Is microfinance the new subprime?

by on June 21, 2008 at 6:55 am in Economics | Permalink

Ryan Hahn asks:

In the case of microfinance, however, it seems to me the problem of limited liability is rearing its ugly head. Poor borrowers generally have little or no collateral, so they usually have little reason to avoid a strategic default.

It is a common myth that microfinance loans have no collateral.  I sooner worry that the process of collateralization is too thorough.  Remember that microfinance loans are made to small groups of five to ten people, typically neighbors.  If you don’t pay up, your associate has to.  The reality is that the person left holding the bag — who knows you well — will come seize your TV set or in some cases the process is a bit less pleasant.  Part of the efficiency of microfinance is simply the separation of the lending and the "thug" functions.  Banks can lend to high-risk individual borrowers without themselves resorting to the illegal intimidation practices of the village moneylender.  The dynamics of cooperative behavior in the village are not always pretty but overall it works better than the moneylender; if nothing else the person seizing the collateral knows that next time around he or she may be the non-payer.  For more detail, see my Wilson Quarterly article with Karol Boudreaux.

1 Anonymous June 21, 2008 at 9:29 am

Not all microfinance loans are group “peer pressure” loans; many are now made to individuals. And hardly all of these borrowers are dirt-poor peasants, either; many might be considered their local village’s equivalent of middle class or relatively well-to-do, sometimes hiring outside labor.

Many of these individuals receive multiple rounds of loans, for increasing amounts, as they establish their creditworthiness and expand and diversify their projects. The same family might, for instance, start out raising pigs but expand by opening a grocery store and buying a rice-husking machine. Clawing your way to prosperity is rarely done in a single step with a single loan.

The penalty to be feared for not paying back is being cut off from future rounds of microloans, rather than seizure of collateral.

2 jb June 22, 2008 at 12:26 am

What the first two comments said. It is a real problem that most microfinance lending techniques do not work well in the presence of competition.

Ultimately, microfinance is an attempt to solve the information problem (how much can this person pay back?) cheaply enough to make it worth lending to them. Within that, there are as many different models as there are lending institutions.

It’s also worth noting that there are 7 times as many savings accounts with microfinance institutions than there are loan accounts. Microcredit is in fact a very small portion of the market, and with the growth of microinsurance will become smaller yet.

3 Anonymous June 22, 2008 at 9:14 am

Subprime had a number of risks that aren’t really applicable to microfinance.

For one thing, easy mortgages led to a huge bubble in house prices, and its deflation is leaving many homeowners underwater, owing more than their house is worth. For another, people got mortgages with unrealistically low teaser rates that reset in a few years to a realistic but unaffordable rate, which they never planned to pay because they expected to refinance or flip the house by then. And third, many subprime mortgages were handed out purely to create collateral for issuing massive amounts of CDOs, by brokers who had no incentive to care whether the mortgages would ever be paid back.

With microloans, this asset inflation, greater fool theory, and principle-agent problem don’t apply, and it seems highly unlikely that microlending will ever become the first domino to fall in some new global financial crisis. Loose lending standards might result in lenders losing money and borrowers getting in over their head, but the subprime metaphor hardly seems accurate.

4 Kevin Carson June 23, 2008 at 3:06 am

What you say of existing microfinance would be even more true if the function were performed by mutual banks piggybacked on LETS systems.

It’s got the same kind of “collateral” as someone incurring “obs” in Eric Frank Russell’s “And Then There Were None.”

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11 Tim.b October 22, 2010 at 2:22 am

A $5,000 microfinance loan to a carpenter for parenthood can easily become an asset class for businessmen who move around in a luxurious Mercedes. The highest yield among fixed-income instruments is attracting a lot of millionaires that can enrich them and also keep the lending to poor going. Tim B. Ezsaver

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