saving credit and insurance

Question 1

Primary function of a financial system

Answer 1

One important role of an effective financial system is to allow individuals to decouple consumption from income - such that they can smooth consumption even where income is volatile
o Consumption Smoothing can occur:
* over the short term (e.g. bank accounts)
* over the long term (e.g. savings and credit)
* over different ‘states’ of the world (e.g. insurance)

Question 2

Limitations of financial systems in low-income countries

Answer 2

▪ Macro volatility – fluctuating exchange rate, inflation, political instability
▪ Weak financial regulation – susceptibility to fraud and corruption
▪ Poor financial infrastructure – weak systems for payments and credit reporting
▪ Limited access to banking services – a large proportion of the population excluded

Question 3

Major market imperfections for those living in developing countries

Answer 3

▪ Substantial savings constraints
▪ Credit constraints and little formal insurance

Question 4

Why is saving so important

Answer 4

o Life-cycle consumption smoothing (e.g., saving for when one is too old to work)
o Finance lumpy expenditures (e.g., school fees, medical expenses)
o Build up assets to use as collateral to obtain credit
o Build up assets to be able to respond to income shocks – risk retention

Question 5

Limitations to savings

Answer 5

o Financial and non-financial costs
o Poor Financial Literacy
o Social Constraints
o Behavioural Biases

Question 6

constraints of savings - financial costs

Answer 6

o When saving accounts are offered free of set-up costs, no minimum deposits and no withdrawal costs, demand is relatively high
o Interest rates can also have an important effect on short- and medium-term savings

Question 7

constraints of savings - non-financial costs

Answer 7

o Non-monetary costs associated with access to formal banks can be extremely high:opportunity costs, lack of convenience, inflexible hours, large distances

Question 8

constraints of savings - poor financial literacy

Answer 8

o Training in financial literacy has been shown to impact financial behaviour
o Effects are often smaller in low-income countries however – Perhaps due to poorunderlying education

Question 9

constraints of savings - social constraints

Answer 9

o Intra-Household constraints and Spousal Control
▪ For example, pressure from husbands might reduce the savings abilities of women
o Household wealth might create pressure to share with other households from the kinship network. This might create a disincentive to save and invest

Question 10

constraints of savings - behavioural biases

Answer 10

o Time-inconsistent preferences - Setting plans to save in the future, but not following these plans when it is time to do so
o Lots of studies look at the effectiveness of commitment devices
▪ A well-known paper by Duflo et al (2011) used fertilizer coupons in Kenya to helpfarmers commit to buying fertilizer for the following season

Question 11

how can constraints to formal saving be avoided

Answer 11

informal saving

Question 12

buffer stocks

Answer 12

o Where income is volatile and monetary saving is problematic, households may build up assets in the form of a buffer stock to smooth consumption
▪ Purchase the asset when income is high, and sell (consume) when income is low

Question 13

limitations of buffer stocks

Answer 13

o Consumption may fall dramatically if buffer stock runs out (often a pre-curser to famine)
o Value of assets might also drop when an income shocks affect a large area
o If assets are productive, the long-term loss might be higher than the short-term gain

Question 14

ROSCAs

Answer 14

o ROSCAs (Rotating savings and credit associations) pool a fixed savings amountfrom each ROSCA member at group meetings
o The pool of funds is allocated on a rotating basis - the order can be fixed, random or through bidding
o At least one participant at each meeting receives the pool, using it for any purpose(e.g., school fees, buying bulky assets, paying off debt)
o ROSCAs are also a form of credit for early recipients
o Enforcement of contributions through social sanctions avoids members defecting
o Pooling provides funds faster than saving individually (half the time on average)
o Often used by women to control savings (e.g., avoid pressure from their husbands)

Question 15

advantages of ROSCAs

Answer 15

o The life of ROSCA has clear beginning and end
o The accounting is very simple
o There is no need to store large amounts of money

Question 16

limitations of ROSCAs

Answer 16

o The contribution is fixed
o The pot size is also fixed
o ROSCAs cannot mobilise funds from outside the community

Question 17

Why is Access to Credit Important?

Answer 17

o For poor households, having access to credit (borrowing) is often vital
o Credit can be used for:
▪ Consumption Smoothing – as with savings
▪ Investment - e.g., in a new business or an expensive productive asset

Question 18

use of credit for consumption smoothing

Answer 18

o Where savings are insufficient, credit can be used to prevent a shock to income becoming a shock to consumption (e.g., food consumption, schooling, healthcare)
o Particularly important in developing countries as incomes are often very irregular(informal work, volatile agricultural income)

Question 19

use of credit for investment

Answer 19

o Access to credit allows individuals to invest in income-generating activities
o Small loans can be used to start or expand businesses, purchase tools or equipment, or even invest in education and skills development
o In particular, women often face more significant barriers to accessing financial resources - providing credit can allow for greater financial independence

Question 20

challenges of providing credit to the poorest

Answer 20

o Information problems and risky projects
o No collateral – by definition, poor households lack assets
o Enforcement of repayment is difficult – weak legal institutions and regulation

Question 21

Microfinance Institutions

Answer 21

o Microfinance Institutions (MFIs) provide financial services (including ‘microcredit’)to people who otherwise have no access, or access only on very unfavorable terms
o The focus is often small loans (‘micro’) for small-scale enterprises, where traditionallenders faced the common issues of no collateral, poor information and/orenforcement
o Microcredit often uses group lending schemes (joint liability) - This provides the“collateral of peer pressure” to jointly repay

Question 22

how are repayments increased in microfinance institutions even without group lending

Answer 22

▪ Dynamic incentives - Borrowers are eligible for a future loan if they repay
▪ Targeting women - Women borrowers repay at significantly higher rates (morecautious investments, more sensitive to public disclosure of default, less likelyhave outside loan opportunities)

Question 23

Grameen Bank

Answer 23

o The Grameen Bank in Bangladesh was the first modern Microfinance Institution
o The model has now been replicated in dozens of countries, including the Philippines,Malaysia, Vietnam, South Africa, and Bolivia
How it works
▪ Individuals offer no collateral
▪ Groups are self-selected, with 5 members
▪ Joint liability for loans within a group
▪ Weekly public repayment meetings, starting immediately
▪ Increasing loan size is conditional on prior repayment
▪ Savings requirements/group funds
▪ Intensive screening and monitoring by the lender

Question 24

Limitations of Microfinance

Answer 24

o Credit constraints are not the only binding constraints on the poor
o Poor people have been described as ‘reluctantly entrepreneurs’ - most would prefer a secure job, not entrepreneurship
o First repayment instalment is typically due soon after initial disbursement
o Much of the credit obtained is used to support consumption not investment
o Joint liability can also hold back some entrepreneurs, particularly:
▪ Those who could otherwise profitably increase borrowing amounts rapidly
▪ Those who may face pressure from their co-signers (group members with whom they have joint liability) to invest in very safe projects, to reduce their own risk
o The Empirical evidence is mixed: In some studies, there are positive effects of microfinance on reducing poverty; in others, no net effect

Question 25

shock to income in low-income countries

Answer 25

The exposure to risk in low-income countries can be remarkably high, especially inrural areas

Question 26

sources of risk

Answer 26

Covariate/aggregate shocks, Idiosyncratic shocks - many shocks have both idiosyncratic and covariate components

Question 27

Covariate/aggregate shocks

Answer 27

▪ Affect all members of a community or region
▪ Formal or informal insurance transfers from outside are needed
▪ For example, drought, rain/floods, crop pests, input or output price shocks

Question 28

Idiosyncratic shocks

Answer 28

▪ Affect only a particular individual or household
▪ Can be insured within community
▪ For example, theft/crime, job loss, illness, death of family member

Question 29

Two possible forms of insurance are available in low-income countries

Answer 29

▪ Indemnity insurance – payouts linked to a specific event
▪ Index insurance – payouts linked to an index (e.g., rainfall)– An example would be agricultural index insurance in Ghana

Question 30

why is take-up of insurance usually very poor in low-income countries

Answer 30

▪ Indemnity insurance tends to be very expensive – saving or credit is preferable
▪ Index insurance contains basis risk (the loss occurs, but the payout is not triggered)
o Households uninsured against substantial levels of risk can limit development without a high degree of social protection

Question 31

what does the poorest being exposed to greater incidence of risk lead to

Answer 31

▪ Reduced investment due to a need to retain sufficient savings
▪ Long-term damaging impacts of large shocks (e.g., drought) on child/adult health
▪ Households prioritising income smoothing activities

Question 32

income smoothing

Answer 32

Income smoothing seeks to prevent risk or limit the impact of risk ex-ante. For example,
▪ Diversification of income which is not perfectly correlated
▪ Avoiding costly inputs with higher rate of return but more uncertainty
o Often income smoothing will reduce income variance but also reduce mean income

Question 33

smooth consumption via risk sharing

Answer 33

o Risk-sharing implies households insure each other by trading across different realizations of the world - one household experiences a shock, others support
o There will be benefits to risk-sharing if income realizations are not perfectly correlated across households – ineffective for covariate shocks to the whole network

Question 34

Who engages in risk sharing?

Answer 34

Commonly found among small, close-knit groups, with strong social and kinship ties(less likely members exploit the network, or default)

Question 35

benefits of government social protection programmes

Answer 35

o Benefits go beyond just providing support when households experience shocks
▪ They lower the need for precautionary savings – potential for more investment
▪ May prevent the use of the most detrimental coping strategies - e.g., taking childrenout of school to work, selling productive assets

Question 36

Issues in providing Social Protection

Answer 36

o Targeting – who is entitled to support?
o Crowding out – will Social Protection just replace informal insurance (no net effect)?
o Distortionary effects – E.g., why work if unemployment benefit are available (little evidence of distortionary effects are large enough to matter)?

Question 37

self-targeting social protection programmes

Answer 37

The Productive Safety Net Program (PSNP), The National Rural Employment Guarantee Act (NREGA)

Question 38

The Productive Safety Net Program (PSNP) – Ethiopia

Answer 38

▪ Targets food-insecure households, often affected by drought and climatic shocks
▪ Provides cash or food transfers in exchange for participation in public works activities(unconditionally, if they can’t work)
▪ Local communities identify works projects that address their specific needs

Question 39

The National Rural Employment Guarantee Act (NREGA) – India

Answer 39

▪ Rural households are guaranteed 100 days of paid work per year
▪ Focuses on projects such as water conservation and rural infrastructure
▪ Has faced strong criticism on implementation - with delayed payments and corruptionkey problems