Banerjee’s Review on Micro-finance Research

Unitus-Microcredit-Borrowers-1

Picture from Engaging Justice GWSS, University of Minnesota.

MIT development economist Abhijit Banerjee wrote a nice and short review of micro finance. Great reading for every development-economist-to-be.

Two decades of research has provided us with a much clearer view of why and how micro finance works. Yet there are still fundamental questions that call for more careful investigation. Does group borrowing help the poor’s long term growth more than individual borrowing? Why does micro credit have limited impact on business creation and income growth? How do the incentives of micro finance institutions (MFIs) affect the debt contracts that borrowers take up?

The answer to the first question is yes and no. It is widely accepted that group borrowers tend to monitor each other in terms of undertaking profit-generating projects and making timely repayments. However, groups formed out of family ties can be more reluctant to press their members in loan repayments. Indeed, an individual in such groups might find it easier to default anyway and let family members cover for him. Fortunately, economists are identifying innovative ways to combine favorable features of group borrowing to enhance the performance of individual loan contracts. For example, letting some of the group members get loans and the others paid to share the joint liability has been recently proved to decrease default rates.

The answer to the second question is a bit trickier. Development economists are tempted to believe that micro-finance to be a silver bullet for all the problems of the poor. But in reality how well an individual utilizes micro credit depends critically on his or her intangible personal traits such as financial literacy, self-control, entrepreneurship, and even ambition. Not all micro-credit borrowers are good at growing businesses. Indeed, the fact that they have difficulty getting credit might have already proved they are poor entrepreneurs. These borrowers might also have poor financial judgment   due to lack of education. In terms of motivation, some borrowers might take loans to facilitate consumption needs instead of long term investments. In addition to these “personal characteristics” reasons, Banerjee also suggests a set of more objective reasons. Frequent repayment might restrict borrowers’ ability to make lump sum investments, and production and consumption might exhibit increasing returns only when investment exceeds a threshold which micro loans cannot reach.

The third question was largely ignored in the early micro-finance literature but is gaining attention recently. MFIs possess the ultimate power to decide the terms of loan contracts, process of approval, enforcement methods, and punishment for defaults. It is important to bear in mind that the current loan contracts are already selected to help the MFIs maximum profits (even though many such organizations usually claim they have a social responsibility) in all economic analyses of micro-finance. For example, lenders might make the terms of individual loans more attractive in order to reduce default rates.

At the end of the article, the author points out several directions for future research. On the theory side, like many other fields in development economics, much remains to be done. Xiao Yu Wang, a new Assistant Professor in our department, has written her job market paper on the matching of risk types within social networks. On the purely empirical side, two questions stand out. First, is it possible to help borrowers make better use of the loan? If so, how should we do it and what should we expect? Some development organizations (e.g. BRAC) offer financial literacy curriculum together with loans, but the impact of such educational programs are rarely rigorously evaluated. Second, is it possible to create a mechanism that makes larger loans than micro-credit loans and still maintain high repayment rates?

If you want to read more about micro finance, The Handbook of Micro-finance provides a thorough review for subject, and Due Diligence by David Roodman (which I blogged about) cites research in sociology and anthropology with a lot of case interviews.

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One thought on “Banerjee’s Review on Micro-finance Research

  1. Reblogged this on makhosetive and commented:
    Interesting review. Microlending and microfinance have for long been touted as magic bullets indeed. What is quite interesting in the literature is the extent to which the halo effect is at play in development circles particularly with regards to microfinance. With emphasis on social capital, perhaps researchers make implicit assumptions that common interests and the fear of expulsion suffice to make microlending a robust model. Yet what is known of social identity suggests that the relationships in groups may not be so simple and in the case of microlending, may lead to unwanted outcomes. There is indeed, a lot that needs to be done in research.

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