Micro-lending skeptics

I sent my formal proposal to Paul Brewbaker, formerly Chief Economist at Bank of Hawaii, and now of TZ Economics. Although he hadn't actually read the proposal, he didn't seem to think much of our idea:



I haven’t read the attachment but here are some quick thoughts, actually a critique on first principles.

Micro-lending occurs in markets that are characterized by: (1) low levels of per capita income; and (2) inadequate financial “deepening.” The two are not independent, but the causality runs from (2) to (1). Hawaii is not a (1) market. Hawaii is a “G-22” market. Honolulu is not Mumbai.

Modern finance and banking theory typically asks why (1) and (2) co-exist in the context of information asymmetry. That is, financial development overcomes two forms of asymmetry—adverse selection and moral hazard—which is it absent in some contexts (like, low-income countries). For a variety of reasons related to cultural and historical specificity, without getting into post-colonial mush, the absence of well-developed private property rights systems in many developing contexts has often been an impediment to the development of traditional bank lending. Collateralization institutions require clear property rights, and credible enforcement of the associated state-contingent contracts (“if you don’t pay back the loan then this happens”). For example, much of the hangup immediately after the start of the Asian Financial Crisis was the lack of credibility of bankruptcy law enforcement in places like Thailand. (Within 90 days of the collapse of the Thai baht in July 1997, acting on an IMF recommendation, Thailand re-wrote its constitution, dissolved the Parliament, had new Parliamentary elections, and passed the necessary bankruptcy law reforms, something that could never happen in Hawaii.) Collateralization, information technology (to confirm borrowers’ financial status), monitoring of covenants in loan agreements, all are tools designed to create an incentive-compatible environment between borrowers and lenders. They mitigate risks of lenders selective adversely, and mitigate risks of borrowers behaving in morally hazardous ways, before and after a loan is made, respectively. Certain substitutes for the enforcement of such contracts—such as peer monitoring, where village elders or “kupuna” ensure credible enforcement threats of loan covenants—have been successful in some micro-lending contexts where other information asymmetry-reducing institutions are not well-developed. That’s not Hawaii, is it?

So the question is: where, in Hawaii, are existing lending institutions inadequate to the needs of a micro-lending borrower segment? We already have a thriving, non-profit, small- (if not micro-) lending community in Hawaii. They are called credit unions. So ubiquitous are they, and so large a share of deposits do they comprise in Hawaii, that during the 1990s the U.S. Justice Department changed antitrust law interpretation to recognize the importance of credit unions in Hawaii when calculating concentration ratios in their due diligence of bank and savings and loan acquisitions. In no other state does the role of credit unions even approximate their role in Hawaii. That’s before we even talk about banks, all of whom are under the (dubious) requirements of the Community Reinvestment Act (CRA) to lend in economically-disadvantaged communities. Call it forced adverse selection: even the legacy of the sub-prime financial crisis has not led anybody to question the wisdom of CRA, at least not very publicly. (Only nerds talk about it at financial economics conferences.) At least one Hawaii bank routinely receives an “outstanding” CRA rating by federal bank examiners, a designation conferred on only 7% of commercial banks nationwide.

I’ll take a look at the doc file in the next couple days but I guess my first concern would be—all kidding about the People’s Republic of Hawaii aside—why would anybody do this in Hawaii and, even more importantly, why would anybody expect a non-profit lender to do it well? The point is to have skin in the game, both borrower and lender, so that the loan gets paid back. Non-profits have nothing at stake, except the self-perception of the goodness of the deeds they do, hardly a basis for good credit allocation. It’s not clear to me that the track record of credit unions in terms of loan quality makes the non-profit channel appealing, and there is plenty of evidence of such clowns as DBEDT, OHA and DHHL that government is an even worse non-profit lender than private not-for-profit institutions. The only way I could see this making sense is if somebody had a better computer algorithm than commercial banks already do (who, let’s remember, do this stuff on-line already). With their existing information technology banks screen borrowers, originate loans, and manage payments and settlement, all with a less than 4% loan loss rate for credit card issues (which is about the max that the last 20 VISA and Mastercard issuers will actually tolerate) or, if you’re a Bank of Hawaii, at a less than 1% loan loss rate. In fact, come to think of it, credit cards ARE the micro-lending channel in the U.S., and every kid in college can get one of those. What is the market here?

OK, harsh reaction, I know. The more I contemplate it, the harsher my reaction gets. Start by having the gang think through answers to those questions and I’ll get back to you.

pb