Formal microcredit schemes include small loans given to people unable to obtain credit from banks. These schemes are increasingly popular in Bangladesh as an alternative to bank loans, but do they reach the most suitable borrowers?

For a long time, many smallholders in developing countries have been unable to access credit from banks. This is mainly because of the high fees charged on each loan and the difficulties that banks experience in identifying the borrowers most likely to repay loans. Information gaps are another problem; because there is little lending to smallholders, banks do not have enough information to identify the best ways to select those smallholders most likely to succeed.

People lending money through formal microcredit schemes face similar problems to banks in identifying which people are likely to succeed in their projects. Because of these problems, many formal attempts to provide cheap credit to smallholder farmers have failed.

By contrast, informal lenders are usually based within a community. This gives them an advantage in selecting the borrowers most likely to be successful. As a result, they are able to charge higher interest rates on the loans they provide. Despite being more expensive, informal micro-lending continues to be popular. This suggests that it provides an important service to smallholders.

Research from the International Institute for Environment and Development, in the UK, compares the formal and informal microcredit schemes used by Bangladeshi shrimp farmers. Improving access to credit will make many tasks easier for rural poor people in Bangladesh, for example difficulties in buying supplies. This will reduce poverty amongst people dependent on the shrimp export industry.

The research shows:

• Access to credit remains a problem for many smallholders; both those who borrow through formal schemes and those who borrow informally would like to borrow more than they actually do.
• Informal borrowers are, on average, more efficient in using credit than the farmers who only borrow formally.
• Both types of borrower overuse workers to reduce the need to pay cash at the beginning of a season. This makes production inefficient.
• However, the overuse of workers is significantly smaller amongst groups using informal credit schemes.

Although formal microcredit schemes avoid the problem that banks face of high administrative fees, they do not solve the problem of how to select successful borrowers. Informal lenders have better information on individual borrowers than formal lenders. This makes them more likely to select the most suitable borrowers. For formal microcredit schemes to succeed, formal lenders need to find ways to access this information.

The researchers conclude:

• Better access to credit remains an important issue for rural smallholders, even in countries such as Bangladesh, where formal microcredit is well established.
• More research is required to identify the most suitable borrowers in a community and ensure they can access the amount of credit they need.

Source(s):
‘Giving Credit to the Microlenders: Formal Microlending, Credit Constraints and Adverse Selection – a Case Study of Shrimp Farmers in Bangladesh’, Environmental Economics Programme Discussion Paper 08-02, International Institute for Environment and Development: IIED, by Camilla Andersson, Erik Holmgren, James MacGregor and Jesper Stage, 2008 (PDF) Full document.

Funded by: Swedish International Development Cooperation Agency (Sida); Jan Wallander and Tom Hedelius Foundation; Länsförsäkringar Research Foundation; Royal Danish Ministry of Foreign Affairs (Danida)

id21 Research Highlight: 5 April 2008

Further Information:
James MacGregor
Senior Researcher
Environmental Economics Programme
International Institute for Environment and Development
3 Endsleigh Street
London WC1H 0DD
UK

Tel: +44 20 73882117
Fax: +44 20 73882826
Contact the contributor: james.macgregor@iied.org

Environmental Economics Programme, International Institute for Environment and Development, London, UK

Other related links:
'Microcredit: killer weapon in the fight against poverty?'

'Innovations in microfinance: new product development in Bangladesh'

'Fine tuning microfinance: better financial systems for the poor'