Benefits and Costs of Financial Products for the Poor

04 October 2012
1 comment

As professionals in the financial inclusion space, we work with a common assumption that formal financial services are better than informal products. Despite recognizing that the poor tap into a variety of informal services, such as savings clubs, loans from family and friends, money hidden under the mattress and credit from moneylenders, we believe implicitly that formal services will do the job better. We define success in the financial inclusion realm as a shift from informal product usage to formal product usage. 

But are our assumptions correct?  To answer this, CGAP hired Bankable Frontier Associates to revisit the Financial Diaries households showcased in Portfolios of the Poor. Orlanda Ruthven, Stuart Rutherford and Daryl Collins collected data about how much households used financial instruments and what they paid in fees with the Indian, Bangladeshi and South African households. We updated their financial information to 2010 and asked additional questions to get the fully loaded cost of each financial service in terms of fees, interest, time of travel and transaction and cost of travel.   As you can read in the deck, we found, in fact, that informal products do indeed sometimes win out over formal ones. 

By analyzing savings, borrowing and insurance usage patterns across formal and informal products, we found that even with increased access to formal products, the poor do not automatically favor formal services at the expense of their informal counterparts. This suggests that the role of introducing formal products to low income households is to expand the financial options of the poor, by providing new options for different purposes. Rather than seeing informal and formal instruments as alternatives, we should see them as complements.  

Consider the classic example of a moneylender loan. We assume that this informal financial option is far more expensive for the poor than formal options. On an APR basis, the moneylender’s 30% per month interest rate balloons up to 2230% per annum and dwarfs the comparative MFI lending rate of 70% per annum.   

This simplistic picture changes, however, when we look at the costs of financial services as part of a complex portfolio, instead of on a stand-alone basis. When we consider both the size and maturity of these two loan types and how they might affect an entire portfolio over a period of time, some formal credit expenses can actually dwarf informal credit. In the table and paragraph below, we demonstrate how examples of both instruments work in an average monthly portfolio over a period of 4 months.

In the South African Financial Diaries sample, less than 1 in 4 respondents earning about $730 a month avail themselves of a bank or MFI loan. However, nearly 50% of the sample used “store cards”, i.e. credit cards unique to specific retailers to be used only with that type of store. In our year-long observations, we found that most card-holders use these cards continuously and pay down the debt at the rate of about $30 a month. In contrast, the majority of the sample used informal services, such as loans from friends, family and neighbors. Importantly, these households borrowed very small amounts (on average $4) and paid back the entire amount within a week with no interest.   In a similar vein, households that used moneylenders took out small loans (on average about $28, less than 5% of monthly income) infrequently (only once a year). Strikingly, they paid these loans back almost immediately. In this case, the high interest rate of 30% typically charged by moneylenders can be described more aptly as a small “fee” of about $8, just over 1% of monthly income.  

The overall impact on household cash flows over time can be seen in the table below. The table illustrates the share of monthly income paid to service (including fees, interest and repayments) formal monthly store card payments (4%), informal moneylender loans (0.6%), informal borrowing between friends and family (0.3%), and bank/MFI loans (rarely used), on average, over a period of four months.

The lesson?  An annualized interest rate is not the only parameter in determining how much borrowing costs poor households – the size, maturity and frequency of the loan matter just as much, if not more. 

 

Illustration of a South Africa Financial Diaries budget: Expenditure over 4 months (in $)*

 

 Avg. Jan.-Apr.

 Avg. % of Income

Income

$730

 

Store card 

$30

4%

Bank/MFI loan 

--

--

Borrowing from friends and family 

$2

0.3%

Moneylender loans

$5

0.6%

 

* Figures in the table above are illustrative and based on calculated averages across the

 entire sample. Note that amounts paid for borrowing include fees, interest and repayment amounts

This is not to say that decisions about whether to use formal services or not are based on loan terms alone. Formal credit holds an important place in a poor person’s portfolio.  Accordingly to what we found during the Financial Diaries, friends and family or a moneylender can rarely provide the loan size a bank or MFI can offer – a loan size big enough, in fact, to warrant payments over time, unlike small informal borrowings that can be paid back within a month.  Formal borrowing is therefore a complement, rather than an alternative to informal credit. 

In the next blog, we’ll review lessons we have learned from formal credit, savings and insurance formal providers and point out the gaps they can fill within the financial options of the poor.  In the meantime, download our deck to read more details about the study and its findings.

Comments

Submitted by Dr.V.Rengarajan on
Thinking on rethinking on assumption on benefit and cost. 1. Regarding financial services for the poor, does’ access ‘or ‘cost’ or ‘size’ really matter irrespective of means –formal or informal from demand side perspectives ? As this is subjective factor with contextual difference due to varying human behavior influenced by one’s value system, the economically oriented tools like portfolio of the poor and financial diary appear to be inadequate . Behavior economics make changes in purposes of financial services there by making difference between intention and actual usage later in many cases irrespective of the cost and size at ultimate client HH end. In the same vein, the total benefit could be prudently judged only on the basis of actual usage of the product at household level. Here I make differences between access and usage of financial services. In such case of access only matters than cost (of access) from client side, then purpose of cost benefit study begs the question. 2. Coming to the benefit, even admittedly both formal and informal services as complementary one , is it ethically a positive phenomenon from the social perspectives in the demand side? What is the social cost? Evidently in India the scenario with positive correlation between formal (Bank/MFI) and informal institutions (money lender) in their business growth performances after the advent of MFIs in supply side and sordid state of affairs like over indebtedness. Debt stress and suicides ( in AP ) in the demand side, was evident . In fact there is cut throat competition among the actors in the rural financial landscape after foray of MFIs . Eventually, multiple lending and multiple borrowing boosted the cash flow as in the HH financial diary with more debt stress without much contributing towards social goal- poverty reduction . In fact it facilitated increased flow between the two type of lending institutions for their growth trajectory. 3. Last, again be it formal or informal services, the function of the money ( micro credit) is the same and here given the vulnerability , capability of poor client in the prudent usage of the product matters among the users of such services for working out real cost and benefit. The fact therefore demands imperative need to go beyond conventional economic log frame with tools like financial diary/portfolio of the poor for discerning real world phenomenon in development intervention process through micro credit particularly poverty cure. To wit, there is a need for integrated evaluative criteria with multidisciplinary perspectives any study in MF realm for perceiving the development complexities in the intervention process and working out strategy for effective achievement of desired outcome. Dr Rengarajan

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