Much is said about the lack of financial inclusion in developing countries. It’s not that basic financial tools are lacking. Far from it: The financial lives of the poor are often characterized by an elaborate array of arrangements for storing and borrowing money, as amply documented in “Portoflios of the Poor.” But the sheer number of options suggests that none work well enough for enough people to displace the others, including time-tested, do-it-yourself (DIY) solutions, such as saving under the mattress or soliciting spare cash or loans from friends and family.
A number of formalized microfinance models have been developed over the last few decades, but none seems to fulfill the range of basic financial needs that people have. They tend to be based on a single service, a strict time horizon or cycle, or a particular view of how people manage their money. Instead of continuing to expect these models to spread in parallel, shouldn’t we strive to find hybrid models that meet more needs for more people?
Financial arrangements differ in flexibility (in a broad sense, including: accessibility, convenience, reliability, and the range of needs, circumstances and transaction sizes for which they are appropriate), and in how they handle credit risk and transaction costs. The problem is that more flexible solutions create room for larger credit risks and higher transaction costs, and managing those in turn creates more complexity. Thus, the basic trade-off is one of flexibility versus complexity.
But there are three ways of handling complexity while also maintaining flexibility: organizing within the community, bureaucratizing into specialized institutions, and introducing technology. Each of these mechanisms is currently used in microfinance.
All households engage in DIY solutions at some level, but very often they transcend these options by organizing into rotating savings and credit associations (ROSCA). Members can now borrow and save regularly and predictably at effectively zero cost. That’s because transaction costs are kept to a minimum by circulating cash only within the physical group meeting, and credit risks are minimized through member selection and peer pressure and by liquidating and regenerating groups periodically.
Rotating savings clubs have very rigid cash in and cash out cycles. One can make them a little more flexible by letting people choose when they collect the pot (ASCA, where members bid for the pot rather than waiting for their turn), letting the group maintain a limited residual balance in a lock box to accommodate any excess of savings collected over borrowed amounts (SLG/SILC/VSLA), or letting the group take an external loan to accommodate any excess demand for borrowing over saved amounts (SHG). But all these options make the running of the group more complex. Now external training and record-keeping support may be required, and in fact, there are bigger opportunities for improper manipulation or outright fraud. These options may be superior to plain vanilla ROSCAs in a number of ways, but they are no longer so simple: The group as an entity now holds or owes money between meetings, and they are still not entirely flexible because ultimately the size and health of the group depends on the capacity of one’s neighbors.
Escaping the strictures of geography and pooling the needs of more people in more locations provides even more flexibility. However, organization costs escalate, incentives for individual action diminish as more people are involved, and compliance becomes hard to ensure. These more-complex forms of organization require specialization of function—enter the bureaucracy. The task of organization, external fundraising, record-keeping, and cash management is delegated by users to a third party, a microcredit institution, which pays people to do specific things. Now there is an infrastructure to serve thousands.
Microcredit institutions have historically tended to be focused on a single product. Deposit-taking institutions (whether multi-product microfinance institutions or banks) offer more products—and therefore choice—to customers, but they are much more complex to manage. For one thing, they cannot plan so easily how much cash they’re operations will soak up or require on a daily basis, since they must stand ready to accept and pay back deposits on demand.
As the complexity of operations rise, financial bureaucracies first introduce technology to preserve the integrity of their accounts on the back end. Then it is extended out to support their operations, pushing the technology to front-line staff who deal with clients so that they have more information at their disposal and so that their activities can be monitored more closely.
The growth of bureaucracies is limited by their ability to onboard, train, motivate, and supervise staff, especially those out in the field. Managers develop key performance indicators (KPIs) to simplify the management of complex operations, but the narrow nature of what can be readily measured often causes metrics to generate perverse behaviors and unintended consequences like overindebtedness or abusive collection practices. Eventually, the growth imperative forces institutions to seek ways to cut costs and reduce reliance on field staff, and they start pushing technology all the way to the client. They invest in self-service channels such as automated teller machines (ATMs) or online banking, or may indeed structure themselves entirely around technology, as with mobile money. However, inherent limitations in these channels may result in minimal complexity and flexibility in the broader sense.
We can apply this story generally to pretty much any sector in the economy. In the case of financial services, the obvious gap in formal financial services is a manifestation of the inadequacy of larger bureaucracy- and technology-based solutions to show decisive benefit over local organization-based and even DIY solutions.
Innovation rarely comes by inventing a radical new thing or even a radical new way of doing something. Innovation is generally about re-mixing known elements in a creative way. Innovation means eroding the boundaries between all these financial models until something emerges that has aspects of each.
The field of microfinance often appears like fundamentalist wars between proponents of these models, where maintaining the purity of the model seems like an objective in its own right. There is not enough comparative analysis and cross-pollination between these models. (An interesting exception is this report by Susan Johnson and colleagues, which links M-PESA’s success in Kenya to the fact that it reinforced established practices of mutual support within social networks). We need to search for all of the models in between, and in doing so, we will come closer to striking the right balance between flexibility for the customer and complexity in delivery.