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Lecture 10

ECON 30801 Lecture Notes - Lecture 10: Microfinance, Moneylender, Small Business


Department
Economics
Course Code
ECON 30801
Professor
Donovan
Lecture
10

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MICROFINANCE
I. Why formal banks don’t lend to the poor
A. Where do loans in poor places come from?
1. Microfinance - 35%
2. Conventional banking - 15%
3. Savings group or informal loans (family and friends) - 51%
4. Moneylenders - 3%
B. Formal banks won’t lend to the poor when it is not profitable
1. Profit of a bank comes from interest
2. Risk that a poor business owner won’t be able to pay you back (default is
high)
3. Small business owners may only want to lend a small principal amount,
so they won’t be able to make a large profit off of it
4. Low collateral, so default is extra costly to the bank
5. HOWEVER, default rates are about 2% in the poorest countries - people
just don’t default on their loans
a) Banks take pains to guarantee no default by requiring collateral
(so the poor borrow less than the rich) and monitoring the loan
(harder to monitor a small loan because no steady employment or
verifiable credit history)
b) So, it’s not profitable to lend to the poor, even if they don’t default
C. Bank Lending
1. Bank makes loan of capital k, business owner has to pay back rk, bank’s
profit = r
2. When someone defaults: Profit= revenue - cost = 0 - k = -k → shouldn’t
lend
3. When the banks require collateral: (s), where capital (savings)kg g
a) Profit = (1+r)g(s)-g(s) = rg(s)
b) Example: g(s) = 2s → you can borrow up to twice your savings
(collateral)
4. Monitoring: the bank pays a cost of M to monitor the loans and make sure
that the people are paying back on time
a) Profit = (1+r)g(s) - (g(s)+M) = rg(s)-M
b) If monitoring cost goes up as the loan gets bigger, this isn’t a
problem, but it’s actually much harder to monitor someone with a
smaller loan (big businesses won’t take off in the middle of the
night)
5. The bank profits the most at an optimal level of savings
II. Other Moneylending
A. Moneylenders stepped in to exploit void left by formal banking sector
1. We know that means that they were able to do two things
a) Keep default low without collateral
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