policy should lean on the restrictive side expectations. Understanding how the flow of newand policymakers should be more ready to tighten information affects market expectations can bethan to ease policy. Conversely, when deflation useful to policymakers. For example, suppose Iand/or recession risk predominates, policy should interpret a surprise change in employment to bebe asymmetric toward policy ease. However, an anomaly in the data but I observe a large marketthere is always the danger of leaning in one reaction to the data release. In that case, I woulddirection too far or too long; policymakers must reexamine my interpretation, and if I still believebe prepared to reverse course and should try not I am correct I might comment during the Q&Ato allow the stance of policy to drift too far from session after a speech that my own personal takea baseline approach. on the data differs from the market view. My It is worth emphasizing that the central bank, aim would be to prompt market participants toas the dominant player in the money market, is reexamine their interpretation of the data.in a different situation than is a competitive firm. Consider another example of the importanceThe central bank’s strategy in mitigating risk of tracking market expectations. When I examinemust work through the markets and by shaping the federal funds futures market, a large discrep-accurate market expectations about future central ancy between market expectations and my “bestbank behavior. guess” of the FOMC’s future actions might suggest The list of possible risks facing private firms to me the possibility of a Fed communicationsand central banks is a long one. A risk that is failure. The ideal situation is one in which theoften incompletely understood by those outside market and the Fed have read available informa-management is reputational risk. The issue is tion the same way. I am only one participant inmuch more than simple embarrassment. Trust is the FOMC process, but I try not to contribute toan essential capital asset for a financial firm, and market misunderstanding of monetary policy.for a central bank. A damaged reputation can send The market is collating information from all FOMCcustomers fleeing to competitors. For a central participants, paying especially close attention,bank, a damaged reputation can lead market of course, to the Chairman’s views.participants to question the bank’s policy consis- I also follow market data carefully as part oftency, its motivations, and even its veracity. For ongoing research on how market expectationsthese reasons, successful private sector firms and are formed. This research, conducted with econ-central banks both invest heavily in programs omists in the St. Louis Fed’s Research Division,and procedures to ensure fair dealing and high helps me to understand monetary policy at aethical standards. With regard to reputational risk, deeper level. My perspective in this research isthe issues inside and outside the central bank essentially the same as similar research conductedare essentially identical. Financial firms and in universities and by active market participants.central banks understand each other very wellon this dimension of managing risk. OBJECTIVESASSESSING ODDS ON FED Private firms have the goal of profit maximiza- tion, whereas the central bank is pursuing thePOLICY ACTION macroeconomic goals of price stability, employ- Market participants are constantly assessing ment stability at a high level, and financial marketthe odds on Fed policy actions at upcoming stability. The private sector and monetary policyFOMC meetings. These assessments register goals are quite different, but that fact does not, inF E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W J A N UA RY / F E B R UA RY 2 0 0 8 3
  7. 7. Poolemy view, define an important difference in I pointed out earlier that both market partici-approach. pants and policymakers try to understand the Policymakers think in terms of a loss function implications of the flow of information for policythat depends on departures of outcomes from actions. Now I want to emphasize the importantdesired outcomes. Policy goals are quantifiable point that policymakers have the task of design-and, as with profits, come with short and long ing systematic policy responses to new informa-horizons. As already discussed, private firms tion. The design should advance achievementand central banks must understand and control of policy goals, such as price stability. There arerisks to the extent possible. many dimensions to policy design. A simple Private firm and central bank governing and example is that the Federal Reserve now adjustsdisciplining processes are, of course, quite differ- its target for the federal funds rate in multiples ofent. Nevertheless, analytical approaches to achiev- 25 basis points. That may seem a trivial example,ing goals are quite similar. I do not believe that but in the past the Fed sometimes adjusted itsdifferences of objectives and governing processes funds rate target by smaller amounts. Anotherdefine an essential difference between the two example is disclosure of the policy decisiontypes of organizations. Thus, in this respect those promptly after the decision. That practice startedin the private sector and in the central bank only in 1994 and ever since the FOMC has almostunderstand and relate to each other easily. constantly grappled with disclosure issues. I could point to many other dimensions of defining a policy rule, or response functionPRICE MAKERS VERSUS PRICE (Poole, 2005). My point is not to elaborate on theTAKERS nature of the policy rule but instead to emphasize What is a critically important difference how different that responsibility is from that of abetween a central bank and a private financial firm portfolio manager. Policymakers should shapeis that the central bank, in the short run anyway, their policy actions by conscious decisions aboutsets a policy interest rate and importantly influ- how to guide market thinking not just in the con-ences longer-term interest rates through effects on text of a particular policy action but also in themarket expectations. The central bank is a price future for policy actions in general. Put anothermaker in the interbank funds market. Private way, when economic conditions recur, policyfinancial firms are essentially price takers in that responses to the same set of conditions shouldmarket and in the government securities market. also recur. If that were not the case, then policy A typical trader or portfolio manager can actions could be interpreted only as random,plan security purchases and sales with little or unpredictable responses to changes in economicno regard to any effects on market prices or the conditions. It simply cannot be good policy forbehavior of other firms. Of course, this statement policy actions to be essentially random.is not precisely true for very large portfolios, but The market interprets every policy actionthe difference in market impact between a central and every policy statement in the context of pastbank and a large private portfolio is enormous. actions and statements. What is a surprise and The fact that a central bank is a price maker what is expected depends on past practice. Themakes its strategy fundamentally different from implication of this obvious point is that everythat of a portfolio manager. To achieve policy policy action needs to be based on an understand-goals, the central bank must think of its policy ing of how the action will be regarded in theactions as following a predictable policy rule that future. Policy actions set precedents, and policy-the private sector can observe. A portfolio man- makers must be careful about those precedents.ager responds to the flow of new information Otherwise, what appears to be a policy successpartly as it affects probabilities of future central today could be the seed of a policy problem inbank action. the future.4 J A N UA RY / F E B R UA RY 2 0 0 8 F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W
  8. 8. Poole Modern macroeconomics emphasizes the tions would justify particular appropriate policyimportance of policy predictability for good policy responses. One way to avoid misinformation isoutcomes (Taylor, 1984). The difference in per- to avoid providing any information. Put anotherspective from standard practice 30 years ago is way, if my mouth is not open, I cannot put myprofound and incompletely recognized by many foot into it.journalists and commentators. Even in the early In my view, however, it is important to try toGreenspan years, many thought that monetary convey correct information. I do not believe thatpolicy worked by creating surprises. That perspec- I would be doing my job if fear of providing mis-tive was natural because policy surprises had information led me to provide no information.visible effects on security prices. For this reason, I have maintained an active speak- Theoretical developments in macroeconomics ing schedule.in the 1970s emphasized that policy surprises I do follow some general practices designedwere undesirable. Efficient planning in the private to reduce missteps. I try to schedule speeches,sector requires that expectations about govern- and certainly press interviews, for times whenment policies be accurate, or as accurate as the the markets are closed. That allows the market toinherent uncertainty of the economic environ- digest what I say overnight. Another practice isment permits. Policymakers ought not to add to that I never predict the outcome of future FOMCinherent economic uncertainty. It is desirable that, meetings. Given that I am only one participant into the maximum possible extent, the economy those meetings and that the Chairman’s opinionbe characterized by an expectational equilibrium carries great weight, predicting the outcomein which the market behaves as policymakers would be foolish. That is obvious, but what isexpect and the central bank behaves as the market less obvious is that I do my best to avoid beingexpects. There are certainly times, however, when committal even in my own mind about the policypolicy surprises are unavoidable. implications of recent data. Clearly, I could draw So, much of my own thinking is driven by an conclusions from available data that would createeffort to help define a policy that will increase a certain presumption about the policy decisionpolicy predictability over time. In my speeches or at least about my policy position. I am veryand ensuing Q&A, I try to emphasize general cautious about drawing firm implications aboutpolicy principles rather than the current policy policy from the data.situation. What is important is not the policy I emphasize that my policy position willaction at the next FOMC meeting, which is typi- depend on all the information available at thecally what people want to know, but the policy time of the FOMC meeting, on the staff analysis,regularity that will extend across many FOMC and on the debate during the meeting. Thatmeetings, which is what people should want to description of my attitude is literally correct. Iknow. noted earlier that I often do not focus on the data arriving day by day because I know that new data will supersede existing data and that I will benefitAVOIDING POLICY from my own intensive preparation before eachDISTURBANCES meeting. I rely on the expert staff analysis pre- An important corollary to the task of defining pared for each FOMC meeting. Given the com-a policy rule is that the central bank ought not to plexity and dynamic nature of the issues, I findbe a source of random disturbances. All of us are it best not to form a settled policy position wellwell aware of the potential for saying things in advance of the meeting.inadvertently that will create market misunder- Moreover, what policy purpose would bestanding of likely future Fed policy actions. Or, served by my discussing publicly every twist andmore precisely, what needs to be understood is turn of my analysis between FOMC meetings?how and why various possible economic condi- Market effects from doing so would not serve aF E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W J A N UA RY / F E B R UA RY 2 0 0 8 5
  9. 9. Pooleconstructive policy purpose—indeed, they would We have tentative signs that the financialviolate one of the important findings in macro- markets are beginning to recover from the recenteconomics that policy should not create random upset, but financial fragility is obviously still andisturbances. issue. If the upset were to deepen in a sustained way, it might have serious consequences for employment stability. As of today, we just do notBASICS OF POLICY STRATEGY know what the consequences may be. My best guess is that the inherent resilience of the U.S. I have emphasized the importance of the economy along with future policy actions, shouldcentral banker perspective in conveying a policy they be desirable, will keep the economy on astrategy. I will conclude by sketching the appro- track of moderate average growth and graduallypriate strategy as I see it. declining inflation over the next few years. First, the central bank should be clear as to Similar bouts of financial market instabilityits goals. The most fundamental goal is maximum in the nineteenth century on up to the financialpossible sustainable economic growth, which in panic of 1907 led Congress to pass the Federalmy mind motivates the dual mandate in the law Reserve Act in 1912. A fundamental responsibilityfor the Federal Reserve to strive for price stability of the central bank is to contribute to orderly andand high employment. Price stability, which is efficient functioning of financial markets. Theuniquely a central bank responsibility, contributes financial market upset of 2007 will join the his-greatly to the goal of maximum sustainable growth. tory of upsets including those in 1970, 1984, 1987,Price stability is not in conflict with high employ- and 1998. Each upset has different specifics butment but contributes to it. all of them have common characteristics, includ- I personally believe, and have so stated on ing especially a flight to safe assets.numerous occasions, that the inflation goal should I believe that part of the policy strategy oughtbe quantified. I know that many disagree on this to be to convey as clearly as possible to the marketpoint. In today’s economy, I believe that a quan- what the central bank is doing and why. A policytified inflation goal is not critically important but strategy that is a mystery to the markets will notquantification might be of great importance in serve the central bank well. Of course, the marketthe future. I ask this question: If the Fed had had will observe what the central bank does and infera specific inflation goal in 1965, would that com- many aspects of the strategy from those observa-mitment have helped to avoid the Great Inflation? tions. Nevertheless, central bank strategy alwaysI think the answer to the question is “yes.” If that relies in part on judgments about incoming infor-is the correct answer, then the United States might mation, such as whether a particular data releasehave avoided a very costly 15-year period of infla- has anomalous features and should be discounted.tion, or the period might have been shorter. The strategy of a central bank should be institu- A central bank cannot fix the level of tionalized and enduring. The strategy should notemployment or its rate of growth, or the average change just because the official roster changes. Therate of unemployment. However, the central bank strategy should evolve as economic knowledgecan contribute to employment stability. Avoiding, improves and as economic conditions change.or at least cushioning, recessions is an important I hope these remarks are useful. They do, ingoal. This goal should not be viewed as in conflict any event, explain something about how I havewith price stability. The most serious employment approached my responsibilities.disaster in U.S. history was the Great Depression,which was a consequence of monetary policy mis-takes that led to ongoing serious deflation. Simi- REFERENCESlarly, the period of the Great Inflation saw four Poole, William. “The Fed’s Monetary Policy Rule.”recessions in 14 years. Price stability is an essen- Federal Reserve Bank of St. Louis Review,tial precondition for overall economic stability. January/February 2006, 88(1), pp. 1-12;6 J A N UA RY / F E B R UA RY 2 0 0 8 F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W
  10. 10. Poole http://research.stlouisfed.org/publications/review/ 06/01/Poole.pdf.Taylor, John B. “An Appeal for Rationality in the Policy Activism Debate.” Federal Reserve Bank of St. Louis Review, December 1984, 66(10), pp. 151-63; http://research.stlouisfed.org/publications/review/ 84/conf/taylor.pdf.F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W J A N UA RY / F E B R UA RY 2 0 0 8 7
  11. 11. 8 J A N UA RY / F E B R UA RY 2 0 0 8 F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W
  12. 12. The Microfinance Revolution: An Overview Rajdeep Sengupta and Craig P. Aubuchon The Nobel Prize committee awarded the 2006 Nobel Peace Prize to Muhammad Yunus and the Grameen Bank “for their efforts to create economic and social development from below.” The microfinance revolution has come a long way since Yunus first provided financing to the poor in Bangladesh. The committee has recognized microfinance as “an important liberating force” and an “ever more important instrument in the struggle against poverty.” Although several authors have provided comprehensive surveys of microfinance, our aim is somewhat more modest: This article is intended as a non-technical overview on the growth and development of microcredit and microfinance. (JEL I3, J41, N80) Federal Reserve Bank of St. Louis Review, January/February 2008, 90(1), pp. 9-30.I n 2006, the Grameen Bank and its founder In its broadest sense, microcredit includes Muhammad Yunus were awarded the the act of providing loans of small amounts, often Nobel Peace Prize for their efforts to reduce $100 or less, to the poor and other borrowers that poverty in Bangladesh. By providing small have been ignored by commercial banks; underloans to the extremely poor, the Grameen Bank this definition, microcredit encompasses alloffers these recipients the chance to become lenders, including the formal participants (suchentrepreneurs and earn sufficiently high income as specialized credit cooperatives set up by theto break themselves free from the cycle of poverty. government for the provision of rural credit)Yunus’s pioneering efforts have brought renewed and those of a more informal variety (such as theattention to the field of microfinance as a tool to village moneylender or even loan sharks). Yunuseliminate poverty; and, since 1976 when he first (2007) argues that it is important to distinguishlent $27 to 42 stool makers, the Grameen Bank microcredit in all its previous forms from thehas grown to include more than 5.5 million mem- specific form of credit adopted at the Grameenbers with greater than $5.2 billion in dispersed Bank, which he calls “Grameencredit.” Yunusloans. As microfinance institutions continue to argues that the “most distinctive feature ofgrow and expand, in both the developing and Grameencredit is that it is not based on any col-developed world, social activists and financial lateral, or legally enforceable contracts. It is basedinvestors alike have begun to take notice. In this on ‘trust,’ not on legal procedures and system.”article we seek to explain the rise in microfinance For the purposes of this article and unless men-since its inception in the early 1980s and the tioned otherwise, our use of the term microcreditvarious mechanisms that make microfinancean effective tool in reducing poverty.1 We also 1 Other, more technical surveys of microfinance include Ghatak andaddress the current problems facing microfinance Guinnane (1999), Morduch (1999), and Armendáriz de Aghionand areas for future growth. and Morduch (2005). Rajdeep Sengupta is an economist and Craig P. Aubuchon is a research associate at the Federal Reserve Bank of St. Louis. © 2008, The Federal Reserve Bank of St. Louis. Articles may be reprinted, reproduced, published, distributed, displayed, and transmitted in their entirety if copyright notice, author name(s), and full citation are included. Abstracts, synopses, and other derivative works may be made only with prior written permission of the Federal Reserve Bank of St. Louis.F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W J A N UA RY / F E B R UA RY 2008 9
  13. 13. Sengupta and Aubuchonwill, for the most part, follow Yunus’s character- Microfinance” section of this paper.) The nextization of Grameencredit. section offers a brief history of the Grameen Bank Although the terms microcredit and micro- and a discussion of its premier innovation offinance are often used interchangeably, it is group lending contracts; the following sectionsimportant to recognize the distinction between describe the current state of microfinance andthe two. As mentioned before, microcredit refers provide a review of some of the common percep-to the act of providing the loan. Microfinance, tions on microfinance. The final section outlineson the other hand, is the act of providing these the future of microfinance, particularly in thesame borrowers with financial services, such as context of global capital markets.savings institutions and insurance policies. Inshort, microfinance encompasses the field ofmicrocredit. Currently, it is estimated that any- A BRIEF HISTORY OF THEwhere from 1,000 to 2,500 microfinance institu- GRAMEEN BANKtions (MFIs) serve some 67.6 million clients inover 100 different countries.2 The story of the Grameen Bank is a suitable Many MFIs have a dual mandate to provide point to begin a discussion of microcredit andfinancial as well as social services, such as health microfinance. After obtaining a PhD in economicscare and educational services for the underprivi- in 1969 and then teaching in the United Statesleged. In this sense, they are not always perceived for a few years, Muhammad Yunus returned toas profit-maximizing financial institutions. At Bangladesh in 1972. Following its independencethe same time, the remarkable accomplishment from Pakistan in 1971 and two years of flooding,of microfinance lies in the fact that some of the Bangladesh found itself in the grips of a terriblesuccessful MFIs report high rates of repayment, famine. By 1974, over 80 percent of the popula-sometimes above 95 percent. This rate demon- tion was living in abject poverty (Yunus, 2003).strates that lending to underprivileged borrow- Yunus, then a professor of economics aters—those without credit histories or the assets Chittagong University in southeast Bangladesh,to post collateral—can be a financially sustainable became disillusioned with economics: “Nothingventure. in the economic theories I taught reflected the life Not surprisingly, philanthropy is not a around me. How could I go on telling my studentsrequirement of microfinance—not all MFIs are make believe stories in the name of economics?”non-profit organizations. While MFIs such as (See Yunus, 2003, p. viii.) He ventured into theBanco Sol of Bolivia operate with the intent to nearby village of Jobra to learn from the poor whatreturn a profit, other MFIs like the Grameen Bank causes their poverty. Yunus soon realized that itcharge below-market rates to promote social was their lack of access to credit that held themequity.3 As will be discussed below, this distinc- in poverty. Hence, the origins of “microfinance” emerged from this experience when Yunus lenttion is important: As the microfinance industry $27 of his own money to 42 women involved incontinues to grow and MFIs serve a wider client the manufacturing of bamboo stools.4base, the commercial viability of an MFI is oftenviewed as crucial for its access to more main- 4 Yunus (2003) describes his conversation with Sufiya, a stool maker.stream sources of finance. (We will return to this She had no money to buy the bamboo for her stools. Instead, sheand related queries in the “The Evidence of was forced to buy the raw materials and sell her stools through the same middleman. After extracting interest on the loan that Sufiya used to buy the bamboo that morning, the moneylender left her2 with a profit of only 2 cents for the day. Sufiya was poor not for Microfinance Information Exchange (MIX) lists financial profiles and data for 973 MFIs. The high estimate of 2,500 comes from a lack of work or skills, but because she lacked the necessary credit survey conducted by the Microcredit Summit Campaign in 2002. to break free from a moneylender. With the help of a graduate stu- dent, Yunus surveyed Jobra and found 41 other women just like3 The social objectives of the Grameen Bank are summarized by the Sufiya. Disillusioned by the poverty around him and questioning 16 decisions in their mission statement. The statement is available what could be done, Yunus lent $27 dollars to these 42 women at http://grameen-info.org/bank/the16.html. and asked that he be repaid whenever they could afford it.10 J A N UA RY / F E B R UA RY 2008 F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W
  14. 14. Sengupta and Aubuchon Figure 1 Grameen Bank Membership Millions of Persons 6 5 4 3 2 1 0 1976 1981 1986 1991 1996 2001 Through a series of trials and errors, Yunus the poor access to credit. The Grameen Bank hassettled on a working model and by 1983, under a challenged decades of thinking and receivedspecial charter from the Bangladesh government, wisdom on lending to the poor. It has success-founded the Grameen Bank as a formal and inde- fully demonstrated this in two ways: First, it haspendent financial institution. Grameen is derived shown that poor households can benefit fromfrom the Bengali word gram, which means village; greater access to credit and that the provision ofgrameen literally means “of the village,” an appro- credit can be an effective tool for poverty allevia-priate name for a lending institution that requires tion. Second, it has proven that institutions dothe cooperation of the villagers. The Grameen not necessarily suffer heavy losses from lendingBank targets the poor, with the goal of lending to the poor. An obvious question, though, is howprimarily to women. Since its inception, the the Grameen Bank succeeded where so many oth-Grameen Bank has experienced high growth rates ers have failed. The answer, according to mostand now has more than 5.5 million members economists, lies in its unique group lending(see Figure 1), more than 95 percent of whom are contracts, which enabled the Grameen Bank towomen.5 ensure repayment without requiring collateral Lending to poor villagers involves a signifi- from the poor.cant credit risk because the poor are believed tobe uncreditworthy: That is, they lack the skills The Group Lending Innovationor the expertise needed to put the borrowed This Grameen Bank lending model can befunds to their best possible use. Consequently, described as follows: Borrowers organize them-mainstream banks have for the most part denied selves into a group of five and present themselves5 to the Bank. After agreeing to the Bank rules, the Grameen Bank, annual reports (various years). Data can be viewed at www.grameen-info.org/annualreport/commonElements/htmls/ first two members of the group receive a loan. If index.html. the first two successfully repay their loans, thenF E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W J A N UA RY / F E B R UA RY 2008 11
  15. 15. Sengupta and Aubuchonfour to six weeks later the next two are offered borrower. Market failure occurs because safeloans; after another four to six weeks, the last per- borrowers (who are more likely to repay) have toson is finally offered a loan. As long as all mem- subsidize risky borrowers (who are more likelybers in the group repay their loans, the promise to default). Because the bank cannot tell a safeof future credit is extended. If any member of the borrower from a risky one, it has to charge thegroup defaults on a loan, then all members are same rate to all borrowers. The rate depends ondenied access to future credit. Furthermore, eight the mix of safe and risky borrowers in the popu-groups of Grameen borrowers are organized into lation. When the proportion of risky borrowerscenters and repayment is collected during public is sufficiently large, the subsidy required (for themeetings. While this ensures transparency, any lender to break even on all borrowers) is so highborrower who defaults is visible to the entire that the lender has to charge all borrowers a sig-village, which imposes a sense of shame. In rural nificantly high rate. If the rates are sufficientlyBangladesh, this societal pressure is a strong dis- high, safe borrowers are unlikely to apply for aincentive to default on the loan. Initial loans are loan, thereby adversely affecting the compositionsmall, generally less than $100, and require weekly of the borrower pool. In extreme cases, this couldrepayments that amount to a rate of 10 percent lead to market failure—a situation in whichper annum.6 Weekly repayments give the borrow- lenders do not offer loans because only the riskyers and lenders the added benefit of discovering types remain in the market!problems early. Economic theory helps show how joint liabil- Group lending—or the joint liability con- ity contracts mitigate adverse selection (Ghataktract—is the most celebrated lending innovation and Guinnane, 1999). Under group lending, bor-by the Grameen Bank. Economies of scale moti- rowers choose their own groups. A direct way invated its first use, and Yunus later found that the which this might help is when a prospectivebenefits of group lending were manifold. Under customer directly informs the bank about thea joint liability contract, the members within the reliability of potential joiners. Perhaps a moregroup (who are typically neighbors in the village) surprising result is that the lender can mitigatecan help mitigate the problems that an outside the adverse selection problem even when cus-lender would face. Outside lenders such as banks tomers do not directly inform the bank but formand government-sponsored agencies face what themselves into like groups (peer selection). Thateconomists call agency costs. For example, they is, given a joint liability clause, safe customerscannot ensure that the borrowed money be put to will more likely group together with other safeits most productive use (moral hazard), cannotverify success or failure of the proposed business customers, leaving the risky types to form groups(costly state verification/auditing), and cannot by themselves. This “assortative matching” miti-enforce repayment. It is not difficult to see how gates the adverse selection problem because nowpeers within the group can help reduce these the risky borrowers are the ones who must bail outcosts, particularly in a situation where the prom- other risky borrowers, while the safe borrowersise of future credit depends on the timely repay- have to shoulder a lesser subsidy. Consequently,ment of all members in the group. Joint liability all borrowers can be charged a lower rate, reduc-lending thus transfers these agency costs from ing the likelihood of a market failure.the bank onto the community of borrowers, whocan provide the same services more efficiently. But perhaps the more difficult agency prob- CURRENT STATE OFlem faced by lenders is that of adverse selection— MICROFINANCEascertaining the potential credit risk of the Since the inception of the Grameen Bank,6 See www.grameen-info.org/bank/GBGlance.htm. Other sources microfinance has spread to cover five continents put the annual rates charged by MFIs at around 30 to 60 percent. and numerous countries. The Grameen Bank has12 J A N UA RY / F E B R UA RY 2008 F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W
  16. 16. Sengupta and Aubuchon Figure 2 Savings by Region 953 MFIs Reporting, July 2007 61 Million Savers Africa, 8.4 S. Asia, 10.6 E. Asia Pacific, 32.6 Latin America, 6.8 Eastern Europe/C. Asia, 2.7 SOURCE: Microfinance Information Exchange Network; www.mixmarket.org.been duplicated in Bolivia, Chile, China, Ethiopia, Bangladesh, which uses the idea that frequentHonduras, India, Malaysia, Mali, the Philippines, small deposits will guard against the temptationSri Lanka, Tanzania, Thailand, the United States, of spending excess income. To keep the transac-and Vietnam; the microfinance information tion costs of daily deposits low, SafeSave hiresexchange market (MIX) lists financial information poor workers from within the collection areasfor 973 MFIs in 105 different countries. Some (typically urban slums) to meet with clients onMFIs have also begun to seek out public and a daily basis. By coming to the client, SafeSaveinternational financing, further increasing their makes it convenient for households to save; byamount of working capital and expanding the hiring individuals from the given area, trainingscope of their operations. As MFIs have become costs and wages are also kept low. With this effi-more efficient and increased their client base, they cient model for both the bank and individuals,have begun to expand their services through differ- SafeSave has accumulated over 7,000 clients inent product offerings such as micro-savings, flexi- six years.7 Not surprisingly, microfinance depositsble loan repayment, and insurance. We discuss (like microfinance loans) break from traditionalthese three different product offerings below. commercial banking experiences. The example At the time of their inception, many MFIs of Bank Rakyat Indonesia (BRI) suggests that theincluded a compulsory savings component that poor often value higher liquidity over higher inter-limited a borrower’s access to deposited funds. est rates on deposit products. In 1986, after a yearThis promoted long-term savings, but ignored of field experiments, they offered two depositthe fact that many poor save for the short term to products: The TABANAS product offered a 12smooth consumption during seasonal lows of pro- percent interest rate but restricted withdrawalsduction. Figure 2 provides a look at the distribu- to twice monthly, whereas the SIMPEDES prod-tion of voluntary MFI savings by region. As MFIs uct offered an interest rate of zero but allowedhave become better versed in the microfinance unlimited withdrawals. The SIMPEDES programmarket, they have applied their innovations in saw the largest gain in popularity and to this daylending to the collection of deposits. One of the 7leading examples is SafeSave, located in Dhaka, See www.savesafe.org.F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W J A N UA RY / F E B R UA RY 2008 13
  17. 17. Sengupta and Aubuchonstill offers a lower interest rate but maintains more either extend the life of the loan or pay only theaccounts than the TABANAS program.8 principle for an extended period of time. As a The original Grameen Bank was one of the penalty, the dynamic incentives of her loan arefirst MFIs that incorporated a compulsory savings reset; she cannot access larger (additional)requirement into their lending structure. Every amounts of credit until the original loan is repaid.client was required to make a deposit worth 5 Because her default now poses no threat to thepercent of their given loan, which was placed group promise of future credit, each member isinto a group fund with strict withdrawal rules accountable only up to their individual liabilities.(generally no withdrawals before three years). In The third offering is the addition of insurance2001, the Grameen Bank reviewed both its lend- to microfinance loans. The most basic insuranceing and savings policy and reinvented itself as is debt relief for the death of a borrower, offeredGrameen II. At the heart of this change were more by many MFIs, including Grameen. Other MFIssavings options and more flexible loans, which have begun experimenting with health insuranceact as a form of insurance. New to Grameen II is and natural disaster insurance. As with lending,a pension fund, which allows clients with loans agency problems present a dilemma for micro-greater than 8,000 taka ($138) to contribute at least insurance. To this end, some groups such as50 taka ($0.86) per month. The client receives 12 FINCA Uganda require life insurance of all bor-percent per year in compound interest, earning a rowers, including “risky” and “healthy” alike and187 percent return after the mandatory 10-year thus avoid the adverse selection problem. Otherwait. This scheme allows Grameen II to earn more ideas include providing rain insurance to guardmoney in the present and expand services, while against catastrophes. This relies on the assumptiondelaying payment in the near future. that crop yields (and much of the developing economy) are tied to seasonal rain cycles. This Grameen II serves as a good example of a sec- innovation eliminates the problem of moral hazardond innovation in microfinance: flexible loan associated with a crop loan. By tying performancerepayment. Group lending still exists and is an to rain cycles, a farmer has no incentive to takeintegral part of the process, but Grameen II intro- crop insurance and then fail to adequately pro-duced a flexi-loan that allows borrowers multi- duce a crop during a season of adequate rainfall.ple options to repay their loan on an individual A more recent phenomenon in microfinancebasis. Yunus (2002) stated that “group solidarity is the emergence of foreign investment in MFIs.is used for forward-looking joint actions for As more and more MFIs establish positive returns,building things for the future, rather than for the microfinance is being seen by many professionalunpleasant task of putting unfriendly pressure on investors as a profitable investment opportunity.a friend.” The flexi-loan is based on the assump- One of the most important developments for thetion that the poor will always pay back a loan and MFIs was the June 2007 release of Standard &thus allows the poor to reschedule their loan Poor’s (S&P) report on the rating methodologyduring difficult periods without defaulting. If for MFIs. By applying a common methodology,the borrower repays as promised, then the flexi- S&P will be able to send a stronger signal to poten-loan operates exactly like the basic loan, using tial investors about the quality of MFI investments.dynamic incentives9 to increase the size of the The process of debt offerings and securitizationloan after each period. If the borrower cannot in the microfinance sector will be covered inmake her payments, she is allowed to renegotiate greater detail below.her loan contract rather than default. She can8 The SIMPEDES program does also use a lottery system to give rewards, often worth 0.7 percent of deposits. More details are MICROFINANCE AROUND THE available at the BRI web page: www.bri.co.id/english/mikrobank- ing/aboutmikrobanking.aspx. WORLD9 Dynamic incentives threaten to exclude defaulted borrowers from As Yunus and the Grameen Bank began to future loans. prove that microfinance is a viable method to14 J A N UA RY / F E B R UA RY 2008 F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W
  18. 18. Sengupta and Aubuchon Table 1 Characteristics of Select Microfinance Institutions Enterprise Grameen Bank, Banco Sol, Compartamos, Development Group, Bangladesh Bolivia Mexico Washington, D.C. Established 1983 1992 1990 1993 Membership 6,948,685 103,786 616,528 250 Average loan balance (US$) $69 $1,571 $440 $22,285** Percent female 96.70% 46.40% 98.40% 30.00% Group lending contracts? Yes Yes Yes No Collateral required? No No No No Portfolio at risk >30 days ratio 1.92% 2.91% 1.13% N/A Return on equity 1.95%* 22.81% 57.35% N/A Operational self-sufficiency 102.24%* 120.09% 181.22% 53%** NOTE: *12/31/2005; **2004. SOURCE: Data for this table come from the Microfinance Information Exchange (MIX) Network, which is a web-based platform: www.mixmarket.org. Information was provided for the Enterprise Development Group because it is the only U.S.-based MFI that reports data on the MIX network. Some of the information for EDG was taken from their 2003/2004 annual report, available at www.entdevgroup.org. Comparable information is not available for the Southern Good Faith Fund, as the scope of their mission has changed and expanded to more training-based programs. A more comprehensive summary chart exists in Morduch (1999).alleviate poverty, their methodology and program activities. By 1992, PRODEM serviced 17,000began to spread around the world. It is difficult clients and disbursed funds totaling $4 millionto know exactly how many MFIs there currently dollars. Constrained by the legal and financialare, but Microfinance Information Exchange (MIX) regulations governing an NGO, the board ofestimates range from 1,000 to 2,500 serving some directors decided to expand their services and67.6 million clients. Of these 67 million, more PRODEM became the commercial bank, Bancothan half of them come from the bottom 50 per- Solidario, later that year. Currently, Banco Solcent of people living below the poverty line. has 48 branches in seven cities with over 110,000That is, some 41.6 million of the poorest people clients and a loan portfolio of more than $172in the world have been reached by MFIs. MFIs million. As of March 31, 2007, Banco Sol reportedhave expanded their operations into five differ- a past-due loans level of only 1.78 percent. Anent continents and penetrated both rural and important distinction between Grameen andurban markets. They have achieved success with Banco Sol is the latter’s emphasis on returning aa variety of credit products and collection mech- profit with poverty alleviation stated only as aanisms. Table 1 provides a comparison of several secondary goal.groups from around the world. Banco Sol offers credit, savings, and a variety of insurance products. Their initial loan offeringBanco Solidario (Bolivia) was based on Grameen-style joint-liability lend- Banco Solidario originally existed as the ing, offering a maximum of $3,000 per client toFundacion para Promocion y el Desarrollo de la groups of three or four individuals with at leastMicroempresa (PRODEM), a non-governmental one year of experience in their proposed occupa-organization (NGO) in the mid-to-late 1980s and tion. Using dynamic incentives, the size of theprovided small capital loans to groups of three loan is gradually increased based on good repay-or more people dedicated to entrepreneurial ment history. Annual interest rates averageF E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W J A N UA RY / F E B R UA RY 2008 15
  19. 19. Sengupta and Aubuchonbetween 12 and 24 percent and can be anywhere through the use of credit enhancements, allow-from 1 to 60 months in length (120 months for a ing them to place the bond with institutionalhousing loan).10 With these higher interest rates, investors. Their fifth issue to date was three timesBanco Sol does not rely on subsidies and, at the oversubscribed with 70 percent of the bond pur-end of 2006, posted returns on equity of 22.8 chased by institutional investors. By accessingpercent. the commercial market, Compartamos has been able to lower the cost of obtaining funds and, inCompartamos (Mexico) turn, offer better services to their borrowers, such as absorbing the costs of providing life insurance Compartamos is the largest MFI in Mexico, for all clients. Their efforts to improve operationalservicing some 630,000 clients with an active efficiency have also created a self-sufficient MFIloan portfolio of $285 million. Located in Mexico that has existed without subsidies for over aCity, Compartamos is active in 26 Mexican states decade.throughout the country and services primarilyrural borrowers. Compartamos was founded in Good Faith Fund (United States)1990 and began by offering joint-liability loansto female borrowers for income-generating activ- The Good Faith Fund was modeled after theities. Compartamos has only recently expanded Grameen Bank and was one of the first MFIs totheir services to allow men to borrow through be established in America. In 1986, while gover-their solidarity group and their individual credit nor of Arkansas, Bill Clinton invited Muhammadprogram; still, around 98 percent of their borrow- Yunus to visit and discuss microfinance. Theers are female. In 1998, Compartamos formed a initial program was started as the Grameen Fund,strategic alliance with Accion International and but the name was later changed to better reflecttransformed into a regulated financial institution, the fund’s commitment to providing loans tocalled a Sociedad Financiera de Objeto Limitado micro-entrepreneurs. Loans weren’t securitized(SFOL). In 2002, Compartamos took a unique step with collateral; rather, they were guaranteed onfor a MFI and became one of the first MFIs to issue “good faith” (Yunus, 2003, p.180).public debt, listing themselves on the Mexican As the Good Faith Fund grew, practitionersStock Exchange. As an SFOL, Compartamos was and academics alike began to question the effec-limited to only offering credit for working capital. tiveness of a pure Grameen-style program in theIn order to offer more services, such as savings United States. Much like the original Grameenand insurance programs, Compartamos became a Bank, the Good Faith Fund has relied on innova-commercial bank in 2006. tion and change to apply microlending to the Compartamos was one of the first MFIs to rural economy of Arkansas. Taub (1998) arguesraise additional capital funds through the sale of that the Good Faith Fund is a successful povertydomestic bond issuances. In 2002, Compartamos alleviation program, but that it is a poor eco-was the first MFI in Mexico and one of the first nomic development program. In Taub’s words,in Latin America to offer a bond sale. Because “the Good Faith Fund has never been able tothis was Standard and Poor’s first attempt at rat- deliver a meaningful volume of customers, pro-ing a microfinance bond, they adapted their cur- vide substantial loan services to the really poor,rent methodology and rated the bond using their or achieve anything close to institutional self-Mexican scale and assumed local buyers. S&P was sufficiency.” He argues that important social dif-impressed with the diversified portfolio of debt ferences arise because rural Arkansas isand offered Compartamos an MXA+ (Mexican inherently different from rural Bangladesh andAA) rating. Reddy and Rhyne (2006) report that that these social differences cause the grouptheir most recent bond was rated an MXAA lending model to fail. Group lending failed for several reasons, but10 Banco Sol, accessed July 27, 2007; www.bancosol.com.bo/en/ foremost was the inability of potential borrowers intro.html. to form a group. In Bangladesh, where poverty16 J A N UA RY / F E B R UA RY 2008 F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W
  20. 20. Sengupta and Aubuchonrates and population density are much higher quently, moneylenders are typically perceivedthan the those in the United States, potential as being exploitative, taking advantage of poorborrowers can more readily find other entrepre- villagers who have no other recourse to loans.neurs. However, a close network of social ties Therefore, it is not surprising that microfinanceamong the poor does not exist in rural Arkansas. has been welcomed by most as an alternative toIn response to this problem, Good Faith Fund the abusive practices of village moneylenders.personnel established a mandatory six-week However, this common perception requires atraining program for individual new members more careful study: Why don’t mainstream banksand then created groups from the training pro- lend to the poor? In the banks’ absence, do localgrams. These newly formed groups of relative moneylenders have monopoly power? Morestrangers lacked the social cohesion to enforce importantly, are these high interest rates chargedcontract payments, unlike group members in rural by moneylenders welfare reducing?Bangladesh, who often live in the same village We begin by listing the difficulties that ariseand have family/community histories together. in lending to the poor. First, early studies believedConsequently, group lending was slowly phased that poor people often lack the resources neededout of the Good Faith Fund. Today, the Good Faith to invest their borrowings to the most productiveFund focuses mainly on career training through use. In short, the poor borrow mostly to financetheir Business Development Center and Asset consumption needs (Bhaduri, 1977; Aleem, 1990).Builders program. They have also found a niche Second, even if loans could be earmarked forin loaning larger amounts of money to small- and investment purposes, commercial banks wouldmedium-sized enterprises that are underserved find it difficult to lend: Lack of credit historiesby the commercial banking center. These loans and documented records on small entrepreneursprovide the same service, but at $100,000 or more, or farmers make it difficult for the bank to assessthey can hardly be considered “micro” credit. the creditworthiness of the borrower. Finally, there is the inability of the poor to post collateral on the loans. This reduces the bank’s recourse to aTHE EVIDENCE ON saleable asset once the borrower defaults on theMICROFINANCE loan. Therefore, it is not difficult to see why com- mercial banks have avoided lending to the poor. In this section, we review some of the impor- On the other hand, it is believed that localtant questions on microfinance. Our assessment moneylenders could mitigate the problems facedis based on numerous studies, technical surveys, by outside banks in lending to the poor. Localand newspaper reports on microfinance. The moneylenders are arguably better informed ofattempt here is to be illustrative rather than pro- borrower quality and have more effective meansvide a comprehensive review of microfinance. of monitoring and enforcing contracts than out- side banks. In short, because of their social ties,Is Microfinance a Desirable Alternative information, and location advantage, these mon-to Informal, Exploitative Sources of eylenders are in a unique position to lend to theFinance? poor. Some observers argue that usurious interest The spread of microfinance and the success rates in these markets can be explained by thisof MFIs in various countries around the world “monopoly” that the local moneylenders enjoy.prompts a question: Who served the poor before Several researchers have studied the marketthe microcredit revolution? It is well known that structure of rural credit markets in developingconventional banks, which act as creditors to most countries. Some argue that rural credit marketsentrepreneurial activity in the modern world, have are more competitive than previously imaginedlargely avoided lending to the poor. Instead, credit because there is free entry for local moneylend-to the poor has been provided mostly by local ers if not outside banks. While there is no broadmoneylenders, often at usurious rates. Conse- consensus yet, most observers believe that despiteF E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W J A N UA RY / F E B R UA RY 2008 17
  21. 21. Sengupta and Aubuchonfree entry in these markets, moneylenders often charged by the moneylender will enter into theseenjoy some form of local monopoly power (in the contracts. Clearly, this situation can be improvedmanner of monopolistic competition), at least in upon by offering lower rates: This would allowthe short run. more borrowers—i.e., those who expect to gener- However, there are other reasons why money- ate a lower rate of return on their investment—tolenders charge high interest rates. First, money- enter into loan contracts. However, this does notlenders have to compensate for the high mean that a high interest rate per se reduces wel-transaction costs of issuing and servicing a small fare. On the contrary, getting rid of moneylendersloan. Second, some observers believe that these or preventing them from offering loans at thesefunds have high “opportunity costs”—that is, high rates can be welfare reducing; in theirmoneylenders can earn high returns by investing absence, entrepreneurs with the highest returnsin their own farms. Finally, and this is despite on their projects have no recourse to loans.their local informational advantage, moneylenders In contrast, MFIs can often offer lower interestface some of the same problems as commercial rates than local moneylenders because of theirbanks in identifying risky borrowers and securing higher efficiency in screening and monitoringcollateral, particularly in poor rural areas. A borrowers, which results from both their economysimple numerical example helps illustrate this of scale (serving more borrowers) and their use ofresult11: Consider two lenders with the same cost joint liability lending mechanisms. This lowersof funds. Suppose now that the first lender oper- the MFI’s cost of lending relative to that of theates in a prime market where borrowers faithfully local moneylender. To the extent that MFIs canrepay all of their loans at 10 percent, giving him provide loans at a lower rate than moneylenders,an expected 10 percent return. However, the sec- enabling more and more borrowers to enter theond lender operates in a poor rural market where credit market, is an argument for both the effi-borrowers arguably have a higher rate of default, ciency (because of the reduced cost of funds) andsay 50 percent.12 Consequently, her expected net welfare enhancement (because of an increase inreturn is thus [ 1 + interest rate * 1 – probability the borrower pool) of microfinance.of default – 1]. Therefore, for the second money-lender to earn the same 10 percent return, she How High are the Repayment Ratesmust charge an interest rate equal to 120 percent: for MFIs? 1 + 120% * 1 – 50% – 1 = 10%. This is not tosay that some moneylenders don’t engage in This is widely regarded as the greatest achieve-price setting, but it does give a simple example ment of microfinance. Many MFIs report highin which a moneylender can be competitive but rates of repayment, often greater than 90 percent.still charge extremely high interest rates. These claims have driven considerable academic Do moneylenders reduce welfare because interest in why and how microfinance works.they charge high interest rates? To the extent that Furthermore, these repayment rates are widelyborrowers willingly accept these loan contracts, cited in popular media (Business Week, July 9the answer is no.13 These loan contracts do gen- and 16, 2007; Wall Street Journal, September 23,erate a positive surplus ex ante. That is, only those 2007) and have been one of the reasons for theborrowers who expect to generate a rate of return recent interest generated by microfinance in finan-from their investment that is higher than that cial markets worldwide. Although the theories of joint liability contracts, progressive lending,1411 This example in Armendáriz de Aghion and Morduch (2005) is frequent repayments, and flexible collateral ade- drawn from the early work of Bottomley (1975). quately explain these high rates of repayment,12 Of course, Yunus believes that this wrong assumption is the root Morduch (1999) raises the important issue of of all the problems that the poor have in obtaining credit.13 14 Bhaduri (1973) points to some degree of coercion in rural credit Progressive lending is a type of dynamic incentive in which markets, particularly in situations where landlords double as access to larger amounts of credit becomes available after each moneylenders. successfully repaid loan.18 J A N UA RY / F E B R UA RY 2008 F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W
  22. 22. Sengupta and Aubuchonvalidation. Because many of these repayment age interest rate on all products to 32 percent.rates are self reported, it is important to under- Morduch is careful to point out that it is unknownstand the methodology used to calculate these whether or not borrowers would defect, becauserepayment rates. for most borrowers the alternative is either no Morduch studies the repayment rates for the loan or an even higher interest rate on loans fromGrameen Bank for the 10-year period of 1985 to a moneylender.1996. During this period, Grameen’s average loan Although there is an apparent disagreementportfolio grew from $10 million to $271 million between Morduch’s adjusted rates of repaymentand membership expanded more than 12-fold to and the Grameen Bank’s self reported rates, thisinclude 2.06 million members in 1996. For this alone does not mean that Grameen is a financialdecade, Grameen reports an average overdue rate failure. In one case, the modest write-offs of badof only 1.6 percent.15 Morduch’s contention is loans offer proof of Yunus’s organizational com-that the Grameen Bank does not follow conven- mitment to the poor and the belief that, given time,tional accounting practices and calculates the they will repay a loan. The since-implementedoverdue rates as the value of loans overdue (for Grameen II Bank builds on this concept andmore than one year) divided by the current port- allows borrowers to restructure a loan into smallerfolio, instead of dividing by the size of the port- payments or to take a scheduled amount of timefolio when the overdue loans were issued. Because off, rather than default. Yunus describes the dif-the size of the loan portfolio expanded 27-fold ference: “[The] overarching objective of the con-during this 10-year period, the loan portfolio is ventional banks is to maximize profit. Thesignificantly larger at the end of any one year than Grameen Bank’s objective is to bring financialat the beginning. Morduch finds the adjusted services to the poor, particularly women and theaverage default rate to be 7.8 percent for the same poorest and to help them fight poverty, stay prof-10-year period. He makes the point that “the rate itable and financially sound. It is a compositeis still impressive relative to the performance of objective, coming out of social and economicgovernment development banks, but it is high visions.” Given that the Grameen Bank’s focus isenough to start creating financial difficulties” largely on social objectives and not profit maxi-(Morduch, 1999, p. 1590). mization, some have argued that it is not obligated As for these financial difficulties, Morduch to adopt standard accounting procedures. Whatthen focuses on reported profits, taking special is important is that Grameen is among the fewcare to examine the provision of loan losses. He transparent microfinance organizations andfinds that the bank is slow to write off bad loans, researchers have been able to review and evaluatedropping only a modest 3.5 percent of its portfolio their financial statements.every year, again overstating the amount of profit. An important consideration here is that MFIs are known to charge considerably higher ratesHe calculates that instead of posting a total of compared with similar loans from conventional$1.5 million in profits, the bank would have banks. In their celebrated work, Stiglitz and Weissinstead lost a total of $18 million. The implica- (1981) showed that the high interest rate that ations to Morduch’s findings are as follows: In the lender charges may itself adversely affect repay-early 1990s, to operate without subsidies, the ment rates by either discouraging creditworthyGrameen Bank would have had to raise interest borrowers (adverse selection) or tempting therates on its general product from 20 percent to borrowers to opt for riskier projects (moral hazard).50 percent, and this would have raised the aver- Consequently, the coexistence of high repayment15 rates (around 95 percent) and higher interest rates In comparison, nonperforming loans averaged between 1 and 1.5 percent for all U.S. commercial banks for the decade of 1995 to (a 30 to 60 percent interest rate is common) in 2005. (Source: Federal Financial Institutions Examination Council.) microfinance has “puzzled” economists. Braverman and Gausch (1986) found that government credit pro- grams in Africa, the Middle East, Latin America, South Asia, and One explanation offered by some economists Southeast Asia all had default rates between 40 and 95 percent. is that MFIs face an inelastic demand for loans.F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W J A N UA RY / F E B R UA RY 2008 19