The inequality of opportunity

They have valid income generating ideas and the required skills and experience, but nobody is willing to fund them.


Dr Hammad Siddiqi May 27, 2014
The writer is a research fellow at the Risk and Sustainable Management Institute at the University of Queensland and an associate professor of economics at LUMS

Economic growth takes place when income generating ideas become a reality. A key hurdle in the way of an income generating idea becoming a reality is financing. People are the custodians of ideas, and the financial sector is the custodian of a society’s savings. Growth takes place through successful linking of income-generating-ideas with funding. However, there is a fundamental inequality of opportunity that lies at the heart of this mechanism. When it comes to funding, a rich person is preferred over a poor person regardless of the quality of their respective ideas.

Consider the case of Javed. He is a skilled electronic repairman working as a driver in Lahore. He knows that if he opens an electronic repair shop in his home town, his business may take off as people in his town, have to travel over 25 miles to get their electronic items fixed. He needs about Rs500,000 to start his business. Masood is working as a bus conductor in Rawalpindi. He had a rickshaw before ill health forced him to sell it. All he needs now is about Rs200,000 to buy a CNG rickshaw, and start transporting people from his village to the nearest major inter-city bus stop, a journey which is presently done on foot. There are a lot of people like Javed and Masood around us. They have the skills to succeed in their respective business plans but nobody is willing to finance them. Banks do not lend to them because they cannot provide collateral. Microfinance institutions lend much smaller sums, which are not sufficient to start new businesses. People like Javed and Masood are all around us. They have valid income generating ideas and the required skills and experience, but nobody is willing to fund them. The average income per rupee of investment in their porposed businesses can be quite large when compared with a typical business that banks willingly lend to. Still, they remain unfunded. What’s the reason behind this inequality of opportunity?

The problem is that both the banks and microfinance lenders rely on the same inflexible debt contract. In a debt contract, a lender has no stake in the upside potential of an endeavour beyond the fixed payoff. Naturally, in a debt contract, a lender’s entire focus is on minimizing downside risk. That is, the objective is to fund the safest borrowers. Wealthy borrowers who can provide collateral and the government which can always print money to pay off its debt are the safest borrowers in the traditional banking sector. Microfinance institutions have taken the debt contract to the poor by developing extensive monitoring and selection networks; however, they cannot lend amounts large enough to start new businesses because poor have low debt repaying capacity.

In practice, we have a financial system that collects the country’s savings, and makes it available only to the wealthy who can provide collateral. Assuming that only the wealthy have income generating ideas is wrong. From a bank’s perspective, the wealthy may have the safest ideas as they provide collateral, but, surely, from the society’s perspective, they may not be the best income generating ideas. Ideally, the financial sector should select the best ideas irrespective of the level of wealth of the idea generator. However, the financial sector is in no position to do that. All it does is collateral management. Think about the loan officers approving bank loans. What do they know about the business being funded? Hardly anything.

In general, a lender has two major concerns: 1) The borrower may play unfair with the money 2) There is a downside from backing losers. In a debt contract, such concerns are mitigated by requiring collateral. But, the ability to reach the wider population is sacrificed as only a few can provide collateral.

Mitigating these concerns without collateral requires investment in a selection and monitoring network. And if collateral is dropped, and funding has to be large enough to support people like Javed and Masood, then one needs to move beyond the inflexible debt contract. The only way people like Javed and Masood can be funded is through a risk sharing or a mudarabah contract. The upside potential in a mudarabah contract can counter-weight the downside risk of business failure. Microfinance institutions have developed extensive monitoring and selection networks that allow for very high recovery rates. However, research indicates that micro lending does not bring about a meaningful change in the lives of the poor. Such lending is typically consumed as it is not large enough to start a new business. By sacrificing breadth in favour of depth, a mudarabah- type contract can be implemented. For example, instead of lending Rs50,000 to 20 people through a debt contract, lend Rs500,000 each to two people on mudarabah basis. The amount is large enough to start a small business, and the upside stake can potentially counter-weight the risk of failure. Hence, the selection and monitoring networks of micro lenders can be tweaked to experiment with mudarabah contracts.

Growth comes from realisation of opportunities. Behind every opportunity is an idea. For a country like Pakistan, ideas that Javed and Masood have are representative of our untapped growth potential. For our sake, we need to tap this potential. And, it is not going to happen through the inflexible debt contract. The question is: is someone willing to try the risk sharing contract?

Published in The Express Tribune, May 28th, 2014.

Like Opinion & Editorial on Facebook, follow @ETOpEd on Twitter to receive all updates on all our daily pieces.

COMMENTS (21)

Hammad Siddiqi | 9 years ago | Reply

@ Hugh Sinclair.

Good points. High interest rates being charged is the direct result of trying to take the inflexible debt contract to the poor. The monitoring and selection cost (operating cost) of microfinance lenders is high because of the large number of very samll borrowers. They have no choice but to give out a large number of small loans (as opposed to a few large ones) because a debt contract does not give anything to the lender on the upside (beyond the fixed payoff). So, the lenders try to lower the risks by spreading it over a large number of borrowers. In other words, the lenders are stuck between a rock and a hard place. In my opinion, the only way forward is to move beyond the inflexible debt contract, and try microfinance venture capital in which the lender keeps a share in the upside as well. That upside can counter the downside risk of failure, and fewer borrowers in venture capital verison would lower operating costs as well.

Afif Naeem (A N) | 9 years ago | Reply

@Hammad Siddiqi: Thanks for the clarification. What incentive or potential loss does the borrower faces under such a setting? With majority of the small businesses having minimum to no documentation for sales or purchase orders, monitoring may not be costly, but it wont reveal the true health of the business. The borrower will show losses on paper, and misappropriate the funds. This is why small businesses in developing countries are much risk borrowers than those in developed countries where detailed documentation is available, thanks to taxation laws and inspections.

I am not trying to undermine your hypothesis here, I think it is a great idea and has potential for being successful initiative. But such issues are better to be discussed on table and possibly resolved, than getting scammed by small business owners and losing confidence of the financial sector.

P.s: I used A N as name above.

VIEW MORE COMMENTS
Replying to X

Comments are moderated and generally will be posted if they are on-topic and not abusive.

For more information, please see our Comments FAQ