Why we need microcredit banks
"Financial inclusion" has been a buzzword in Bangladesh for many years. It has been used to justify the increase in the number of banks in the country, as many—primarily the poor—still do not have bank accounts.
At present, there are 62 banks in Bangladesh. Despite the large number of banks, only 28.3 percent of people have bank accounts, according to the Bangladesh Sample Vital Statistics. This is indeed a paradox. Although state-owned banks operate both in rural and urban areas along with a handful of private banks, the poor have less access to them. Foreign banks do not operate in rural areas, let alone offer any services at all to the poor.
For all latest news, follow The Daily Star's Google News channel. Besides, the rural poor are less interested in maintaining bank accounts and the urban poor keep their money in semi-formal and informal repositories. Nevertheless, it is impossible to create a fair banking system by keeping these people outside the banking network. Hence, banks should customise their services to the needs of the poor, instead of just offering priority services to large depositors.
Historically, banks used to collect short-term deposits to provide short-term loans. Over time, they shifted their preference to long-term and large loans, creating a maturity mismatch problem, where deposits mature earlier than the loans. As a result, banks now have to maintain high liquidity to allow assets (loans) to be converted into cash easily to meet the liability (deposit) withdrawal. A sudden surge in deposit withdrawal may leave banks in a position to liquidate assets at very low prices. Also, large loans are always a threat to bank sustainability because the failure of some large loans can eat up the total capital of a bank.
Conventional banks fail to reach the poor as their lending approach is inappropriate. They sanction loans with collateral, but the poor rarely have any assets to provide as collateral. The banks also follow some defined criteria for lending, which most of the poor fail to comply. They prefer large loans to minimise transaction costs, including loan origination fees, application fees, legal fees, etc. But the poor demand small loans, which these banks avoid as their transaction costs are high.
Also, the cost of monitoring numerous small borrowers is high for traditional banks because rural poor live in remote areas and urban poor are mobile and lack permanent addresses. As the poor belong to a deficit group, it reduces the probability of loan repayment. The poor also often use loans in unproductive sectors. Hence, lending to the poor following traditional methods is risky.
Conventional banks also face the problem of asymmetric information—a situation where one party has more information than the other—while selecting poor borrowers. The poor often lack a formal credit history, which may lead to adverse selection—selecting the wrong borrowers at the cost of the right ones. If the wrong borrowers are selected, they tend to divert loans to unproductive sectors, leading to moral hazard. Therefore, banks prefer collateral-backed lending to the poor.
Moneylenders provide loans to the poor without collateral in the informal credit market. As they live in the same community, they possess vast knowledge about potential borrowers. As a result, they can select the right borrowers for lending. But a limited number of professional moneylenders with inadequate funds cannot reach all the poor. Moreover, their interest rates are abnormally high.
In this setting, microfinance institutions (MFIs) have been able to grant collateral-free loans to the poor, reducing the asymmetric information problem through self-selected groups and joint liability. They leave the responsibility of borrower selection to the poor. In the microcredit system, generally, a group of five members is formed. Although a loan is sanctioned to a borrower, all members of the group remain liable for its repayment. If the loan is not repaid, other members will not be granted any new loans. So, every member has an incentive to monitor the loan performance. They ensure that the loan is appropriately used and repaid on time. This motivates poor households to select those people for the group who tend to be honest. Living in a well-connected society, the poor have comprehensive information about each other's financial discipline.
The provision of collateral-free loans is important to the poor, and this feature makes microcredit superior to other credit. MFIs do not require borrowers' formal credit history; the loan application process is simple; the cost of information search and loan monitoring is transferred to groups; and there is proximity between borrowers and lenders. So, the transaction costs become low.
However, microcredit ceased to be a panacea as it has some limitations. In the microcredit arrangement, members need to form groups, attend weekly meetings, and go through formal training. They have to make some compulsory savings. MFIs operate mainly in rural areas and their presence in urban areas is very narrow; they mainly target women; some charge high interest rates; they fail to target the ultra-poor; and their funds are not enough to cover all the poor. Thus, many poor find microcredit unfit for their needs.
Even though traditional banks do not mind receiving deposits from the poor, they have reservations about granting them loans. The current banking system transfers the funds of the poor to the rich and creates a financial inequality between the rich and the poor. So, a banking system that will reinvest deposits from disadvantaged communities back into those communities is needed. This can be done by microcredit banks to a large extent.
Microcredit banks will provide financial services to low-income individuals, who are usually excluded from traditional banking systems. Their main objective should be to fight poverty by increasing the financial inclusion of underserved communities. They will essentially grant short-term and small loans without collateral at reasonable interest rates. Their loan application process will be simple, and loans will be sanctioned within a short time. They will create a congenial financial environment for rural and urban poor, which will contribute to the growth of small businesses, leading to sustainable development. The poor will find a dedicated banking system for them. With its help, they will come out of the debt-trap, taking new loans to repay the old ones, leading to growing indebtedness. Eventually, this new institution will help the poor come out of poverty.
Furthermore, conventional banks offering small loans will face competition from microcredit banks. The presence of usurious moneylenders will come down. Some MFIs will be compelled to rationalise their interest rates. By maintaining an acceptable level of maturity mismatch between deposits and loans, microcredit banks will face less liquidity risk, which is a principal source of bank failure. This will ensure a viable banking system by protecting deposits and promoting public confidence. The emergence of microcredit banks will highlight the failure of our prevailing financial system to reach the poor, and show the conventional banks how they missed a big business opportunity by ignoring a large section of consumers.
Dr Md Main Uddin is professor and former chairman of the Department of Banking and Insurance at the University of Dhaka. He can be reached at mainuddin@du.ac.bd.
Views expressed in this article are the author's own.
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