University of Massachusetts at Amherst
Department of Economics, Due to Dec 12th
ECON 765 Economic Development

Microfinance in Latin America

by: Lion Hirth

1) Introduction

2) Roots and History of Microfinance

a) Informal Financial Sector
b) Credit Cooperatives
c) National Development Banks
d) Modern Microfinance

3) Banking Theory and Microfinance’s response

a) Group Lending
b) Dynamic Incentives
c) Collateral Substitutes
d) Repayment Schedules and Saving
e) Other technologies

4) Microfinance in Latin America

a) Institutional Overview
b) Commercialization
c) Village Banking
d) Do commercial MFIs help the poor?

5) Concluding Remarks

6) Tables

7) References

1) Introduction

Rewarding the Nobel Peace Prize to Muhammad Yunus, the committee acknowledged that microfinance is the latest fashion of both development policy and development economics, some call it even a “popular mass movement” (Woller et al. 1998). Indeed, the development over the last 30 years is impressive: Today, more than 100 million poor have access to small loans. While the formal financial sector perceived financial services to the poor “unimportant for the economy, unprofitable for financial institutions, and unnecessary for the poor”, modern microfinance institutions (MFIs)¹ have proven that high recovery rates do not depend mainly on circumstances and the characteristics of the borrower, but on the design of the credit program: “repayment depends fundamentally on factors within the control of the lending institutions” (Robinson 2001).
This paper gives a short overview about the roots of modern microfinance and its global history. Some central theoretical aspects of financial markets are discussed and the main innovations of modern microfinance are presented. Focusing on Latin America, the paper shows that microfinance is booming on the continent. While Village Banks, focused on the poor, are still growing, a larger trend goes towards commercialization, including the entrance of established banks to the market. It seems quite clear that these banks reach even less of the poorest than not for profit NGOs do. More disturbing, there is little empirical evidence that microfinance can help many poor people in Latin America. The role of microfinance in the overall development progress is small at best.

2) Roots and History of Microfinance

What today is called „microfinance“ began in the 1970s, but is based on earlier experiences. The most important are (a) informal financial institutions, (b) credit cooperatives, and (c) development banks.

a) Informal Financial Sector

Of course, informal financial institutions are a lot older than any formal bank or insurance system and they are indeed the ancestors of today’s formalized institutions. Still today, informal institutions are the main providers of financial services for the world’s poor. The most important institutions are (a) the family, (b) ROSCAs, (c) money lenders, and (d) credit cooperatives. Rotating Savings and Credit Associations (ROSCAs) are an institution to finance larger lumpsum investments or consumption expenditures. Several people form a group and everyone pays a little amount every time period and every time another single member gets all the contributions. Cleary, there are little incentives to keep paying after having received the disbursement. Further, this model is highly inflexible and it is purely redistributive: there is no possibility for saving or credit for the group as a whole.
Moneylenders are specialised money lenders or landlords, large farmers, or shopkeepers. In rural areas they have often de facto a monopoly, and they charge always very high interest rates. Marguerite Robinson (2001) gives estimates of 5% interest per day or 30% per month, which is 56.000.000 % and 2300% p.a., respectively. Beside of being very expensive moneylenders are a bad institution for saving since they are unregulated. Further, credit from moneylenders is normally not used for productive investments, but for emergency consumption needs (Nourse 2001).

b) Credit Cooperatives

Credit cooperatives or credit unions were developed in Germany in the 1850s and spread fast over the country and later over the world. They were based on many of the same assumptions today’s microfinance is based on. Most important: Poor need credit, but are excluded by the established banking system. Also, they used much of the same lending methodology, e.g. progressive lending, forced savings and primitive group lending (mutual guarantors). Most of the credits were very long-term and used for agricultural investments. In 1914 more than 19.000 Genossenschaftsbanken supplied 8% of the German credit. Today the Genossenschaftsbank founded by Frederick Raiffeisen in 1849 is one of the largest credit and saving banks of Germany. Interestingly, the connection to modern micro banking is closer than most people know: In the late 19th century there was a huge wave of credit unions in Ireland, and soon the British exported the concept to India. In 1946, credit cooperatives in India had already nine million members. So only few decades before Muhammad Yunus invented the Grameen Bank, a somewhat old fashioned form of “microfinance” was already established in Bangladesh (Ghatak & Guinnane 1999 and Murdoch 1999).
Many credit cooperatives and credit unions in Latin America were founded in the 1950s and 60s, often by catholic priests, US Peace Corps and USAID. The Confederación Latinoamericana de Cooperativas de Ahorro y Crédito (COLAC) was founded in 1970. Cooperatives do not use external sources of financing, but lend the savings of its members. They act manly locally and are managed by their own members. Although everyone agrees that credit cooperative play an important role in Latin American financial markets, actual figures vary enormously. Bicciato et al. (2002) report that in 1998 credit cooperatives in Latin America had a loan portfolio of $5bn and estimate that they provided 80% of all financial services on the continent.² Ramírez (2004) reports 1.5m clients of credit unions in 2001 throughout Latin America and a total credit portfolio of $1.6bn, which are roughly the same numbers as for MFIs in the same year.

c) National Development Banks

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1 I use the term microfinance institutions in the broadest sense, including NGOs, village banks, financial companies and regulated banks – every formal institution that offers financial services to people with low-income.

2 $5bn is about the amount of outstanding credit of all MFIs in Latin America in 2005 and ten times more as the largest global MFI in 1998 – The Grameen Bank – had at this point of time. But I doubt that they number of services provided is anything close to 80% and I can hardly believe that the aggregate portfolio was $5bn.