From Shylock to the neighborhood pawn-broker, money lenders have always been reviled for exploitative practices and prices in lending to the poor. However, for those of us in the business, we know that moneylenders are very often an important source of liquidity – price notwithstanding.
Let’s understand the “value proposition” of the moneylender in some more detail:
Flexibility in collateral and contract type: For a household with low-income and irregular cash flows, financial services should be flexible and convenient. Unfortunately, this is not the case with most formal financial institutions. In such a scenario, the money lenders provide loans that match these criteria, enabling access to credit for the urban and rural poor.
They function in close physical proximity to the borrower, enabling frequent contact and thus minimizing the need for traditional collateral. Collateral accepted includes agricultural land, jewelry, food grains and other moveable and immoveable assets providing the clients a wide range to choose from. Screening of clients by the moneylenders is highly subjective and based on personal relationships. The loans provided are usually short-term finance, ideal to meet consumption mismatches frequently experienced by the poor.
Timeliness: The instantaneous appraisal of the loan request and any-time availability of loan (since moneylenders keep cash at home) provides convenience to the clients in accessing the credit. Most importantly, money lenders are not fussy about the purpose of the loan (which can be even used for consumption purpose or to repay another loan) as long as they repay it.
Flexibility in repayment: Moneylenders not only offer doorstep repayment collection service but also accept various modes of repayment. In-kind repayment modes like providing goods (farm produce or other goods) and services (labor) are very common.
With all these advantages, what is the hue and cry about moneylenders? The major criticism against them is that they charge exorbitant interest rates from the poor, ranging from 70% per annum (Aleem, I 1990, Swaminathan, M.1991) and 10% per day for daily working capital. So with such a high interest rate and little operating expenses, you would think that money lending is an extremely profitable activity?
However the paper written by Antoinette Schoar of MIT and Rohit Mukkawar of IFMR compels us to understand this business from a money lender’s perspective. The paper sheds light on the internal dynamics and economic constraints of the money lending business. It is interesting to observe from the paper that the greatest constraint for the moneylender in expanding his business is – moneylender himself. The absence of delegation of decision-making to his employees in terms of selection of clients and the time involved in screening of clients (which is based on personal relationships and recommendation) prevents them from exploiting economies of scale in the business. Since lending decisions are based on personal relationship and knowledge about the borrowers, the area of operation for the moneylender gets restricted to a small geography – less borrowers to choose from and lend to! The cost of capital for the moneylenders is also high as they largely depend on their own funds. This, in addition to the prevalence of high default rates among the clients’ forces them to be choosy and limits their ability to expand.
In such a scenario, with clearly a gap in credit supply, newer money lenders see an opportunity and step in to plug the gap. However as the Schoar and Mukkawar paper suggests that difficulty in managing the portfolios by new moneylenders who are inexperienced as regards the intricacies of the business, forces many of them to leave the market. Hence in a world, where financial access relies on relationship and building track record with your lender, even good clients can be barred from credit after the moneylenders drop out.
The fact that the high interest rates are not just because of the monopolistic rent but due to many other factors like – high transaction cost, limited geographical scope for expansion of business, expensive screening of borrowers and cash collection from doorstep – should perhaps explain why most moneylenders are still small time business person and not the millionaires you might expect them to be!
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C.A Farzana Najeeb and Rohit Mukkawar contributed to this post.
3 Responses
Insightful..
Though most moneylenders probably fall in this category do you know of any others that have been able to expand their coverage and customer size? And if so how have they gone about new customer acquisition and customer credit checks?
Dear Advait,
Some moneylenders who expand beyond their regions, seek for strong recommendation cum guarantee from a person well known to him/her and living in his/her operating region. While making lending decision in case of such customers, they rely on their past experiences with the person who is recommending cum guaranteeing and also on their on gut feeling about the potential customer.
Regarding the new customer acquisition, I would like to quote what one of the moneylender had said to me while interviewing him: "Even if you are sitting on top of Himalayas, needy borrowers will reach you!" There is so much gap in the demand and supply of credit, there is hardly any competition amongst the moneylenders.
Only solution to bringing about the change is to increase penetration of formal financial institutions who can leverage on depositors and investors funds for providing credit to the needy.