Finance runs afoul

An inquiry into why financial companies might not be following the rules.

Advertisements

A recent article by published the Times of India titled “Finance companies not following rules: Self-help groups,” reported on the ongoing protest of women in Nashik. These women from a number of self-help groups (SHGs) were out protesting to demand an inquiry into multiple micro finance companies in the district. The protesters claimed that these financial companies were not following the rules agreed upon between the financial companies and the SGHs. These rules mostly dealt with contact between financial companies and SGH members. Two stated violations were contacting SGH members outside of agreed upon hours and harassing SGH members to repay debts of other SGH members. Other allegations included the charging of exorbitant fees, forced recovery (also known as seizing property), and that these companies have been forging groups to increase their business. The protesters are demanding that the collector, the government, and the Reserve Bank of India review the performance of these financial companies. An employee of a micro finance company did respond for the article and denied the allegations saying the protesters were all made aware of the terms and refuse to pay it back. They further made the statement that while some collection agents do play foul they are easily identified and reprimanded.

The protestors make troubling claims that suggest behavior different than what the theory of micro credit predicts. The claim that companies are setting up their own groups to expand their business goes against the main strength of micro credit theory; which is that by lending only to groups, the groups that arise are positively assorted matches. Micro credit uses these positive assorted matches to reduce the risk of the lender by shifting it onto the borrower. In micro credit if one member of the group fails to repay all the members lose access to credit. This risk is what causes the positive assertive matching because risky people who need the extra income of their peers to cover their loan if their project fails, and safe borrowers want to match with safe borrowers to make sure they don’t have risk losing access since they wouldn’t be able to cover another members’ share of the loan if they failed.

If the claims made by the protestors are true then the companies are ignoring the benefits this positive assertive matching provides, and assuming that they are rational there must be something the model is missing. One solution could be that there are strong laws in favor of property seizure in the region. If a contract is binding and legally strong enough to allow for easy seizure of property maybe the risk of failure is not a deterrent. By expanding their business and including the amount they must be repaid they don’t have to fear if their loan fails as long as the signer has the required wealth. Based on the protestors testimony we can assume that the seizure of property is not outside of the finance companies reach, since they are protesting forced recovery. The extra cost of seizure or its ease could also help explain the allegations that these firms are charging exorbitant prices. If it is difficult to seize property the extra price could cover the cost. The flip side of the coin is that if seizure is easy maybe it is worth increasing the price as failure of a loan can be recouped through property seizure.

Another possibility is that these financial companies are not truly following the microfinance model and are instead using a model closer to the neoclassical model. This model differs from the micro credit model because it doesn’t utilize the benefits of positive assertive matching and instead has individuals responsible for themselves. This decreases the chance that the lender will get repaid because the borrower doesn’t have a group to fall back on to repay his share. Because of the decrease in chance that the lender gets repaid they charge higher prices than they would under a grouped positively assorted micro finance system. This could help explain why the prices were viewed as exorbitant. The question that must then be answered is why would a company using this model bother with forming groups instead of individual contracts. One reason would be that by creating groups of shared liabilities they are able to solve the problem of ex ante moral hazard. Ex ante moral hazard is that the borrower might choose a risky project that has a higher chance of failure and thus not being able to repay the lender. By forming groups, they can rely on a sort of social pressure to not put the group at risk or to force the group to repay the failure. With the ability to force recovery the company now doesn’t have to worry about ex post moral hazard, the risk that the borrower doesn’t repay, because even if they don’t repay the company can seize the borrower’s assets.

A third possibility is that the financial company employee is telling the truth. This is the easiest possibility to explain in economic theory. If the employee is telling the truth then the current model of micro financial theory is working as intended, and the problem lies with the protestors trying to shirk from their obligations. If there are existing cultural standards that would make the recovery of loans impossible the borrower would be much better off. They would have the support of the government and not have to repay the money that they borrowed.

The current situation shows a desire for credit in the area, otherwise people would not be protesting the financial institutions and instead just ignore them. We can also assume that access to credit is under supplied if there are claims about exorbitant fees because any company charging exorbitant fees would be undercut and removed from the market in a perfect equilibrium. In conclusion, we can see that the entire story is not being told in this article. If it were we would know why the claims made by the protesters seem to contradict the micro credit theory, why the company might be using the neo-liberal credit model, or the incentives provided to the protesters for shirking from their repayment.

1 thought on “Finance runs afoul”

  1. The situation occurring here is very interesting due to the fact that the behavior occurring seemingly contradicts the theory of microcredit. Corruption does play a large role in developing nations and may indeed be at play in this instance. I look forward to hopefully gaining more information about the situation in order to determine whether the protestors are attempting to shirk from their repayment or if the financial companies indeed are engaging in corrupt behavior.

    Like

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s