(Poverty Trap Part 2) Online Loans: Poverty Alleviation or Poverty Reenforcement ?

In this article, I will teach myself (writing as part of thinking), and this is a work in progress:

A. Underlying Theories of Poverty: the grand management, the middle-range and the low-range theories, and the positioning of Esther Duflo's works.

B. Perception is Reality: Why Microloans Reenforcing Poverty? I will study the current state and th challenges, what may have been omitted the due process,

C. What are the pre-determinant success factors?

D. Micro-lending Axiologies: the raison d'être!

E. Micro-lending best practice: summary

A. Underlying Theories:

When investigating the impact of online loans on poverty alleviation, it's essential to understand the multifaceted nature of poverty and its interaction with financial systems. Here's a breakdown of potential theories at different levels of granularity that you can consider:

Grand Management Theories:

1. Systems Theory: Ludwig von Bertalanffy (1968), General System Theory: Foundations, Development, Applications"). We can examine how the entire financial ecosystem, including online lending platforms, interacts with the broader economic system. Here, the focus would be on the interconnectedness of different elements and their impact on poverty.
2. Contingency Theory: one of the proponents (since it is hard rot pin this theory on a single author as many contributed) was Fred Fiedler (1967) "A Theory of Leadership Effectiveness". This would involve looking at the conditions under which online loans might be effective in alleviating poverty. Different circumstances, such as regional economics, societal norms, or technology infrastructure, might influence outcomes.

Mid-range Theories:

1. Financial Inclusion Theory: This theory posits that providing marginalized individuals access to financial services can improve their economic condition. Online loans could serve as a mechanism for financial inclusion, especially for those who are underserved by traditional banks. Who proposed this theory originally was not black and white define, as this is more a broad concept than a theory with a single author. However, the World bank and other institutions have extensively promoted and studied it.
2. Human Capital Theory: Investing in human capital (education, health, skills) is crucial for breaking the cycle of poverty. Online loans, if used for these purposes, can theoretically contribute to poverty reduction. The originator of this theory might be Gary Becker (1964), "Human Capital: A Theoretical and Empirical Analysis, with Special Reference to Education"
3. Social Capital Theory: Online lending platforms might foster community-based lending, helping create networks of trust and reciprocity that can be crucial in poverty alleviation. One of the main figures for this theory might be Pierre Bourdieu (1979) in "A Social Critique of the Judgment of Taste" and Robert Putnam (2000) who popularized the concept in "Bowling alone: The Collapse and Rival of American Community"

Low-range Theories:

1. Microfinance Theory: While traditionally associated with institutions like Grameen Bank, the principles of microfinance can apply to online loans. This theory focuses on the benefits and potential pitfalls of small loans to entrepreneurs and households.Professor Muhammad Yunus as found in "Banker to the Poor: Microlending and the Battle Against World Poverty" (1999), is indeed a foundational figure in the world of microfinance and has significantly contributed to the broader concept of financial inclusion. He and the Grameen Bank, which he founded, were jointly awarded the Nobel Peace Prize in 2006 for their efforts to "create economic and social development from below" through microcredit.However, when discussing financial inclusion as a comprehensive theory, we're addressing a broader set of principles and practices that aim to provide financial services to underserved populations. This includes not only credit but also savings, insurance, payment services, and financial education, among others. Financial inclusion is a holistic approach to ensuring that all individuals, regardless of their economic status, have access to and can effectively use the appropriate financial services they need to improve their lives.While Professor Yunus's pioneering work with microcredit is a crucial component of financial inclusion, the theory and practice of financial inclusion encompass a wider range of services and interventions. As a result, while Yunus might not be referred to as the "birth maker" of the entire financial inclusion theory, he is undeniably one of its most influential pioneers, especially in the realm of microcredit.In academic and policy discussions, it's crucial to acknowledge the contributions of various individuals and institutions to the evolving landscape of financial inclusion. Professor Yunus's work is a cornerstone of this landscape, and his influence on the microfinance movement and its role in promoting financial inclusion cannot be overstated.
2. Debt Trap Theory: On the flip side, there's the possibility that online loans can lead individuals into debt traps, where they take on more debt than they can repay, worsening their economic condition. This is a more general concept observed in many financial systems and doesn't have a single originating author. Instead, it's been discussed in various studies on indebtedness.
3. Behavioral Economics Insights: This includes concepts like present bias (preferring immediate rewards over future ones) and loss aversion. Such behaviors can influence how individuals interact with online loans and whether they use them beneficially. Richard Thaler (2015) in "Misbehaving: the Making of Behavioral Economics" and Daniel Kahneman (2011) in "Thinking Fast and Slow" and others are the originators of the theory.

In doing research on this topic, it would be beneficial to approach the topic from multiple theoretical angles to get a holistic understanding. Combining insights from these theories can help paint a comprehensive picture of how online loans interact with the complexities of poverty.

What about Esther Duflo?

I am tempted to include Prof. Esther Duflo. She, along with her husband Abhijit Banerjee and colleauge Michael Kremer, are pioneering figures in the field of development economics, particularly in their use of randomized controlled trials (RCTs) to assess the efficacy of anti-poverty interventions. They were awarded the Nobel Prize in Economics in 2019 for their experimental approach to alleviating global poverty.

The reason she wasn't initially mentioned is that the nature of grand, middle-range and low-range theories seemed to be focused on broader management and economic theories rather than specific contributions in the field of development economics. Duflo and her collaborators, through their work at the Abdul Latif Jameel Poverty Action Lab (J-PAL), have provided empirical evidence on a range of topics, including education, health, microfinance, and more. Their approach is more about rigorous empirical methods to determine "what works" rather than positing grand or mid-range theories in the traditional sense.

Having said that, knowing and learning about poverty traps and the impact of online loans on poverty alleviation, the work of Duflo and her colleagues is indeed highly relevant. Their research methodology and findings can provide crucial insights into the design and assessment of poverty alleviation interventions.

Their seminal book: "Poor Economics: A Radical Rethinking of the Way to Fight Global Poverty" published in 2011 is a great resource to understand their approach and findings in various domains related to poverty. In the context of your research, their empirical methodologies and findings on microfinance and related areas could be particularly valuable.

Esther Duflo, along with Abhijit Banerjee and their colleagues, doesn't advocate for a singular "theory" in the way that some other economists might be associated with a particular theoretical framework. Instead, their major contribution is methodological: they've popularized the use of randomized controlled trials (RCTs) in development economics to rigorously test interventions and derive empirical results.

Their work through J-PAL has covered a myriad of topics, from education and health interventions to microfinance and labor markets. The findings from these studies often challenge pre-existing notions or theories about what works in development and poverty alleviation.

The book "Poor Economics" is not about positing a new grand theory but rather a compendium of their empirical findings across various domains, challenging many traditional beliefs about poverty and development.

So, it wouldn't be accurate to place Duflo's work under a "low-range theory" or any specific theoretical classification. Instead, her contribution (along with her colleagues) is in the rigorous empirical approach they've championed and the insights derived from those studies about what truly works in the field of development.

Still, shall I include hers or not, since her works influenced my thinking a lot?

Whether or not I should include Esther Duflo's work as an underlying theory in research may depend on the specific focus and objectives of my study.

I must consider these:

1. Focus on Methodology: If the research aims to employ a rigorous empirical approach similar to randomized controlled trials (RCTs), then referencing the work of Duflo, Banerjee, and J-PAL would be very appropriate, as they've set a standard for this methodology in the field of development economics.

2. Specific Topics: If my work is examining topics that Duflo and her colleagues have directly researched (e.g., microfinance, education interventions, health initiatives), their empirical findings can be invaluable, even if I don't use their methodology.

3. Theory vs. Empirical Evidence: Duflo's work is more about empirical evidence than theoretical frameworks. If my dissertation requires underlying theories about poverty, Duflo's work might serve as empirical support or challenge to those theories rather than a theory in itself.

4. Contemporary Relevance: Including the work of recent Nobel laureates can showcase that your research is informed by contemporary thought leaders in the field. This can strengthen the credibility and relevance of my study.

In conclusion, while Duflo's work might not fit the traditional mold of an "underlying theory," it represents a significant body of empirical evidence in the field of poverty research. If my dissertation seeks to be comprehensive and up-to-date, considering her contributions (and the broader work of J-PAL) could be beneficial. However, how I position it—in terms of theory, empirical evidence, or methodology—will depend on the structure and objectives of my study.

B. Perception is Reality: Micro-loans are Reenforcing Poverty?

My initial observation, the oversupply micro loans here have moral hazards: those whom banks serve, now mostly are trapped with debt. Is it because the loan not micro anymore, hence beyond their capacity to repay? Do they really practice the traditional 4Cs KYC in banking?

Your observation touches upon a significant issue. Financial inclusion, while aimed at providing financial services to the underserved, can sometimes lead to over-indebtedness, especially if not managed correctly. This issue isn't exclusive to microloans but can also be observed in more mainstream financial services.

The transition from microloans to larger loan sizes, or the provision of loans without proper assessment of the borrower's capacity to repay, can indeed contribute to debt traps.

Current State: Criteria for Accepting Loans - The 4Cs

Traditionally, lenders assess potential borrowers based on the "Four Cs of Credit" to determine the creditworthiness and the likelihood of repayment. These are:

1. Capacity: This assesses a borrower's ability to repay a loan by evaluating their income relative to their ongoing debts. It helps in determining if the borrower can comfortably manage the loan payments.
2. Capital: Lenders consider any capital the borrower puts toward a potential investment. A large contribution by the borrower decreases the chance of default.
3. Collateral: This refers to assets that the borrower pledges to secure the loan. In the event of default, the lender can seize these assets. In microfinance, traditional collateral might not always be available, so alternative forms of collateral or group guarantees can be used.
4. Character: This is a subjective evaluation of the borrower's reliability. Lenders may consider the borrower's credit history, employment stability, and other factors to assess the likelihood of repayment.

Challenges in Financial Inclusion

In the context of financial inclusion, especially microfinance:

• Loan Sizes: Not all microloans remain "micro." As borrowers build credit histories or as their businesses grow, they may access larger loan sizes, which can increase the risk of over-indebtedness if not proportional to their income growth.
• Multiple Borrowing: One issue observed in some areas is that borrowers take loans from multiple lenders simultaneously. Without centralized credit reporting, this can lead to over-indebtedness.
• Interest Rates: Microloans sometimes have higher interest rates than conventional loans due to higher administration costs relative to the loan size and higher perceived risks. This can further strain borrowers.
• Evaluation Methods: Not all microfinance institutions rigorously apply the 4Cs in the same manner as traditional banks, especially when assessing "character" and "capacity."

To avoid the pitfalls of over-indebtedness while promoting financial inclusion, it's crucial for lenders to offer financial education, promote responsible lending practices, and ensure that loans align with borrowers' needs and repayment capacities.

The current practice is approving loans merely based on their payslip , and few references. I must say these references become ones because simply they are colleagues or they are his/her supervisors. Most of the time, they don’t even know that they are the references. Such practice, where loans are approved based predominantly on payslips and loosely verified references, is unfortunately not uncommon in some regions or lending institutions. It can be especially prevalent where there's a push for aggressive portfolio growth or where regulatory oversight might be lacking.

What may have been omitted in the due process:

Here are some of the potential concerns and implications with such a practice:

1. Limited Due Diligence: Relying solely on a payslip does not provide a holistic view of an individual's financial health. There may be other outstanding debts or financial obligations not captured by this single document.
2. Unverified References: If references aren't even aware that they've been listed, it undermines the whole point of having a reference. Typically, references should serve as a testament to an individual's character and reliability.
3. Over-indebtedness: Such practices can lead to customers borrowing beyond their capacity to repay, resulting in financial strain or default.
4. Reputation Risk: For lending institutions, such practices can undermine their credibility. In the event of widespread defaults, the reputation of the institution can be significantly damaged.
5. Systemic Risk: On a broader scale, if many institutions in a financial system adopt such lax lending practices, it can lead to systemic risks, potentially culminating in a credit crisis.
6. Ethical Concerns: There's a moral dimension as well. Irresponsible lending can push individuals into debt traps, severely affecting their well-being.

For sustainable and responsible financial inclusion, a more comprehensive approach to credit evaluation is necessary. This should ideally take into account an individual's complete financial picture, including other debts, monthly obligations, and genuine character references. It's also crucial for regulators to step in and ensure that lending institutions uphold responsible lending practices.

What are the predeterminant success factor ?

Financial inclusion as a concept is rooted in the noble aim of providing financial services to those traditionally underserved or excluded from the formal financial system. The potential benefits include improved economic conditions, empowerment, and enhanced quality of life for individuals.

However, the effectiveness and positive outcomes of financial inclusion initiatives largely depend on the discipline, integrity, and responsibility with which they are executed. Irresponsible lending practices, lack of borrower education, and insufficient oversight can turn a well-intentioned effort into a counterproductive one, leading to over-indebtedness and financial strain for individuals.

In essence, the success of financial inclusion doesn't just rest on the accessibility of financial services, but also on the quality, fairness, and responsibility of those services. Proper execution, oversight, and continuous refinement based on real-world outcomes are essential to ensure that financial inclusion truly benefits its target population.

Debt leverage ratios and the appropriate levels can vary widely based on industries, economic conditions, and the specific nature of individual entities or persons. However, for individuals and especially in the context of personal loans, the ratio you mentioned (being able to borrow up to 40 times their monthly income with an effective annual rate of more than 60%) sounds particularly aggressive.

Issues with High Leverage and Excessive Interest Rates:

1. Over-Indebtedness: Allowing individuals to borrow up to 40 times their monthly income puts them at significant risk of over-indebtedness. It could become challenging for borrowers to manage such high levels of debt, especially if they face unforeseen financial hardships.
2. High Interest Rates: An effective annual rate of over 60% is exceedingly high. Such rates can quickly make the loan amount balloon, making it hard for borrowers to keep up with payments.
3. Predatory Lending: Such practices can be seen as predatory, especially if borrowers are not fully informed or do not fully understand the implications of taking on such debt.

Violations of Good Banking Practices:

1. Due Diligence: Good banking practices involve thorough due diligence to assess the creditworthiness of borrowers. This ensures that loans are extended to those who have the capacity to repay without undue financial strain. High leverage ratios suggest a potential lapse in this diligence.
2. Transparency: Borrowers should be clearly informed about all aspects of their loan, including how interest is calculated, potential penalties, and the implications of non-payment. Hidden fees or complex terms can violate this principle.
3. Fair Pricing: Charging excessive interest rates, especially if they are significantly above market or regulatory rates, goes against the principle of fair pricing.
4. Ethical Considerations: Financial institutions have a responsibility to act in the best interests of their clients. Encouraging or allowing clients to take on unsustainable debt can be seen as a violation of this ethical duty.
5. Risk Management: From the lender's perspective, allowing borrowers to take on high levels of debt without adequate checks increases the risk of defaults. Good banking practices emphasize sound risk management to protect both the institution and its clients.
6. Consumer Protection: Protecting consumers from unfair practices, ensuring they have the necessary information to make informed decisions, and not taking advantage of information asymmetries are cornerstones of good banking practice.

If online lenders are engaging in such practices, they may not only be violating good banking principles but could also be in breach of regulatory standards, depending on the jurisdiction. It's essential for regulators to be aware of and act on such practices to protect consumers and maintain the integrity of the financial system.

Micro-Lending Axiologies:

Micro-lending, or microfinance, has evolved over time and encompasses a broad range of financial products tailored to the needs of underserved populations. While micro-loans for emergency needs such as health and education are indeed vital components, a significant portion of microfinance has been directed towards supporting micro-entrepreneurship.

Here's a breakdown:

1. Emergency Needs:

• Health: Many low-income individuals do not have access to health insurance or savings to cover medical emergencies. Micro-loans can provide the funds needed for urgent medical care, thereby preventing a financial catastrophe for the family.
• Education: Education loans can help families cover school fees, uniforms, and other related expenses, ensuring that children can continue their schooling without interruption.

2. Micro-Entrepreneurship:

• Business Loans: Many micro-lenders provide loans to individuals or groups to start or expand small businesses. These businesses could be as simple as a street vending stall, a small craft business, or farming. The idea is that these loans can help individuals generate a sustainable income and, over time, lift themselves and their families out of poverty.
• Agricultural Loans: Many microfinance institutions (MFIs) operate in rural areas and provide loans tailored to the needs of small-scale farmers. These loans might be used to buy seeds, tools, or livestock.

3. Other Uses:

• Home Improvement: Some MFIs provide loans for home improvements, such as adding a new room or improving sanitation facilities. Improved living conditions can lead to better health and overall well-being.
• Consumer Durables: Some MFIs provide loans for the purchase of durable goods, such as solar lamps or efficient cookstoves, that can improve the quality of life and reduce long-term expenses.

It's true that business-related loans carry inherent risks – businesses can fail, and external factors like market conditions or natural disasters can impact a borrower's ability to repay. However, the philosophy behind micro-entrepreneurship lending is empowerment. By providing individuals with the means to start or grow a business, they're given an opportunity to build a sustainable livelihood.

That said, it's essential for MFIs to offer such loans responsibly, with proper vetting, financial education, and ongoing support to mitigate potential risks. The ultimate goal of microfinance, whether it's for emergency needs or business ventures, is to empower individuals and communities to achieve financial stability and improve their quality of life.

Micro-lending, while rooted in noble purposes, does come with both expected benefits and potential moral hazards. Let's delve into these:

Expected Benefits:

1. Economic Empowerment: Micro-lending provides capital to individuals who otherwise wouldn't have access to traditional financial services, enabling them to start or expand small businesses, leading to increased income and economic self-sufficiency.
2. Poverty Reduction: Over time, successful micro-entrepreneurs can elevate their economic status, pulling themselves and their families out of poverty.
3. Gender Empowerment: Micro-lending has often targeted women, who in many societies face economic disadvantages. By providing women with capital, they gain economic agency, leading to broader social and gender empowerment.
4. Community Development: Successful micro-entrepreneurs can stimulate their local economies, creating job opportunities and fostering community growth.
5. Financial Inclusion: Micro-lending brings marginalized populations into the formal financial system, fostering a culture of savings, financial planning, and creditworthiness.

Moral Hazards from the Lender's Perspective:

1. Predatory Lending: There's a risk that some micro-lenders could engage in unethical practices, charging exorbitant interest rates or employing aggressive collection practices.
2. Multiple Lending: Without coordination among MFIs, a borrower might take out loans from multiple lenders, leading to over-indebtedness.
3. Insufficient Due Diligence: Lenders might not adequately vet borrowers, leading to loans that the borrower cannot realistically repay.
4. Misaligned Incentives: If loan officers are rewarded purely based on the volume of loans disbursed, it can lead to an emphasis on quantity over quality.

Moral Hazards from the Debtor's Perspective:

1. Overborrowing: Borrowers, especially those new to credit, might not fully understand the implications of taking on debt and could borrow more than they can repay.
2. Misallocation of Funds: Borrowers might use the loan for unintended purposes. For instance, using a business loan for personal needs.
3. Strategic Default: If borrowers feel the loan was not beneficial or if they believe the MFI would not enforce repayment, they might choose not to repay even if they have the means.
4. Dependence on Credit: Instead of using micro-loans as a temporary boost, there's a risk that borrowers become dependent on continuous borrowing, leading to a cycle of debt.

For micro-lending to achieve its noble goals, it's essential to recognize these potential moral hazards and implement measures to mitigate them. This requires a combination of effective regulation, responsible lending practices by MFIs, financial education for borrowers, and a focus on transparency and ethical behavior from all parties involved.

Micro-Lending Best Practices:

Micro-lending, or microfinance, is designed to serve clients who traditionally lack access to conventional banking and related services. Best practices in micro-lending are grounded in both financial sustainability for the lender and positive, ethical outcomes for the borrower.

1. Loan Amount (Multipliers of Income):

• Best Practice: The loan amount should be proportional to the borrower's ability to repay. Commonly, loan amounts are determined based on the borrower's business cash flows or income, with an emphasis on not overburdening the borrower. There's no universally accepted multiplier, but the loan should be within a range where repayment is feasible considering the borrower's earnings and expenses.

2. Duration:

• Best Practice: Loan durations in microfinance are typically shorter, often ranging from a few months to a year. However, the duration should align with the purpose of the loan. For instance, a short-term working capital loan might have a tenure of 3-6 months, while a loan for a capital purchase could be longer.

3. Interest Rate:

• Best Practice: Interest rates in micro-lending are often higher than conventional loans due to the higher cost of delivering small loans and the risk profile. However, rates should still be fair and transparent. They should be set at a level where the microfinance institution (MFI) can cover costs and be sustainable but not so high that they become predatory.

4. Forgiveness or Grace Periods:

• Best Practice: Some MFIs offer grace periods where repayments can start after a certain period post-disbursement, especially for business investments that will take time to generate returns. Loan forgiveness is rarer but can be considered in exceptional circumstances, like natural disasters or extreme personal hardships.

5. Other Good Banking and Credit Practices:

• Transparent Communication: All terms and conditions, including interest rates, fees, and penalties, should be clearly communicated to the borrower.
• Client Education: MFIs often provide financial education to clients, helping them understand credit, savings, and how to manage their finances.
• Flexible Repayment: Given the often irregular income patterns of micro-entrepreneurs, offering flexible repayment schedules can be beneficial.
• Avoiding Over-Indebtedness: MFIs should check if borrowers have taken loans from other sources and ensure that the new loan won't push the borrower into over-indebtedness.
• Feedback and Redress Mechanisms: Establishing systems where clients can provide feedback or lodge complaints is essential for maintaining trust and accountability.
• Privacy and Data Protection: MFIs should ensure that clients' data is protected and only used for its intended purpose.
• Ethical Collections: While MFIs need to maintain high repayment rates to be sustainable, collection practices should be ethical, avoiding any form of harassment or coercion.

6. Periodic Review: It's also a good practice for MFIs to periodically review loan terms, interest rates, and other policies to ensure they align with market conditions, regulatory changes, and the evolving needs of their clients.

In essence, the best practices in micro-lending balance the financial sustainability of the lending institution with the welfare and empowerment of the borrowers.

References:

In addition to above mentioned resources, foundational and influential works on microfinance and financial inclusion, here are several other books and references:

1. "Banker to the Poor: Micro-Lending and the Battle Against World Poverty" by Muhammad YunusThis is a seminal work where Professor Yunus recounts the story of Grameen Bank and his personal journey in pioneering the idea of microcredit. It's a must-read for anyone interested in the history of microfinance.
2. "Creating a World Without Poverty: Social Business and the Future of Capitalism" by Muhammad YunusIn this book, Yunus expands on his vision beyond microcredit and discusses the concept of social businesses as a tool against poverty.
3. "Portfolios of the Poor: How the World's Poor Live on $2 a Day" by Daryl Collins, Jonathan Morduch, Stuart Rutherford, and Orlanda RuthvenThis book provides an in-depth look into the financial lives of the world's poor, based on financial diaries collected from individuals in Bangladesh, India, and South Africa.
4. "The Economics of Microfinance" by Beatriz Armendáriz and Jonathan MorduchThis is an academic take on microfinance, delving into the underlying economics, successes, and challenges of the sector.
5. "The Microfinance Revolution: Sustainable Finance for the Poor" by Marguerite RobinsonThis book offers an overview of the development of microfinance from the perspective of sustainable financial services for the poor.
6. "Financial Inclusion at the Bottom of the Pyramid" by Carol Realini and Karl MehtaFocusing on financial technology's role, this book examines how tech innovations are expanding access to financial services globally.
7. "Transforming Microfinance Institutions: Providing Full Financial Services to the Poor" by Joanna Ledgerwood and Victoria WhiteThis guide looks at how microfinance institutions can transform into formal financial institutions to offer a fuller range of services.
8. "The Poor and Their Money" by Stuart RutherfordRutherford provides insights into how the poor handle money, save, and borrow, offering a ground-level perspective crucial for anyone in the microfinance space.

These books and references provide a mix of firsthand accounts, academic perspectives, and ground-level insights into microfinance and financial inclusion. As always, when diving into these topics, it's beneficial to approach them with a critical mind, considering the diverse contexts, challenges, and successes across different regions and communities.