Debunking Myths about the Poor and Financial Services
By Suyash Rai and Sona Varma
The Wall Street Journal
Friday, September 4, 2009
The power of finance to transform the lives of the poor is not well understood. Despite recent articles that raise concerns about microfinance, the evidence at large shows that successful microfinance institutions (and their list is growing) have managed to implement service delivery mechanisms that meet the needs of the poor, at a lower cost than most accessible alternatives. The work of these institutions, and a number of well-researched reports, shed light on the economic lives of the poor and the way the poor manage their finances.* These reports use detailed surveys, interviews and robust analytical techniques to improve our understanding of the impact of financial services on poverty.
Drawing on this body of evidence helps counter a number of popularly held misconceptions about role of finance in the lives of the poor. The following noteworthy misconceptions are worth highlighting:
The poor are not creditworthy: The recent financial crisis has given a bad name to 'sub-prime' borrowers in general, and often the terms 'poor' and 'sub-prime' are used interchangeably and equated with 'lack of creditworthiness'. As research on the crisis is pouring in, we are learning that the real causes probably had more to do with the mechanisms of service provision and inadequate regulation. Moreover, the micro credit experience of the last three decades decisively challenges this perception, showing that if suitable mechanisms are used, the poor can be as creditworthy as the rich. The poor's lack of collateral can be overcome with joint liability within a group of borrowers, and this has resulted in very high repayment rates in micro credit over the last three decades. Micro finance institutions have consistently reported repayments upwards of 95% in a number of developing countries.
Finance falls lower in the 'hierarchy' of needs for the poor, below health, education etc: Finance should ideally fall out of any such hierarchical ordering of 'inputs' into a household, because it is a cross-cutting tool that helps households' wellbeing across several dimensions. For example, even someone living just on government support can benefit from a sound payment system that ensures timely delivery of cash or a savings facility that provides a safe option to save. Empirical research shows that the poor use many financial instruments frequently, but due to absence and unsuitability of formal mechanisms, they have to rely mainly on unreliable informal service providers.
Credit is the only financial service required by the poor: Most people equate financial service provision with the provision of credit. Studies clearly show that the poor need a range of services such as a) risk mitigation mechanisms, for example insurance, to protect against exogenous shocks; b) savings facilities to smooth consumption and get reasonable returns even on small amounts; and c) investment/risk management mechanisms that allow for wealth creation and diversification of risk. A number of successful initiatives, such as those providing micro insurance or small ticket investments in mutual funds, re-affirm the hypothesis that the poor demand and can benefit from the same wide range of financial services that are routinely provided for the rich.
The poor are not sophisticated in using financial services, so access to finance may end up damaging their livelihoods: On the contrary, research on the use of financial services by the poor shows that given the complexity in their financial lives, the poor are very sophisticated in their use of financial instruments. Due to the absence of well-designed formal services, they end up creating a complex mesh of informal financial mechanisms around their lives. It seems this is the only way they can meet multiple needs using informal instruments. For example, financial diaries of the poor show how they creatively use a variety of loan sources to deal with the irregularity in their incomes and expenditures. Research also shows quite convincingly that on an average the chronic poor, i.e. those who fail to move out of poverty, do take initiatives to change their conditions. Failure to move out of poverty is primarily because of lack of access to capital and relevant networks. The recent evaluation of a micro credit program in India shows how entrepreneurial households consistently use credit to start successful new businesses or improve the profitability of existing businesses.
Finance can help poor households optimize severely constrained resources across their lifetime. Like the rich, the poor also need to use finance responsibly to ensure that they avoid over-indebtedness and other problematic outcomes. Similarly, financial service providers need to focus on reducing delivery costs while ensuring high quality services that reflect a good understanding of client needs. This often ups the ante in terms of the work that goes into offering a useful suite of financial services for the poor. But the rewards can be immense.
* A report by the World Bank titled "Moving out of Poverty" presents results of research on the processes of falling into and coming out of poverty. Similarly, "Portfolios of the Poor: How the world's poor live on $2 a day", a book by leading researchers in the area of access to finance, presents analysis of households' financial behaviors in three developing countries, documented using rigorous methodologies. A recent paper from researchers at MIT presents the results of evaluation of a microfinance operation in Hyderabad, India, the first ever randomised evaluation of micro credit