Economics of loans to the poor and how technology will help

"One lends only to the rich."

The usual reason given for high interest rates on loans to the poor is the high default rate. If you need to make 5% to cover your costs, but only half your customers are going to pay you back, then you need to charge 210%, so that the ones who do repay can make up for the ones who don't.

This logic assumes that high default rates are a given, not a variable that can be influenced, or even selected. The default rate has a few key drivers and understanding them can lead to ways to influence the economics of a loan.

1. COLLATERAL
One of the basic protections that lenders seek is collateral - something of value that the borrower puts at risk if he doesn't repay. Wealthier borrowers can pledge larger collateral. Often the value of the collateral is proportional to the size of the loan. This explains why poorer borrowers can borrow less, but it doesn't explain why their interest rates should be higher.

2. INFORMATION
If the borrower has no money after using up the loan, then the lender will not be able recover his loan. So the lender needs to know how likely the borrower is to repay the loan, the nature of his income and his financial situation. The lender may even want to monitor the borrower and periodically recollect some of this information. These efforts have a cost that has to be covered by the interest rate. And this cost doesn't scale down with the size of the loan.

To make it worse, this is a bad spiral. When the interest rate goes up, the borrower has a larger incentive not to repay, which means the lender needs to be more thorough in collecting information and monitoring the borrower - further pushing up the cost and further increasing the incentive not to repay.

3. CONTRACT ENFORCEABILITY
The flip side of information is the enforceability of the contract. If the lender had a way to enforce the contract, then they wouldn't incur the costs of having to collect information. While this seems like a theoretical possibility, examples occur all through the real world. The mafia is reported to be the largest bank in Italy (and most profitable). In India, the legal systems takes years to review litigation. This keeps banks out of lending to the poor and those with more innovative ways to collect have stepped in.
 

IMPACT OF TECHNOLOGY
Now look at how technology can affect these drivers. Everyone has a cell phone and increasingly people have smart phones. These are essentially mini sensing and computing devices that everyone has become tied to. The widespread adoption of cell phones and the movement of information to the cloud make the ability to collect and monitor information much much easier.

Further, people are taking their social relations online (1 billion of them on facebook!) and are creating digital assets that have value (think of online timesheets, points, miles, twitter accounts, BBM contact lists, blogs etc) that are not directly correlated to their wealth. It's not inconceivable that social networks can be a platform to enforce contracts or that digital assets can be put up as collateral.

Eventually technology will drive down the cost of loans to the poor. For an example of this has already started, take a look at activehours.

 

A version of this post was originally published at blog.activehours.com.