For centuries, moneylenders have been disbursing loans to the poor, besides other sections of society. Yet they are more often than not pilloried for the exorbitant interest rates they charge and the vicious recovery methods they employ. In India, moneylenders have developed several distinct practices. First, two-thirds of their lending is for a tenor longer than three years—this generally helps reduce the operational cost per rupee of credit per annum. Second, repayment (principal or interest or both) in some cases is in the form of crops, reducing credit risk on a farmer who grows that crop. This is because the borrowers’ ability to repay is now a function of only the quantity of crops grown, not of the quality and price of the crop. Third, many offer a bullet repayment facility for collateralized loans, often in the form of a flat interest rate (unlike an interest rate per annum). This enables the borrower to use funds for a wider variety of purposes.
For moneylenders to be effective in helping the furthering of financial access, it is desirable that the above good practices are leveraged effectively.
However, most moneylenders are handicapped by the absence of economies of scale. Accessing such economies of scale could have allowed moneylenders to diversify their portfolio, resulting in a smaller credit risk premium. In turn, this would have meant a lower interest rate. This is one of the reasons moneylenders charge interest rates between 25% and 150% per annum. Economies of scale could also drive down cost of operations per rupee of credit per annum—especially considering the potential of mobile phone based payment systems to scale money lending operations in a big way.
In addition, moneylenders have to deal with high risks of loss, given chances of default.
One way of addressing the problem of this low recovery rate is for the state’s law enforcement machinery to actively assist moneylenders in bad loan recovery. This may be politically viable (in a democratic society) when there isn’t widespread distress due to drought, floods or famines, for which the state would do well to buy insurance for compensating the moneylender. Further, the state could lend to moneylenders so that they in turn have larger economies of scale. Building a credit rating history of moneylenders would be much more manageable than building a nationwide credit history of 450 million poor people. And in order to avoid leakages, it is best that funds are lent to moneylenders at a price—an interest rate appropriate for the credit risk associated with the particular moneylender. This is important, because the government could otherwise end up subsidizing non-poor people.
Subsequently, what is also required is competition between moneylenders—for example, by lending to them for only the loan amounts disbursed outside their home administrative unit.
With superior creditors’ rights, access to funding and competition, we can reasonably expect the price of money—the interest rate—to come down.
But simply increasing competition will not suffice. In their 1997 paper “Moneylenders and bankers: price-increasing subsidies in a monopolistically competitive market”, Karla Hoff and Joseph Stiglitz wrote that new entry raises the cost of enforcing loan repayments, and that “if lending is to be profitable, the threat to the borrower of a loss of future income is also necessary to induce repayment. Part of this threat comes from the fact that if a borrower defaults, his moneylender cuts off access to future credit”. So competition has to be complemented with superior bad loan recovery.
Both moneylending as well as law enforcement come under the States list in India. This should be the occasion for state governments to devise a strategy to co-opt moneylenders, at least on an experimental basis in certain districts. The benefits could be enormous.
AM Godbole is a business analyst with Misys Software Solutions (India) Pvt. Ltd in Bangalore.
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