Lecture Rural Finance 1

8/12/2019 Lecture Rural Finance 1

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Universitt Hohenheim, Institut 490a1

Rural Finance

Prof. Dr. Manfred ZellerProf. Dr. Franz Heidhues

Thomas Dufhues


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WS 2005/06 5110 Rural Finance

Universitt Hohenheim, Institut 490a 2

Structure of the lecture1. 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


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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:Funct ions:

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 Impl icat ion:

Major functions of the

formal financial system

Source: Adapted from Geis (1975)

1. Rural financial system

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




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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 = SavingsI = Investment

P = Productivity


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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

Forward1. Rural financial system

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


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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 of individualcontributions

50

50

5050

50

50

5050

50

50

5050

50

50

5050

200

200

200200

of contributionsreceived by individual

member

200 200 200 200

of net loan receivedby individual member

150 100 50 0


1.1 Formal

1.2 Informal




3.1 Credits


- Micro finance

3.2 Savings

3.3 Insurances




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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 needand no interregional

inter-mediation

(fragmentation)

Back


1.1 Formal

1.2 Informal




3.1 Credits


- Micro finance

3.2 Savings

3.3 Insurances




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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


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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




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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 influencepossible

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




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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


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Arise before

the transaction

Mostly related tosearching for and

screening of

potential trading

partners and

obtaining price

information

Arise dur ing

the transaction

Including costsof arranging the

transactions,

physically

transferring the

product or

service, anddrawing up

contracts

Arise after

the transaction

Including costsofmonitoring 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




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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




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Financial services contracts (savings, credit, insurance) are relat ional co ntracts

(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 onpersonal 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 ofborrower (STIGLITZ), quality of

used cars (AKERLOF)

TCsMFIs 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




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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 (STIGLITZ credit). 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 hazard1. Rural financial system

1.1 Formal

1.2 Informal




3.1 Credits


- Micro finance

3.2 Savings

3.3 Insurances



adverse selection moral hazard

ex-postex-ante

Transactio

n


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Source: Buchenrieder, Heidhues, and Dung (2003)

Financialmarket

Credit Savings

Insurance

The product triangle of rural finance

Financialmarket

Credit Savings

Insurance


Vogels (1984)

forgotten half of

microfinance in the

1980s

Financialmarket

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




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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




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Key features of the traditional

agricultural credit supply

1. External (to the rural sector) financing by government and externaldonors

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




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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




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Effects of low interest rate policy

1. Weakening of rural finance institutions

2. Adverse allocation effects

4. Distribution effect, regressive5. 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


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Misallocation of funds


1.1 Formal

1.2 Informal

1.3 Formal vs. informal2. NIE in rural finance


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


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Adverse employment effects


1.1 Formal

1.2 Informal



3.1 Credits


- Micro finance

3.2 Savings

3.3 Insurances



Lopt

Labor

CapitalCopt

Isoquant

Iso-cost-function


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Adverse employment effects


1.1 Formal

1.2 Informal



3.1 Credits


- Micro finance

3.2 Savings

3.3 Insurances



Lopt

* = subsidized interest rate

Labor

CapitalCopt

Lopt*

Copt*

Back

Iso-cost-function*

Isoquant


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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 demandBack


1.1 Formal

1.2 Informal



3.1 Credits


- Micro finance

3.2 Savings

3.3 Insurances




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Nominal and real rate of interest

10011

1

p

ir

Example: i=18%, p=12%

%36,5

100)10536,1(

100112,118,1

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




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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



WS 200 /06 110 R l Fi


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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

WS 2005/06 5110 R l Fi


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1. Sustainability Back

Why sustainability?

The poor value secure but more expensive access to credit higherthen 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


4. Financial innovationsBUT: For the few sustainable MFIs, see Microbanking Bulletin


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Benchmarking

Provides an avenue forbest practices to emerge

Gives practitioners,

board, funders, andregulators a comparativepicture of MFIperformance

Helps coordinate effortsand efficiency to helpMFIs increase outreach

Figures: Averages for All MFIs by RegionData source: Microbanking Bulletin (MBB) Issue 7

EFFICIENCY

Administrative Expense Ratio

WS 2005/06 5110 R l Fi


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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 ou treach: high share of women, poorest,

etc.

Breadth of outreach:reaching huge numbers of

target group people

While outreach is used from the perspective of thefinancial 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



WS 2005/06 5110 R l Fi


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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 corruptionProduct 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





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Some argue there is a trade-off between sustainability andoutreach (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





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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





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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 veryfew 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





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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.

Back5. 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





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Reasons for households to save

1. Income smoothingSafeguards 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 reciprocityThe 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


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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 goldIn cash:

Money collectors

Reciprocal lending (e.g. RoSCAs)

Under the pillow



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1. Transaction costsTCs 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. SafetyHow 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





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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 maydecrease 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





42/71



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





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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) loansmay 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





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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 thanwhat 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 possiblebut 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



45/71



4

Saving down

Saving up

Saving through

Pay-o

ut

Pay-in

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



46/71

S 005/06 5 0 u a a ce


The Schumpeterian qualification, thatinnovation 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 system2. Innovations at the level of the financial

intermediary

3. Innovations in organizing financial

intermediation

4. Financial product innovations



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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





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Innovations at the level of the financial organization referto 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





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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 marketingapproach

(3) Innovations in organizing financial

intermediation


1.1 Formal

1.2 Informal



3.1 Credits


- Micro finance

3.2 Savings

3.3 Insurances





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Innovative financial products reflect new or modifiedproducts.

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





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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 withcold money, i.e. (exclusively)funds by the government orinternational donors

2. Subsidizing of interest rate(but support of institutionbuilding often indispensable)

3. Credit as appendage to aproduction project

4. Politically motivated debtrelieve

5. Use of extension workers asdebt collectors


1.1 Formal

1.2 Informal



3.1 Credits


- Micro finance

3.2 Savings

3.3 Insurances



Market research9.

Integration or connection to the

formal financial market

10.

6. Do not use blue prints, especiallynot from other countries



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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/


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Models of Rural

Finance Institutions

Manfred ZellerPresentation 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/



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Outline of presentation

1. Renewed interest in rural and ag finance:Why?

2. Changing paradigms and policy objectivesin development finance.

3. What is specific about rural and ag finance:environments, ag production, clientele.

4. Types (or models) of rural financeinstitutions.

5. Micro-finance best practices: Transfer?

6. Policy recommendations: Towardssustainable rural financial systems.



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Renewed interest in rural and

ag finance: Why?1. Decline in formal rural and agric credit afterjustified collapse of subsidized ag creditsystems.

2. Role of rural finance for agric and economicgrowth, food security and poverty reduction.

3. Hope of doing better this time because of ourenhanced 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



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Old versus new paradigm

Old paradigm of sector-directed, supply-led andsubsidized 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 systemsneed institutional and technological innovations toreduce transaction costs

Demand orientation, three objectives



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Outreach (Breadthand 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.



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The Urban-Rural Dichotomy

higher transaction costs for FIs and theirclients (irrespective of the institutionalmodel)

higher systemic risks, more volatilecash 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



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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 foodcrops.

6. High incidence and depth of poverty amongpopulation dependent on agriculture.

7. High volatility of prices in ag commodities.

Serving ag clients is EVEN more difficult.



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Creating inst. innovations

1. Institutional innovations in rural and microfinanceare rarely the PURE product of market forcesseeking to maximize profit.

2. Successful innovations were done conform withmarket principles. Yet, they were fostered by public

investments (example BRI) or by private altruisticaction (1. coop movement in Germany started byRaiffeissen and Schultze von Delitzsch, 2.Grameen Bank: Yunus 3. Many other leaders in theindustry supported by donors.

3. State has a role to invest in innovations and relatedlearning 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).



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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 solidaritygroup lending, and linkage model (with pre-existing

self-help groups). Other: (1) State-owned ag/rural dev banks (2)

downscaling commercial banks (3) contractfarming (4) supplier credit/leasing and other


C dit i (CU )


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Credit unions (CUs) Formal institutions owned and controlled by

their members, regional networks and

(coop) banks facilitate transformation ofterm, size, and risk.

Larger CUs managed by professionals (ifnot interfered by state), technical assistanceand supervision important.

Number one (rural) MFI large breadth,some depth, proven sustainability over manyyears.

Comparative advantages:1. Proven ability to service many rural depositors and

provide diversified range of individual loans.

2. Governance structures tend to protect saver.



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Village banks (VBs)Semi-formal institution owned and controlled by

its members often promoted byinternational NGOs such as FINCA, CARE,CRS, Freedom from Hunger, etc. The Prosare:

1. In comparison with a credit union, a VB is muchsmaller and less complex in structure, thus enablingless educated/poorer members to manage/participate.

2. Member-driven interest rate policy for internally

generated savings deposits (and loans) can adaptto segmented rural financial markets interestrates often set much higher than in other MFIs.

Cons: Small size of bank and homogeneity of memberslimits scope for term, size and risk transformation.



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Microbanks Formal, profit-oriented institutions that use

microfinance technology. Examples: Unitbanks of BRI, BancoSol, IPC-supportedbanks.

Heterogenous ownership structure in

practice: Private, NGO, equity stakes ofpublic 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 forcommercial banks that ignore MF technology.

Cons: Ownership structure may not call for depth ofoutreach. Social commitment of owners? Risk of

mission drift?


State owned rural/ag dev


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State-owned rural/ag dev

banks

Need to be transformed (based on businessprinciples), or, if not possible, liquidated.

Successful transformation is possible even ifSTATE OWNERSHIP is retained (BRI, BAAC)

depends on political will, suitable macro-economic and ag sectoral framework, and onmgt that is independent and has incentives toperform

A number of donors are involved in reform ofstate-owned banks (IFAD/GTZ/IDB/USAID):No reason to write them off.

Liquidation (even if possible) is often not the

best option.



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Micro-finance best practicesKnowledge on best practices in micro-finance

are relevant, but not sufficient because ofspecific characteristics of agric finance

Agricultural lending: See FAO, Table 3 inpaper

Savings: CGAP working papers.

Insurance against idiosyncratic risks such assickness, 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 practicemeans to develop demand-oriented products

and delivery technologies.



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Conclusions/recommendations

1. Learn from past failures of rural/agfinance. It is too costly to repeat them.

2. No (model) blueprint but promoteinstitutional diversity/innovation. Eachinstitutional model has its comparativeadvantages, and diversity enhancescompetition, outreach, and impact.

3.

Promote rural finance institutionswithin a financial systems perspective.Stand-alone retail rural financial institutionsare doomed to vanish needhorizontal/vertical integration.



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Conclusions/recommendations4. Do the relatively easy things first, while

gradually experimenting with the moredifficult ones. Rural and ag finance is moredifficult than urban finance, and manyenvironments are too hostile without preceding

improvements in other sectors (infrastructure, agtech, ag policy). Rural finance follows ratherthan precedes

5. Be patient. Building of rural financial institutions

and systems is a labor-, knowledge-, and time-consuming process. It is technical, not financialassistance that matters. More of capital can do

more harm than good.



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Literature used for this lectureBuchenrieder, 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 NorthernVietnam. 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 f inancial 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. Accessibil ity of rural credit in Northern Nicaragua: The importance of networks of

information and recommendation. Savings and Development25 (1): 5-32.

Vogel, R., 1984. Savings mobilization, the forgotten half of rural finance. In: Adams, D. W., Graham, D., VonPischke, 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 Policy25 (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).



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Literature used for this lectureLapenu, Ccile, and Manfred Zeller, 2002. Distribution, growth, and performance of the microfinance

institutions in Africa, Asia and Latin America: A Recent Inventory. Sav ings 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. Economi c Devel opment and

Cul tura l 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.

http://www.ifpri.org/http://www.ifpri.org/


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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 impact6. 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)

I f you have questions while

preparing the seminar-papers

you can contact me under:

[email protected]

you can find me in the office

of Dr. Gertrdu Buchenrieder.

Documents

Lecture Rural Finance 1