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The Economics of Microfinance.

The Economics of Microfinance By Beatriz Armendariz de Aghion and Jonathan Morduch. Cambridge, MA: The MIT Press, 2005. Pp. 352. $45.00.

The year was 1998: Professor Jonathan Morduch was visiting Princeton University and Professor Beatriz Armendariz de Aghion was visiting the Massachusetts Institute of Technology (MIT). Armendariz de Aghion had studied microfinance in Latin America (including founding Grameen Trust Chiapas in Mexico), and Morduch had researched microfinance in Bangladesh, Indonesia, and China. They both were concerned because their experiences in Asia and Latin America seemed to conflict with the theoretical literature. It was during this time that their common interest in microfinance prompted them to undertake a series of joint projects. One of these projects was to write the first draft of the initial chapters of a book entitled The Economics of Microfinance. Following this early start, it took quite a while--almost seven years--before the book was finished. In the meantime, there was an explosion of research on microfinance, greatly expanding the scope of the book. The popularity of microfinance as a poverty alleviation strategy also grew during this period, increasing the demand for published works on the topic. Sheer coincidence or not, both of these economists, as well as MIT Press, must have been very happy to be able to publish this book in 2005, the year the United Nations' designated as the International Year of Microcredit. The time was right to deliver this extensively researched, much-needed book.

The microfinance revolution, particularly the success stories of institutions like Grameen Bank in Bangladesh, Banco Sol in Bolivia, and Bank Rakyat in Indonesia, attracted several economists to study microfinance in the latter half of the 1990s. The authors themselves belonged to this group of enthusiastic people who were conducting both theoretical and empirical research on a topic that now forms an integral part of the new development strategies. However, for undergraduate and graduate students of economics, public policy, and development studies, there was a nagging problem--the plethora of mechanisms and institutions that fell under the label of microfinance were varied and complex, and there was no accessible source that presented all the material coherently. There were two excellent surveys of the literature--Ghatak and Guinnane (1999) and Morduch (1999)--but these were not exhaustive; in addition, many exciting new developments and innovations that subsequently occurred were not included. Moreover, attempts to translate various microfinance mechanisms from one country to another had repeatedly failed, and several theoretically promising mechanisms were ignored because practitioners were skeptical about implementing them. Therefore, even in the presence of several hundred research papers, students, researchers, and practitioners needed something more accessible and handy that provided a thorough understanding of the basic concepts, as well as extensive information about this growing development strategy. Without a doubt, Armendariz de Aghion and Morduch's The Economics of Microfinance is a one-of-a-kind book and fills this void admirably!

"Rethinking Banking," the introductory chapter of the book, is an overview. It begins by explaining the need for microfinance programs and whether such programs can be operated profitably. It is now well recognized that the development banks of the 1950s and 1960s were not very successful in helping the poor. Of course, given the myriad asymmetric information problems inherent in lending to the poor, formal credit institutions have shied away from providing credit to this group of borrowers, thereby setting the stage for microfinance. Early in this chapter, the authors distinguish between the words microcredit and microfinance. According to Armendariz de Aghion and Morduch, the notion of microcredit focuses on poverty reduction through loans and social change, while the newly coined term, microfinance, emphasizes the benefits to households of receiving a wider variety of financial services. These precise definitions are important, as they will help to reduce the extent to which both terms are misused. More importantly, by establishing this difference, the chapter makes abundantly clear the need for microfinance as a poverty-reduction strategy. It provides a cogent summary of the achievements and challenges of microfinance programs and forms the reference point for the ongoing debates in microfinance that are examined in subsequent chapters. Primarily, this chapter helps readers to understand how a simple but sound idea has led to fascinating new strategies that create a "win-win" situation for all.

In Chapter 2, the authors make a case for intervention in rural credit markets. It introduces readers to the basic toolbox of asymmetric information problems in the context of credit markets. Terms such as agency problems, limited liability, adverse selection, ex-ante moral hazard and ex-post moral hazard are explained. Without stressing technicalities (a consistent overall feature of the book), the authors use simplified versions of classic models to explain adverse selection and moral hazard problems associated with the credit markets. While these credit market imperfections can lead to higher interest rates, Armendariz de Aghion and Morduch make a vital point relating to microfinance. Higher interest rates cannot be the raison d'etre for intervention in credit markets--rather, microfinance has to be justified on grounds that it can provide a host of financial services at reasonable costs. The authors stress that although the interest rates cannot be too low, they cannot be too high either--there needs to be a happy medium.

Chapter 3 is a "back to the roots" chapter. It deals with the worldwide evolution of the two predecessors of joint liability lending--Credit Cooperatives and Rotating Savings and Credit Associations (ROSCAs). This chapter provides a detailed discussion of these two institutions, including their organizational structures, simple analytics, and basic mechanisms adopted, as well as their success and failure. This information enables the reader to grasp the significance of these two institutions for joint liability lending. ROSCAs are simple but limited mechanisms for generating savings. Credit cooperatives are more flexible arrangements for mobilizing local resources that demonstrate the benefits of peer monitoring. The authors cite recent evidence from Grameen credit cooperatives that highlights their role in promoting savings. They go on to suggest that the extraordinarily high repayment rates of group-lending programs may be socially suboptimal and may be the result of excessive peer monitoring.

Chapter 4 focuses on group lending, which is the most well-known form of microfinance. Using essential results from contract theory, Armendariz de Aghion and Morduch illustrate how imposing joint liability on the borrowers can alleviate adverse selection and moral hazard problems. The chapter intuitively explains how assortative matching emerges as the first-best outcome under group lending, and therefore is mutually beneficial to both the lender and the borrower. The authors also provide a survey of the recent empirical work on group lending. In the concluding section of this chapter, the authors discuss the limitations of conventional group-lending programs. They explain how hidden costs, collusion among borrowers, or the tension arising from conflict between results on paper and in reality can hinder the achievement of group-lending goals.

Chapter 5, which is appropriately titled, "Beyond Group Lending," discusses the relatively new lending mechanisms known as progressive lending or complementary information mechanisms. Inspired by its previous success, in 2001 the Grameen Bank launched a new program they christened the Grameen Generalized System (GSS) or Grameen Bank II. This second-generation idea is commercially more sophisticated and better equipped than its earlier lending program, now called the Grameen Classic System (GCS) or Grameen Bank I (Yunus 1999).

In this chapter, Armendariz de Aghion and Morduch systematically attempt to answer the question of whether group lending is really necessary or if there are other alternatives. They discuss a variety of second-generation microfinance institutions, including new techniques to secure repayment and improve the existing first-generation schemes. These techniques consist of measures such as smaller but more frequent repayment installments and replacing the joint-liability clause with a requirement of public repayment. One interesting approach that is becoming popular requires the microlenders to help borrowers acquire financial assets, which may be used as collateral later. Moreover, many of these new flexible approaches adopted by the second-generation lenders provide borrowers with a much-needed safe savings option. With the help of a simple theoretical model, the authors show that instituting a collateral requirement actually reduces the rate of default or debt burden.

Another interesting topic in this chapter is the role of dynamic incentives in new microfinance schemes. Armendariz de Aghion and Morduch analyze how, in terms of dynamic incentives, women who have access to relatively fewer sources of credit are more likely to repay their debts than men. Progressive lending schemes (loan size increases over time) and easy installments are important tools to attract female borrowers, as women are more concerned with household improvement, children's education and their health, than are male family members.

Chapter 6 concentrates on the activities responsible for the transition from microcredit to microfinance. The authors argue that, for the poor, neither the ability to save nor borrow is more important than the other. Instead, they are possibly complementary, with the prefix "micro" in front of both activities being the key. In fact, a holistic picture emerges only when we study both the saving and borrowing constraints. This chapter stresses that the poor need to have the ability to conduct small but frequent transactions of either type. The authors believe that low-income households have difficulty generating savings, and thus find it relatively expensive to accumulate capital as documented by Rutherford (2000). They attribute this problem to a lack of effective institutions. They claim that most new-generation microfinance programs have a predilection for microsavings for obvious reasons--mobilizing savings, acting as collateral, and providing loanable funds. They also discuss microinsurance, which is a growing movement that helps give low-income households accessibility to loans on fair terms. A typical microinsurance package may offer a variety of insurance methods, such as life, health, and property insurance--even rainfall insurance. The idea of providing life insurance at the grass roots level has been welcomed by people worldwide. However, this chapter points out that providing insurance at the microlevel is not an easy task, and that institutions that do so have to contend with numerous problems. Apart from the usual issues of adverse selection and moral hazard, the authors express concern about practical issues, such as the positive correlation between the loan size and the premium, and the limited duration of insurance coverage (it only lasts for the duration of a loan). Paying a large premium or remaining excluded from the program between loans may create tension and push borrowers toward risky situations. In spite of these problems, the authors believe that program diversification is a necessity.

Chapter 7 deals with issues of gender empowerment, emphasizing that women are the agents of change in the household. The chapter lists numerous reasons why microfinance should target women. Given that most women are credit constrained, they tend to have a conservative attitude in their investment strategies, thus improving their chances of success. Women are more concerned about children's health and education, making them the ideal borrowers to have an impact on poverty. Another reason for focusing on women is gender empowerment, as women in developing countries face great social, legal, and economic obstacles. This chapter asks the question of whether or not microfinance enhances the bargaining power of women. To address this issue, the authors briefly introduce the theory of intra-household decision-making in the tradition of Becker (1981). This model suggests that the credible threat of leaving the household determines bargaining power in the house. Even after accounting for the fact that, because of their limited access to inputs, supplies, and marketing facilities, women must rely on male family members, the authors argue that it might be a better policy to have women as direct customers of the microlending institutions. The authors then use studies from Africa, Latin America, and Asia to justify favoring women in microfinance schemes. Another fact that emerges from these empirical studies is that although women's empowerment can be achieved through microfinance, the program design needs to take this specific objective into consideration. An important caveat is that such gender-driven social goals might be in conflict with financial sustainability. The authors conclude by stating that there are a number of interesting questions on the relationship between gender and microfinance that are open to debate and deserve further study, in particular, its impact on education, skill acquisition, and access to the formal sector.

The discussion in Chapter 8 is empirically oriented. Using longitudinal data from India, Peru, and Zimbabwe, and cross-sectional data from Bangladesh, the authors evaluate the performance of different microfinance programs. According to Armendariz de Aghion and Morduch, the main challenge in evaluation is due to selection bias--not every individual in an economy has access to microcredit. Microfinance institutions choose their operating region and clients. In order to do a proper evaluation, relevant characteristics such as age, gender, education, social status, and the profession of the borrower must be taken into consideration. Good infrastructure in chosen areas may also lead to upwardly biased estimates. The authors suggest a variety of approaches to address the selection problem. They cite Coleman's (1999) approach, which uses information on borrowers before the microfinance program arrives. One potential problem with Coleman's approach is that the researcher seldom gets a chance to evaluate a program where the concerned authorities have taken the trouble to organize all of the villagers. Consequently, using cross-sectional data, researchers often end up doing a comparison of "old borrowers" with "new borrowers" within the same area. Karlan's study in Peru (2001) is an example of this. The drawback of this approach is "attrition bias," i.e., the exit of unsuccessful agents. The authors also discuss using an instrumental variable to approach the problem in a different way. As measurement errors, reverse causality, and omitted variable bias are common problems in this area of research, the authors believe finding a good instrument may ease the pain. One such instrument possibly could be the interest rate, as it is not a direct determinant of income, but explains the need for a specific credit volume. Though the authors are concerned with these biases (selection, attrition, omitted variables), they also criticize the pessimistic attitude of some observers. In conclusion, the authors advocate simple and credible impact studies like Coleman's 1999 study in Northeast Thailand over complicated ones.

Chapters 9 and 10, which are entitled "Subsidy and Sustainability," and "Managing Microfinance," respectively, cover important policy issues and will be of great help to practioners. Most microfinance programs rely on domestic and foreign subsidies to a varying extent, which has been the subject of a fair amount of criticism. Morduch (1999) pointed out the overdependence of microfinance programs on subsidies as one of their major limitations. Chapter 9 explores the advantages and disadvantages of subsidy dependence in great detail. Critics often point to ASA Bangladesh as the success story for the "no subsidies" case. Detailed studies from Bangladesh (Grameen Bank) and Thailand (Bank for Agriculture and Agricultural Cooperatives), among others, show that even though substantial subsidies are required to support these programs, such support is indeed a good social investment. However, after acknowledging the fact that subsidies may be a good investment, the authors express their concerns regarding three issues--proper channeling and usage of the subsidy, leading to the need for smart subsidies; reliance on subsidies limiting the scale of operations, affecting poverty eradication; and the emergence of "induced innovations" that may outweigh the gains from the subsidy. This last term, which was coined by Danish economist Esther Boserup, refers to subsidies replacing innovations that help in achieving financial sustainability.

Chapter 10 is a lesson in microfinance management. The authors analyze common but important problems arising from multiple-objective issues, such as poverty reduction versus profitability, or high-powered versus low-powered incentives or team incentives. (Bonus schemes are considered as high-powered incentives, whereas low-powered incentives are basic combinations of fixed wages and rewards, such as promotion.) These problems have been examined in the framework of principal-agent models and incentive theory. The authors provide a systematic way of looking at incentive problems and discuss the pros and cons of each type of scheme. They recommend that when creating optimal incentive structures, it is crucial to not only be concerned with risk, loan volume or quality, but also with improved teamwork, pursuing a balanced mix of short-term versus long-term objectives, discouraging fraud, and creating and maintaining an organizational culture within the microfinance institutions.

An interesting feature of the book is the inclusion of analytical and mathematical problems at the end of each chapter. This makes it handy for teaching an advanced undergraduate course, or a graduate course in development economics. Another attractive feature for graduate students is that, throughout the book, a number of open research questions are identified. However, while the book is reasonably comprehensive, the authors have ignored a few important contemporary topics in the microfinance literature. For example, most countries now have competing microfinance providers. The book fails to address such competition and its social impact. Other contract theory topics like auditing and enforcement, advantages and disadvantages of simultaneous versus sequential group lending, and risk heterogeneity among borrowers are either missing or have not been dealt with adequately. This last topic, for instance, is an important design issue that would be of great help to practitioners. Of course, the replacement of such technical material with more intuitive explanations does make the book more accessible. Other aspects of microfinance that have been overlooked are the free-tiding tendency that arises from the group liability structure and predicted patterns of risk-taking and risk-sharing due to identical group liability. The authors could also have mentioned recent experimental field and lab work on group-based mechanisms. In conclusion, The Economics of Microfinance is a splendid book that will be invaluable for helping academicians and practitioners understand the pros and cons of many aspects of microfinance.

Additional suggested readings for each chapter:

(I) Rethinking Banking: (1) Stiglitz, J. 1990. World Bank Econ. Rev., (2) Yunus, M. 1999. Public Affairs, (3) Khandekar, S. R. 1998. OUP, (4) Armendariz de Aghion, B. 1999. Jour. of Dev. Econ. (II) Why Intervene in Credit Markets: (1) Paulson, A. and Townsend, R. 2001 Working Paper, University of Chicago, (2) Adamas, D. W., Douglas, H. G., and Pischke, D. J. 1984. West View Press, (3) Fuentes, G. 1996. Jour. of Dev. Stud. (III) ROSCAs and Credit Cooperatives: (1) Banerjee, A., Besley, T., and Guinnane, T. 1994. QJE, (2) Gugerty, M. K. 2003. Manuscript, University of Washington, (3) Besley, T., Coate, S., and Loury, G. 1993. AER. (IV) Group Lending: (1) Ghatak, M., and Guinnane, T. 1999. Jour. of Dev. Econ., (2) Laffont, J., and Rey, P. 2003. Draft, IDEI Toulouse and University of Southern California, (3) Rai, A., and Sjostrom, T. 2004. Rev. of Econ. Stud. (V) Beyond Group Lending: (1) McIntosh, C., and Wydick, B. 2005. Jour. of Dev. Econ. (2) Khandekar, S. R., Khalily, B., and Kahn, Z. 1995. Worm Bank DP 306, (3) Rutherford, S. 2000. OUP. (VI) Savings and Insurance: (1) Deaton, A. 1992. Clarendon Press, (2) Richardson, D. 2003. Microbanking Bull., (3) Cohen, M., and Sebstad, J. 2003. MicroSave Africa Report. (VII) Gender: (1) Udry, C. 1996. JPE, (2) Keavane, M., and Wydick, B. 2001. Worm Dev., (3) Goetz, A. M., and Sengupta, R. 1996. WorldDev. (VIII) Measuring Impacts: (1) McKeman, S. M. 2002. Rev. of Econ. and Star., (2) Coleman, B. 1999. Jour. of Dev. Econ., (3) Karlan, D. 2001. Jour. of Microfinance. (IX) Subsidy and Sustainability: (1) Townsend, R., and Yaron, J. 2001. Econ Perspectives, (2) Morduch, J. 1999. Jour. of Dev. Econ., (3) Matin, I., and Hulme, D. 2003. Worm Dev. (X) Managing Microfinance: (1) Hart, O., and Moore, J. 1998. Working Paper no. 1816, Harvard Institute of Economic Research, (2) Drake, D., and Rhyne, E. 2002. Kumarian Press, (3) Bazoberry, E. 2001. Microbanking Bull.

(XI) Some other interesting papers: (1) Roy Chowdhury, P. 2005. Jour. of Dev. Econ. (sequential lending), (2) Jain, S. and Mansuri, G. 2004. Working Paper, University of Virginia. (competing providers), (3) Abbink, K., Irlenbusch, B. and Renner, E. 2003. CeDEX WP 2003-7, University of Nottingham. (lab experiment), (4) Xavier, G., Jakiela, P., Karlan, D. and Morduch, J. 2005. Mimeo, University of Groningen, (field experiment) (5) Aniket, K. 2005. Working Paper, University of Edinburgh (savings and microfinance), (6) Ahlin, C. and Townsend, R. 2004, 2005. Working Paper, Vanderbilt University (various empirical aspects).


Becker, G. 1981. A treatise on the family. Cambridge, MA: Harvard University Press.

Coleman, B. 1999. The impact of group lending in northeast Thailand. Journal of Development Economics 60:105-42.

Ghatak, M., T. Guinnane. 1999. The economics of lending with joint liability: Theory and practice. Journal of Development Economics 60:195-228.

Karlan, D. 2001. Microfinance impact assessments: The perils of using new members as a control group. Journal of Microfinance 3:76-85.

Morduch, J. 1999. The role of subsidies in microfinance: Evidence from the Grameen Bank. Journal of Development Economics 60:229-48.

Rutherford, S. 2000. The poor and their money. New Delhi, India: Oxford University Press.

Yunus, M. 1999. Banker to the poor. New York: Public Affairs.

Prabirendra Chatterjee

University of Washington

Sudipta Sarangi

Louisiana State University
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Author:Sarangi, Sudipta
Publication:Southern Economic Journal
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Date:Jul 1, 2006
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