Universität Hohenheim, Institut 490a 1 Rural Finance Prof. Dr. Manfred Zeller Prof. Dr. Franz Heidhues Thomas Dufhues

Universität Hohenheim, Institut 490a 1

Rural Finance

Prof. Dr. Manfred Zeller

Prof. Dr. Franz Heidhues

Thomas Dufhues


WS 2005/06 5110 Rural Finance

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



Government, Central Bank

Financialmarket policy

Monetary policy

Tradepolicy

Exchange rate

relations

Rural infra-

structure

Agricultural sector

Extensionsystem

Off-farmactivitiesFormal

Semi-formal

Informal

Insured party

BorrowerSaver

Rural financial market

Financial intermediaries

The rural financial subsystem

Source: Adapted from Buchenrieder, Heidhues, and Dung (2000)

1. Rural financial system1.1 Formal1.2 Informal1.3 Formal vs. informal2. NIE in rural finance3. Financial services3.1 Credits

- Agricultural credit- Micro finance

3.2 Savings3.3 Insurances3.4 Safety net of MF4. Financial innovations



Regional intermediation

Sectoral intermediation

Social intermediation

Size transformation Time transformation

Information transformation

Risk transformation

Intermediation

Financial assettransformation

Financial DepthWidth of financial instruments

Diffusion Promotion of financial asset accumulation

Effects:Functions:

Increase in theefficiency of resource

allocation

Promotion offactor mobility

Provision of afinancial

infrastructure

Setting monetary policy

Enforcement of financialdiscipline in the

enterprise sector

Framework for structural adjustment

Economicstability

Form of Implication:

Major functions of theformal financial system

Source: Adapted from Geis (1975)






The traditional reason forformal agricultural credit

Traditional approach towards agricultural credit




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

Forward1. Rural financial system1.1 Formal1.2 Informal1.3 Formal vs. informal2. NIE in rural finance3. Financial services3.1 Credits



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 of individual contributions

50505050

50505050

50505050

50505050

200200200200

of contributions received by individual member

200 200 200 200

of net loan received by individual member

150 100 50 0






RoSCAs pros and cons

pros cons+ low cost

+ high repayment rates

+ need orientation

+ unbureaucratic, quickloan decision process

+ no collateral

+ mutual insurance system

- generally relatively short-term oriented

- cumulative credit need and no interregional inter-mediation (fragmentation)

Back






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




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






Informal vs. formal finance

Informal financial sector Formal financial sector

Advantages Disadvantages Disadvantages Advantages

• closeness toclients/members

• little bureaucracy

• flexibility

• low TCs

• short-term financialproducts

• savings eventuallyinsecure

• low, locally limitedcapital mobilization,fragmentation (social,

• sectoral, geograph)• Monopolistic supply

• little cost efficiency

• little closeness toclients

• political influencepossible

• bureaucraticprocedures

• monetarisation, i.e.systemic savingsmobilization

• economicdevelopment

• High volume andlong-term loanspossible






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)




Importance of TCs in Development(Micro)-finance



Arise beforethe transaction

Mostly related to searching for and

screening ofpotential trading

partners andobtaining price information

Arise duringthe transaction

Including costsof arranging the transactions,

physicallytransferring the

product orservice, anddrawing up contracts

Arise afterthe transaction

Including costsof monitoring the

terms of thetransaction and

enforcing liability

MFIs

Clients

Informationcosts

Negotiation costs

Enforcementcosts

Classification of TCs






average transaction cost per lent unit of money

averagecost per loan

small-scale-farmers medium-size-farmers large-scale-farmers

Selection of borrowerstowards bigger farmers/ wealthier clients

Back






• 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)

TCsMFIs HHs

Information cost

Relational contracts

Information asymmetry

• All relational contracts face information asymmetry

• Most of TCs are due to costs of acquiring information.






• 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 hazard 1. Rural financial system1.1 Formal1.2 Informal1.3 Formal vs. informal2. NIE in rural finance3. Financial services3.1 Credits



adverse selection moral hazard

ex-postex-ante

Tra

nsac

tion



Source: Buchenrieder, Heidhues, and Dung (2003)

Financialmarket

Credit Savings

Insurance

The product triangle of rural finance

Financialmarket

Credit Savings

Insurance


Vogel‘s (1984) forgotten half of microfinance in the 1980s

Financialmarket

Credit Savings

Insurance


Vogel‘s (1984) forgotten half of microfinance in the 1980s

Zeller et al. (1997) termed insurance as the forgotten third in the 1990s






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






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)






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)






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 andpolitical power

lower cost/larger loans

3. Non-market (non-price) rationing




Forward

Next



Misallocation of funds




i

i*

i**

i* = market interest ratei** = subsidized interest rate

Investments

Economic rent



Adverse employment effects




Lopt

Labor

CapitalCopt

Isoquant

Iso-cost-function



Adverse employment effects




Lopt

* = subsidized interest rate

Labor

CapitalCopt

Lopt*

Copt*

Back

Iso-cost-function*

Isoquant



S

D

i

Credit

i*

i**

S** D**i* = market interest ratei** = subsidized interest rateE* = equilibrium

E*

Effects of an imbalancein supply and demand

Back






Nominal and real rate of interest

10011

1

p

ir

Example: i=18%, p=12%

%36,5

100)10536,1(

100112,1

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:






“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 inagricultural lending






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




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%), andc) organizational efficiency (low hierarchies, de-

central decision making lower administrative costs)




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 RegionData source: Microbanking Bulletin (MBB) Issue 7

EFFICIENCYAdministrative 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).






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.ProblemUsually 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 designProblemCritics say, that with product targeting alone the very poor can not be reached

2. Outreach - How to reach the target group?






• 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






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. Rural financial system1.1 Formal1.2 Informal1.3 Formal vs. informal2. NIE in rural finance3.1 Credits





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






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






Reasons for households to save

1. Income smoothingSafeguards against uneven income streams due to seasonal variations

2. InsuranceProvisions against disability, disease, retirement, sudden income losses and other contingencies

3. Wealth accumulationFinancing household’s 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




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The need for income and consumption smoothing (Morduch, 1995)

Cash flow within the lunar year of anethnic 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

Mon

etar

y un

it

Back




ExpenditureIncome



Formal and informal savings

Formal savings




• 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 costsTCs incurred on transforming available surplus into a specific savings option or on liquidating it

2. LiquidityTime of liquidating the saving option in case of need

3. Real interest ratesRemunerations of the saving option

4. DivisibilityPossibility of parting of the savings in different sizes

5. SafetyHow secure are the savings stored?

6. Trustworthiness and confidence

7. Piggy bankLocking money away from relatives and friends

Decision parameters for choosing asaving option






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 depositor’s access to financial support from the social environment in times of scarce resources. Social cohesion as well as individuals’ safety nets may be disrupted






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 ofinformal 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 countrieswith crop insurance schemesBUT: 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 investmentinsurance to secure their portfolio






• 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 MFI‘s clients do not yet have access to flexible savings and credit, providing insurance may be premature.

Challenges of micro-insurance in MF






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!!!




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Next



4

‘ Saving down’

‘ Saving up’

‘ Saving through‘

Pay

-out

Pay

-inCash flows of different financial products

Source: Rutherford (2000)




Back



„The Schumpeterian qualification, that innovation must be cost reducing, separates change from innovation (Von Pischke 1995

p.121).“

Categories of financial innovations




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-financialsystem






• 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 thefinancial organization






• 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 adoptingproductivity increasing innovations.

Examples: Monitoring Software specifically for small-scale clientele

Simplification of used forms

Participatory marketing approach

(3) Innovations in organizing financialintermediation






• 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






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




Market research9.

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 inthe 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/


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 paradigmOld 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 agriculture1. 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-banksLending 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 gov’t.

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 practicesKnowledge 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/recommendations1. 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/recommendations4. 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 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 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 lectureLapenu, Cécile, 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.



FinancialMarket

Credit Savings

Insurance

Steps to select a topic for a seminar paper:1. Germans select a country (developing or transition) of their choice,

all others should take their home country2. You may select a rural financial service (see rural finance triangle) or an

FFI of the country3. Select the sector (formal or informal) and/or specific financial institution4. Discuss strengths and/or weaknesses of sector and/or financial institution5. Use the templates of the institute6. Not more then five pages (incl. tables, figures & references)

Assessment of strengths & weaknessesof selected rural finance issues:Implications for the future

Source: Buchenrieder, Heidhues, and Dung (2003)

If you have questions while preparing the seminar-papers you can contact me under:[email protected] can find me in the office of Dr. Gertrdu Buchenrieder.

Documents

Universität Hohenheim, Institut 490a 1 Rural Finance Prof. Dr. Manfred Zeller Prof. Dr. Franz Heidhues Thomas Dufhues