Rural Finance

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

2. Structure of the lecture 1. 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 Universität Hohenheim, Institut 490a

3. The rural financial subsystem Rural infra-structure Agricultural sector Extension system Off-farm activities Government, Central Bank Insured party Financial market policy Monetary policy Trade policy Exchange rate relations Financial intermediaries Formal Semi-formal Informal Saver Borrower 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Rural financial market Source: Adapted from Buchenrieder, Heidhues, and Dung (2000) Universität Hohenheim, Institut 490a

4. Functions: Form of Implication: Effects: Regional intermediation Increase in theefficiency of resourceallocation Promotion offactor mobility Intermediation Financial assettransformation Sectoral intermediation Social intermediation Size transformation Time transformation Information transformation Risk transformation Diffusion Financial DepthWidth of financial instruments Promotion of financial asset accumulation Provision of afinancialinfrastructure Setting monetary policy Economicstability Enforcement of financialdiscipline in theenterprise sector Framework for structural adjustment Major functions of theformal financial system 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Source: Adapted from Geis (1975) Universität Hohenheim, Institut 490a

5. Vicious cycle of capital formation - A descending spiral - Y  Y = Yield/income S = Savings I = Investment P = Productivity S  P  I  Traditional approach towards agricultural credit Source: Heidhues and Schrieder (1999) The traditional reason forformal agricultural credit 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

6. } Profit segment = outside moral community } • Family members or friends • ROSCAS • Traditional money lenders • Deposit collectors • Pawnbrokers • Landlords, employers •  Interlinked contracts Non-profit segment = “moral community” Forward Formal financial intermediaries (FFI)? Next Definition of formal finance: • All intermediaries under control of the central bank • Usually all banks and institutions which are collecting savings Semiformal = village banks, solidarity and self-help groups promoted by NGOs Informal sector: 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

7. RoSCA members and their contribution A B C D  of individual contributions 50 50 50 50 50 50 50 50 50 50 50 50 50 50 50 50 200 200 200 200  of contributions received by individual member 200 200 200 200  of net loan received by individual member 150 100 50 0 Rotating savings & credit associations(RoSCAs): 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Note: All RoSCA members contribute the same amount at their periodic group meeting (Four members: A, B, C and D) Universität Hohenheim, Institut 490a

8. RoSCAs pros and cons Back 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

9. 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. Lenders assess … credit worthiness(3 essential Cs) 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Capacity to repay Character Collateral Physical and financial capital Human and social capital Credit history Personal background Return on invest-ment Income Debt / Expenditures Universität Hohenheim, Institut 490a

10. For the creditinstitution 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 Cost of credit extension 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

11. closeness toclients/members • short-term financialproducts • little cost efficiency • monetarisation, i.e.systemic savingsmobilization • little closeness toclients • little bureaucracy • savings eventuallyinsecure • economicdevelopment • political influencepossible • flexibility • low, locally limitedcapital mobilization,fragmentation (social, • sectoral, geograph) • Monopolistic supply • low TCs • High volume andlong-term loanspossible • bureaucraticprocedures Informal vs. formal finance Informal financial sector Formal financial sector Advantages Disadvantages Disadvantages Advantages 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

12. 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) Importance of TCs in Development(Micro)-finance 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations • 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) Universität Hohenheim, Institut 490a

13. Classification of TCs Arise beforethe transaction Mostly related to searching for andscreening of potential tradingpartners and obtaining price information Arise duringthe transaction Including costs of arranging the transactions,physicallytransferring theproduct orservice, anddrawing up contracts Arise afterthe transaction Including costs of monitoring theterms of thetransaction andenforcing liability Informationcosts Negotiation costs Enforcementcosts MFIs 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Clients Universität Hohenheim, Institut 490a

14. Selection of borrowerstowards bigger farmers/ wealthier clients Back average transaction cost per lent unit of money averagecost per loan 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations small-scale-farmers medium-size-farmers large-scale-farmers Universität Hohenheim, Institut 490a

15. MFIs TCs HHs Information cost Relational contracts • 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 Information asymmetry • 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) 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations • All relational contracts face information asymmetry • Most of TCs are due to costs of acquiring information. Universität Hohenheim, Institut 490a

16. Transaction ex-ante ex-post adverse selection moral hazard Information asymmetry  adverse selection and moral hazard • 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. Moral hazard 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations • 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. Universität Hohenheim, Institut 490a

17. The product triangle of rural finance The product triangle of rural finance The product triangle of rural finance Credit Credit Credit Savings Savings Savings Vogel‘s (1984)forgotten half of microfinancein the 1980s Vogel‘s (1984)forgotten half of microfinancein the 1980s Financial Financial Financial market market market Insurance Insurance Insurance Zeller et al. (1997) termed insurance as the forgotten third in the 1990s 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Source: Buchenrieder, Heidhues, and Dung (2003) Universität Hohenheim, Institut 490a

18. The efficiency of informal finance 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. 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

19. Key features of the traditional agricultural credit supply • External (to the rural sector) financing by government and external donors • (Short-term) production credit (supervised credit, credit targeted to certain crops/animal husbandry activities) • Strong focus on (production) credit; no savings mobilization, no insurance or insurance substitutes • Subsidized credit (low interest rate) providing opportunities for seeking rents that tend to be captured by the wealthy/powerful • Collateral to overcome information asymmetry (systematically screening out the poor) • Policy of “Give and forgive” (Zeller et al., 1997) 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

20. 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. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

21. Effects of low interest rate policy Next • Weakening of rural finance institutions • Adverse allocation effects Forward 3. Non-market (non-price) rationing lower cost/larger loans economic andpolitical power 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations 4. Distribution effect, regressive 5. Low savings interest rate(often negative, below inflation) Universität Hohenheim, Institut 490a

22. Misallocation of funds i i* Economic rent i** 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Investments i* = market interest rate i** = subsidized interest rate Universität Hohenheim, Institut 490a

23. Adverse employment effects Labor Isoquant Lopt 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Iso-cost-function Copt Capital Universität Hohenheim, Institut 490a

24. Lopt* Copt* Adverse employment effects Back Labor Isoquant Lopt 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Iso-cost-function* Copt Capital * = subsidized interest rate Universität Hohenheim, Institut 490a

25. Effects of an imbalancein supply and demand Back i S i* i** D 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations S** E* D** Credit i* = market interest rate i** = subsidized interest rate E* = equilibrium Universität Hohenheim, Institut 490a

26. Nominal and real rate of interest 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: Example: i=18%, p=12% 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

27. Reasons for high costs inagricultural lending “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” • Riskier because of relatively undiversified loan portfolio, mainly agriculture • Riskier because of the productive risk of agriculture, droughts, floods, diseases etc. • Usually thinly populated areas with bad infrastructure • Small amounts of loans are required • Vulnerable clientele (smallholders often poor, women play major role in farming systems) • See Zeller, 2003 (paper on rural finance institutions for D.C. conference) 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

28. The new approach to rural finance- The microfinance revolution - Next • 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 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Forward Forward Universität Hohenheim, Institut 490a

29. 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%), and c) organizational efficiency (low hierarchies, de- central decision making  lower administrative costs) 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations BUT:For the few sustainable MFIs, see Microbanking Bulletin Universität Hohenheim, Institut 490a

30. Benchmarking EFFICIENCY Administrative Expense Ratio • 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 Region Data source: Microbanking Bulletin (MBB) Issue 7

31. 2. Outreach 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). • 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 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

32. 2. Outreach - How to reach the target group? • 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 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 design • Problem • Critics say, that with product targeting alone the very poor can not be reached 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

33. 2. Outreach vs. Sustainability Back • 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 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

34. 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 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 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

35. 5. Collateral • 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. 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

36. 5. Collateral Back • 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 • 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. 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

37. Reasons for householdsto save Next • Income smoothingSafeguards against uneven income streams due to seasonal variations • InsuranceProvisions against disability, disease, retirement, sudden income losses and other contingencies • Wealth accumulationFinancing household’s long-term goals (social and religious purposes, heritage, consumer durable) • Future investments • Financial reciprocity or social reciprocityThe possibility of using savings to gain access to credit or other services Forward 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

38. Income Expenditure The need for income and consumption smoothing (Morduch, 1995) Cash flow within the lunar year of an ethnic minority in Northern Vietnam Back 6 5 4 3 Monetary unit 2 1 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations 0 1 2 3 4 5 6 7 8 9 10 11 12 Lunar month Universität Hohenheim, Institut 490a

39. 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. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

40. Decision parameters for choosing asaving option • Transaction costsTCs incurred on transforming available surplus into a specific savings option or on liquidating it • LiquidityTime of liquidating the saving option in case of need • Real interest ratesRemunerations of the saving option • DivisibilityPossibility of parting of the savings in different sizes • SafetyHow secure are the savings stored? • Trustworthiness and confidence • Piggy bankLocking money away from relatives and friends 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

41. 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 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

42. 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 investmentinsuranceto secure their portfolio 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

43. Challenges of micro-insurance in MF • 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. 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

44. The safety net role of microfinance? Next • 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!!! Forward 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

45. Cash flows of different financial products Back 4 ‘ Saving up ’ out ‘ Saving through - ‘ Pay ‘ Saving down ’ 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations in - Pay Source: Rutherford (2000) Universität Hohenheim, Institut 490a

46.  Categories of financial innovations „The Schumpeterian qualification, that innovation must be cost reducing, separates change from innovation (Von Pischke 1995 p.121).“ • Innovations in the macro-financial system • Innovations at the level of the financial intermediary • Innovations in organizing financial intermediation • Financial product innovations 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

47. (1)Innovations in the macro-financialsystem • 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 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations  Innovations in the macro-financial system allowed NGOs to take up financial intermediation activities in many countries which was illegal before Universität Hohenheim, Institut 490a

48. (2)Innovations at the level of thefinancial organization • 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 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

49. (3) Innovations in organizing financialintermediation • 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 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Universität Hohenheim, Institut 490a

50. (4)Financial product innovations • 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 1. Rural financial system 1.1 Formal 1.2 Informal 1.3 Formal vs. informal 2. NIE in rural finance 3. Financial services 3.1 Credits - Agricultural credit - Micro finance 3.2 Savings 3.3 Insurances 3.4 Safety net of MF 4. Financial innovations Rural Credit Project of the Bangladesh Rural Advancement Committee (BRAC) offers life insurance policies Universität Hohenheim, Institut 490a