Lessons for Rural Finance from the Microfinance Revolution

Topic :

This paper aims to highlight which institutional and technological developments hold promise for rural finance. The author argues that over the last two decades, we have essentially witnessed a disintegration of state-owned rural institutions. It is noted that the presence of public agricultural support institutions and state owned intermediaries shrank due to reductions in government expenditures and organisational reforms. Moreover, private commercial banks and other financial intermediaries have not rushed to rural areas to fill the vacuum left by state-owned credit programs despite the liberalisation of interest rates.

Yet, the paper highlights, a microfinance revolution is unfolding in urban areas. The coverage of urban microfinance institutions has substantially increased and some of these institutions have been able to deliver services in a financially sustainable manner.

The question this paper aims to address is what lessons can be learned from the successful urban microfinance institutions and applied to rural areas.

This paper begins by discussing the decline of rural finance supplies and the demise of development banks. It also considers promising dimensions, in the form of some sources of optimism that come from theoretical development and recent policy reforms. The paper then moves on to analyse the challenges for rural finance and looks at the role of incentives, information and institutions.

The key part of the paper looks at the lessons that can be learnt from microfinance institutions. In particular it points to the success of some microfinance institutions in achieving gains in outreach and sustainability in making financial services available to poor households and businesses. The paper states that experience confirms that a hospitable policy environment, appropriate innovations in financial technologies, and improvements in the institutional design of financial organisations can allow important improvement in expanding the supply of formal financial services to broader sections of the population.

Also provided is a list of basic principles that differentiate microfinance institutions successful in rural areas and those not:

  1. They do not lend only to agriculture; they consider the global demand for financial services on the part of rural/farm households;
  2. They further address idiosyncratic risk by relying on the income diversification strategies of households;
  3. They do not condition loans to specific fund uses; instead they measure repayment ability in terms of household cashflows and they allow borrowers discretion in the use of loan funds;
  4. They rely on more individualised and detailed screening efforts – including risk adjusted forecasts of crop yields and prices;
  5. They introduce greater flexibility in terms and conditions of loan contracts that respond to the special circumstances of agricultural activities;
  6. They attempt to further reduce transaction costs for borrowers;
  7. They reduce the threat of moral hazard by requiring greater borrower equity contributions to the project;
  8. They base cashflow forecasts and risk assessment not only on average historical outcomes, but also on worse-case scenarios and forecasts about future conditions
  9. They invest in better understanding of macroeconomic and sectoral patterns, in order to address the threat of systemic risk.

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