LITERATURE REVIEW

Literature Review

Literature Review

The growth in the microfinance sector has prompted a large number of academic empirical studies6 examining different aspects of the industry. These studies have implications for the design of microfinance programmes as well as broader issues relating to the structure and regulation of the sector. This chapter reviews the findings of this literature which are relevant for the situation in the Mediterranean region, and this discussion places in context more specific questions relating to microfinance impact assessment.

How Microfinance Works

The basic rationale for intervention in microfinance is due to the failure of financial markets to adequately supply services to the poor and the economically marginalized.

The lack of ability to enforce contracts, combined with information failures and high transactions costs mean that markets either do not exist or fall short of the required level of service.

High transactions costs are often cited as an obstacle to increasing outreach. MFIs that seek to cover their operating costs must pass on the cost of providing small loans in remote areas in the form of high interest rates. However, two sets of empirical studies suggest that this obstacle may not be as serious as it appears. First, case studies in Sri Lanka7 and Mexico8 show that micro-enterprise returns are generally high, and returns greater than 10% per month are not exceptional. Second, results from Dhaka9 and S Africa10 suggest that the elasticity of demand for credit is low.

Taken together, these findings suggest that high interest rates11 need not be an obstacle to growth of sustainable microfinance.

Different types of market failures have been widely examined in the literature. Bester (1985) discussed the use of interest rates and collateral as screening mechanisms in cases of asymmetric information. However, collateral is not typically available for microfinance and when lenders cannot distinguish between high-risk and low-risk enterprises there is a tendency for loan pricing to discourage the low-risk projects. This problem of adverse selection may mean that there is no market-clearing price and that services cannot be provided by the market12. High transactions costs tend to accentuate the problem by raising interest rates to a point where low-risk projects are discouraged. Furthermore, when asymmetries of information prevent lenders from monitoring what the loans are spent on, and when contract enforcement is weak, there are problems of moral hazard where loans may be diverted to uses where repayment rates are low.

Group lending has offered a practical way to address these market failures. The group model provides a screening and selection process undertaken by insiders who have access to the relevant enterprise-specific information. Combined with incentives of progressive access to larger loans, social pressure from within the group also serves to enforce repayment. The effectiveness of these incentive mechanisms is evident from the high reported rates of repayment13.

Implications for the Design of Microfinance Programmes

The diversity of microfinance programmes, both because of country differences and differences in the MFIs, means that it is difficult to transfer a successful lending model from one context to ...