Finance can be a glue that holds all the pieces of our life together. It enables money to be in the right place at the right time for the right situation. To borrow and save is to move money from the future to the present, or from the present to the future. To insure is to move money from a “good” situation to a “bad” one. Ideally, we would never have to think about finance. It would be seamless, operating in the background. It would allow us to invest and consume exactly as we deem optimal, given all the other constraints that we have in life.
For finance to work this way, four conditions need to be in place: enforceability of contracts, an absence of transaction costs, perfect competition, and fully rational consumer behavior. No country fully meets these ideal conditions, of course. But in developing countries, the situation is especially challenging: Contracts are often not enforceable; long physical distances drive up transaction costs; a lack of competition gives a small number of firms an inordinate degree of market power; and behavioral biases (which are present in wealthy countries, too) lead people to make systematic and costly mistakes.
For a long period, such inefficiencies prevented financial markets from emerging in these countries, and the result was stark: The poor had little access to credit and little ability to build savings through formal institutions. The obstacles were simply too high for traditional banks to want to serve them, and no one else was filling the gap. Then, starting in the 1970s, Muhammad Yunus changed the landscape of finance for the poor. He developed a new business model—known as microcredit—that lowered transaction costs for the lender and removed some of the information asymmetries that made it difficult to lend. This innovation required some tinkering, some exploration, and a great deal of risk. In its early stages, the microcredit movement was not financially sustainable; it required a subsidy. For that reason, donors and nongovernmental organizations (NGOs) played a central role in building the movement.
Today, the business of providing microcredit has reached a stage of relative maturity. Significantly, for-profit companies and investors are now shifting into this space, and in some cases nonprofit organizations have even converted to for-profit entities. In Mexico, for example, Compartamos Banco started as a nonprofit organization and then converted to a for-profit operation; it was the first microlender to become a publicly traded company. SKS Microfinance, based in India, followed a similar path.
Read the rest in the Stanford Social Innovation Review.