Lecture Rural Finance 1

Universitt Hohenheim, Institut 490a
1
Rural Finance
Prof. Dr. Manfred Zeller
Prof. Dr. Franz Heidhues
Thomas Dufhues
WS 2005/06 5110 Rural Finance
Universitt Hohenheim, Institut 490a 2
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
Government,
Central Bank
Financial
market
policy
Monetary
policy
Trade
policy
Exchange
rate
relations
Rural
infra-
structure
Agricultural
sector
Extension
system
Off-farm
activities
Formal
Semi-formal
Informal
Insured party
Borrower Saver
Rural financial market
Financial
intermediaries
The rural financial subsystem
Source: Adapted from Buchenrieder, Heidhues, and Dung (2000)
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
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:
Major functions of the
formal financial system
Source: Adapted from Geis (1975)
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
The traditional reason for
formal agricultural credit
Traditional
approach towards
agricultural credit
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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
Informal sector:
Definition of formal finance:
Formal financial intermediaries (FFI)?
All intermediaries under control of the central bank
Usually all banks and institutions which are collecting
savings
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
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
Next
Semiformal = village banks, solidarity and
self-help groups promoted by NGOs
Rotating savings & credit associations
(RoSCAs):
Note: All RoSCA members contribute the same amount at their
periodic group meeting (Four members: A, B, C and D)
RoSCA members and
their contribution
A B C D E of individual
contributions
50
50
50
50
50
50
50
50
50
50
50
50
50
50
50
50
200
200
200
200
E of contributions
received by individual
member
200 200 200 200
E of net loan received
by individual member
150 100 50 0
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
RoSCAs pros and cons
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)
Back
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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.
Collateral
Character Capacity to repay
Physical
and
financial
capital
Lenders assess
credit worthiness
(3 essential Cs)
Human
and social
capital
Credit
history
Personal
background
Income Debt /
Expenditures
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
Return on
invest-
ment
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
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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)
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)
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
Importance of TCs in Development
(Micro)-finance
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
MFIs
Clients
Information
costs
Negotiation
costs
Enforcement
costs
Classification of TCs
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
average transaction cost per lent unit of money
average
cost per loan
small-scale-farmers medium-size-farmers large-scale-farmers
Selection of borrowers
towards bigger farmers/
wealthier clients
Back
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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
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)
TCs MFIs HHs
Information cost
Relational contracts
Information asymmetry
All relational contracts face information asymmetry
Most of TCs are due to costs of acquiring information.
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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 (STIGLITZcredit). Responses: Signaling, screening.
Information asymmetry adverse selection and moral hazard
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.
Moral hazard
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
adverse selection moral hazard
ex-post ex-ante
T
r
a
n
s
a
c
t
i
o
n
Source: Buchenrieder, Heidhues, and Dung (2003)
Financial
market
Credit Savings
Insurance
The product triangle of rural finance
Financial
market
Credit Savings
Insurance
Vogels (1984)
forgotten half of
microfinance in the
1980s
Financial
market
Credit Savings
Insurance
Vogels (1984)
forgotten half of
microfinance in the
1980s
Zeller et al. (1997)
termed insurance as
the forgotten third in
the 1990s
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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 efficiency of informal finance
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
Key features of the traditional
agricultural credit supply
1. External (to the rural sector) financing by government and external
donors
2. (Short-term) production credit (supervised credit, credit targeted to
certain crops/animal husbandry activities)
3. Strong focus on (production) credit; no savings mobilization, no
insurance or insurance substitutes
4. Subsidized credit (low interest rate) providing opportunities for
seeking rents that tend to be captured by the wealthy/powerful
5. Collateral to overcome information asymmetry (systematically
screening out the poor)
6. Policy of Give and forgive (Zeller et al., 1997)
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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)
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
Effects of low interest rate policy
1. Weakening of rural finance institutions
2. Adverse allocation effects
4. Distribution effect, regressive
5. Low savings interest rate
(often negative, below inflation)
economic and
political power
lower cost/
larger loans
3. Non-market (non-price) rationing
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
Forward
Next
Misallocation of funds
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
i
i*
i**
i* = market interest rate
i** = subsidized interest rate
Investments
Economic rent
Adverse employment effects
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
L
opt
Labor
Capital C
opt
Isoquant
Iso-cost-function
Adverse employment effects
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
L
opt
* = subsidized interest rate
Labor
Capital C
opt
L
opt*
C
opt*
Back
Iso-cost-
function*
Isoquant
S
D
i
Credit
i*
i**
S** D**
i* = market interest rate
i** = subsidized interest rate
E* = equilibrium
E*
Effects of an imbalance
in supply and demand
Back
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
Nominal and real rate of interest
100 1
1
1
|
|
.
|
\
|

+
+
=
p
i
r
Example: i=18%, p=12%
% 36 , 5
100 ) 1 0536 , 1 (
100 1
12 , 1
18 , 1
=
=
|
.
|
\
|
= r
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:
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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
1. Riskier because of relatively undiversified loan portfolio,
mainly agriculture
2. Riskier because of the productive risk of agriculture,
droughts, floods, diseases etc.
3. Usually thinly populated areas with bad infrastructure
4. Small amounts of loans are required
5. Vulnerable clientele (smallholders often poor, women play
major role in farming systems)
See Zeller, 2003 (paper on rural finance institutions for D.C.
conference)
Reasons for high costs in
agricultural lending
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
The new approach to rural finance
- The microfinance revolution -
1. 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
Forward
Forward
Forward
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
Next
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)
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
BUT: For the few sustainable MFIs, see Microbanking Bulletin
Benchmarking
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
Figures: Averages for All MFIs by Region
Data source: Microbanking Bulletin (MBB) Issue 7
EFFICIENCY
Administrative Expense Ratio
2. Outreach
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
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).
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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
2. Outreach - How to reach the target group?
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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
2. Outreach vs. Sustainability
Back
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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.
5. Collateral
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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.
Back
5. Collateral
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
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
Reasons for households to save
1. Income smoothing
Safeguards against uneven income streams due to
seasonal variations
2. Insurance
Provisions against disability, disease, retirement,
sudden income losses and other contingencies
3. Wealth accumulation
Financing households long-term goals (social and
religious purposes, heritage, consumer durable)
4. Future investments
5. Financial reciprocity or social reciprocity
The possibility of using savings to gain access to credit
or other services
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
Forward
Next
The need for income and consumption smoothing
(Morduch, 1995)
Cash flow within the lunar year of an
ethnic minority in Northern Vietnam
0
1
2
3
4
5
6
1 2 3 4 5 6 7 8 9 10 11 12
Lunar month
M
o
n
e
t
a
r
y

u
n
i
t
Back
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
Expenditure Income
Formal and informal savings
Formal savings
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
Bank accounts
Certain insurances
Stocks
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. Transaction costs
TCs incurred on transforming available surplus into a
specific savings option or on liquidating it
2. Liquidity
Time of liquidating the saving option in case of need
3. Real interest rates
Remunerations of the saving option
4. Divisibility
Possibility of parting of the savings in different sizes
5. Safety
How secure are the savings stored?
6. Trustworthiness and confidence
7. Piggy bank
Locking money away from relatives and friends
Decision parameters for choosing a
saving option
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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 depositors access to financial
support from the social environment in times of
scarce resources. Social cohesion as well as
individuals safety nets may be disrupted
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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 MFIs clients do not yet have access to flexible
savings and credit, providing insurance may be premature.
Challenges of micro-insurance in MF
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
The safety net role of microfinance?
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!!!
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
Forward
Next
4
Saving down
Saving up
Saving through
P
a
y
-
o
u
t
P
a
y
-
i
n
Cash flows of different financial products
Source: Rutherford (2000)
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
Back
The Schumpeterian qualification, that
innovation must be cost reducing, separates
change from innovation (Von Pischke 1995
p.121).
Categories of financial innovations
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
1. Innovations in the macro-financial system
2. Innovations at the level of the financial
intermediary
3. Innovations in organizing financial
intermediation
4. Financial product innovations
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
Innovations in the macro-financial system allowed
NGOs to take up financial intermediation activities
in many countries which was illegal before
(1) Innovations in the macro-financial
system
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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
(2) Innovations at the level of the
financial organization
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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
(3) Innovations in organizing financial
intermediation
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
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
Rural Credit Project of the Bangladesh Rural
Advancement Committee (BRAC) offers life
insurance policies
(4) Financial product innovations
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
Building of rural financial markets
Dos
(innovative approaches)
Don'ts
1. Mobilization of savings; savings
as collateral
2. Implementation of alternative
forms of collateral, e.g. joint-
liability groups
Credit/saving allocation at the
local level (decentralization)
3.
4. Integration of women (outreach)
5. Building of guarantee and
emergency funds
6. Unconventional enforcement of
repayment (exclude group from
access to further loans, seizing of
group savings, etc.)
7. Cover costs (sustainability)
8. Credit/savings/plus approach, i.e.
offering of agricultural extension
in addition to savings and credits
1. Start from the beginning with
cold money, i.e. (exclusively)
funds by the government or
international donors
2. Subsidizing of interest rate
(but support of institution
building often indispensable)
3. Credit as appendage to a
production project
4. Politically motivated debt
relieve
5. Use of extension workers as
debt collectors
1.1 Formal
1.2 Informal
3.1 Credits
- Micro finance
3.2 Savings
3.3 Insurances
Market research 9.
Integration or connection to the
formal financial market
10.
6. Do not use blue prints, especially
not from other countries
Recommended literature for first steps in
the field of rural (micro) finance
Ledgerwood,J. 1999. Sustainable banking with the poor - Microfinance handbook
- An institutional and financial perspective, Washington DC, USA: The World
Bank.
Robinson, M.S. 2001. The microfinance revolution - Sustainable finance for the
poor. Washington DC, USA: The World Bank and Open Society Institute.
Rutherford, S. 2000. The poor and their money. New Delhi, India: Oxford
University Press.
Pischke, von, J.d. 1991. 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. 1983. Rural financial markets in
developing countries. EDI Series in Economic Development. Washington DC,
USA: Economic Development Institute and The World Bank.
http://www.cgap.org/
http://www.microfinancegateway.org/
http://www.alternative-finance.org.uk/en/
http://econ.worldbank.org/
Universitt Hohenheim, Institut 490a
53
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 http://www.basis.wisc.edu/rfc/
Outline of presentation
1. Renewed interest in rural and ag finance:
Why?
2. Changing paradigms and policy objectives
in development finance.
3. What is specific about rural and ag finance:
environments, ag production, clientele.
4. Types (or models) of rural finance
institutions.
5. Micro-finance best practices: Transfer?
6. Policy recommendations: Towards
sustainable rural financial systems.
Renewed interest in rural and
ag finance: Why?
1. Decline in formal rural and agric credit after
justified collapse of subsidized ag credit
systems.
2. Role of rural finance for agric and economic
growth, food security and poverty reduction.
3. 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
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
Outreach (Breadth
and Depth)
Welfare impact
(Direct/Indirect)
Financial sustainability
The triangle of finance:
Synergies and trade-offs
Source: Zeller, M., and Meyer, R.L. 2002. The triangle of microfinance: Financial sustainability,
outreach, and impact. IPPRI/John Hopkins Univ, Dec. 2002.
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
Specific characteristics of agriculture
1. Location-specificity (ag is production in space).
2. Unfavorable terms of trade for agriculture.
3. Production depends on natural conditions
(covariant risks!), gestation periods of several years
e.g. tree crops, dairy.
4. Seasonality (production, food and factor prices).
5. Significant role of women in ag, especially food
crops.
6. High incidence and depth of poverty among
population dependent on agriculture.
7. High volatility of prices in ag commodities.
Serving ag clients is EVEN more difficult.
Creating inst. innovations
1. Institutional innovations in rural and microfinance
are rarely the PURE product of market forces
seeking to maximize profit.
2. 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.
3. 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).
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
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:
1. Proven ability to service many rural depositors and
provide diversified range of individual loans.
2. Governance structures tend to protect saver.
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:
1. 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.
2. 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.
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 govt.
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?
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.
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.
Conclusions/recommendations
1. Learn from past failures of rural/ag
finance. It is too costly to repeat them.
2. No (model) blueprint but promote
institutional diversity/innovation. Each
institutional model has its comparative
advantages, and diversity enhances
competition, outreach, and impact.
3. Promote rural finance institutions
within a financial systems perspective.
Stand-alone retail rural financial institutions
are doomed to vanish need
horizontal/vertical integration.
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.
Literature used for this lecture
Buchenrieder, G., Heidhues, F., and P.T.M. Dung. 2000. 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. 2003.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. 1975. 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. 1999. 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): 121-131
Rutherford,S. 2000. Raising the curtain on the 'microfinancial services era'. Small Enterprise Development
11 (1): 13-25.
Seibel, D. 1999. 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. 2001. Accessibility of rural credit in Northern Nicaragua: The importance of networks of
information and recommendation. Savings and Development 25 (1): 5-32.
Vogel, R., 1984. Savings mobilization, the forgotten half of rural finance. In: Adams, D. W., Graham, D., Von
Pischke, J. D. (Eds.): 248-265. Undermining rural development with cheap credit. Boulder, USA:
Westview Press.
Zeller, M. 2001. Promoting institutional innovation in microfinance - Replicating best practices is not enough.
Development and Cooperation (1): 8-11.
Zeller,M. and M. Sharma. 2000. Many borrow, more save, and all insure: Implications for food and
microfinance policy. Food Policy 25 (2): 143-167.
Zeller,M., Schrieder,G., Braun von,.J., and F. Heidhues. 1997. 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).
Literature used for this lecture
Lapenu, Ccile, and Manfred Zeller, 2002. Distribution, growth, and performance of the microfinance
institutions in Africa, Asia and Latin America: A Recent Inventory. Savings and Development, Vol. 26
(1), pp 87 -111. (a longer version of this paper can be downloaded at www.ifpri.org under discussion
papers)
1. Zeller, Manfred. 1998. 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. 599-620, January 1998, University of Chicago Press.
Sharma, Manohar, and Manfred Zeller. 1997. Repayment performance in group-based credit programs in
Bangladesh: an empirical analysis. World Development, Vol. 25 (10), pp. 1731-1742. October 1997.
Adams, D.W. 1988. The conundrum of successful credit projects in floundering rural financial markets.
Economic Development and Cultural Change 36 (2): 355-367.
Feder, G., R.E. Just, and D. Zilberman. 1985. Adoption of agricultural innovations in developing countries.
Economic Development and Cultural Change 22(2): 255-296.
Hulme, D., and P. Mosley. 1996. Finance against poverty. Routledge: London and New York.
Financial
Market
Credit Savings
Insurance
Steps to select a topic for report:
1. Select an area case(Best, good, moderate, poor)
2. You may select a rural financial service (see rural finance triangle) or an
FFI of the case
3. Select the sector (formal or informal) and/or specific financial institution
4. Discuss the context, mechanism, impacts of financial institution
5. Recommend the options for improvement and justify with the impact
6. Not more then five pages (incl. tables, figures & references)
Assessment
of selected rural finance institutions ans
option: Innovations and impacts
Source: Buchenrieder, Heidhues, and Dung (2003)
If you have questions while
preparing the seminar-papers
you can contact me under:
tdufhues@uni-hohenheim.de
or
you can find me in the office
of Dr. Gertrdu Buchenrieder.

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