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How can it be that entrepreneurs with great skills, a solid business plan and a clear market opportunity still have a hard time to get funding? The answer lies in economics.

Blessings of the free market…

The ethics of capitalism and the free market can be summarized by an economic principle first described by the classical economist Adam Smith in 1776: The invisible hand of the market. It means that by pursuing our self-interest, we are serving society as a whole. As Smith explains in The Wealth of Nations:

It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.

In the same way we don’t expect the baker to serve us out of pure generosity, we don’t expect investors to give money to charities for altruistic reasons. Rather, financial markets are expected to allocate capital to those places where the return on investment is highest. They serve society by efficiently allocating capital to maximize value creation. Now we know that capital suffers from diminishing returns, meaning that adding ever more capital will not necessarily result in ever more growth. A simple example: the first computer a shopkeeper buys adds tremendously to his productivity, allowing for digital bookkeeping and control of his inventory. The second and third computer he buys may add some productivity, but much less so than the first computer did.

Different marginal returns for poor and rich entrepreneurs

Extending this example on a macro-economic scale, this means that entrepreneurs with little initial capital should be able to make a higher return on capital than already well-endowed entrepreneurs. It follows that in a perfect market, capital should flow from developed countries with less growth opportunities to developing countries where marginal return on capital is higher.

However, this is not what is observed in practice. In fact, access to finance is one of the biggest challenges for micro, small- and medium enterprises (MSMEs) around the world. 26% of firms surveyed by the world bank identify access to finance as a major constraint, more so than political instability, a stable electricity network or high tax rates. Do banks consider these companies as not having viable investment opportunities, are they unsuitable to pursue these opportunities or is there something else at stake here?

…But not for everyone

Theory is at odds with reality here due to two market failures. First, asymmetric information increases uncertainty and risk for the lender. Asymmetric information means that one party knows more than the other party. In the credit market, where providers want to minimize risk and maximize reward, this is a trust issue: How can a lender know for sure whether the borrower will pay back the agreed mount on the agreed time? The simple answer is: He can’t. There are several ways the borrower can signal to the lender he actually is a trustworthy borrower: For example, he can provide collateral, reducing the damage done in case of default for a bank. Or he can show his credit history, proving his reputation. In the context of developing countries signaling trust may be harder though.

Example Consider Marta, a 26-year-old ambitious hairdresser in Guatemala looking to set up her own shop in the city of Cabán. There are few hairdressers in town, and Marta, who started serving customers from her parents house, is renowned in the neighborhood for her exceptional skills and creative style. She made a business plan, identified a nice spot at the central street, a perfect place to start her business. All she needs is a loan to buy the place and set-up the shop. The bank reviews her business plan and is excited. However, funding a starting business is a risky activity and some previous clients ran off with the money without ever repaying, so they demand more certainty. The bank asks Marta to put up a collateral and to provide a credit history, so they know she’s trustworthy. This is a problem for her: Coming from a poor family and no business in place she doesn’t have any collateral to put up. Moreover, she didn’t own a bank account until recently. With no collateral and no credit history, the bank won’t provide her a loan. Marta can’t pursue her dream due to asymmetric information. This is a loss for Marta, the people of Cabán and ultimately society at large, as an opportunity for value creation is forgone.

Second, transaction costs are not zero, as assumed in the theoretical model. The high operating costs of providing relatively small loans make it hard for banks to provide the relatively small loans to MSMEs. No matter the size of the loan, there is still staff needed to advice customers and take on loan applications in the front office, check loan applications in the mid office and monitor loans in the back office. The costs associated with providing the loan may top the revenues.

It is not only operating costs from the lenders’ side that make it harder for entrepreneurs to get funding. Transaction costs for the borrower may impose a barrier to finance too. A shop owner in Tarabuco, Bolivia may want to expand his business by taking a small loan from his local bank branch. The problem is, the branch is a two-hour bus ride away from his village. Closing his shop for a day to get a loan means he’s missing a day’s income. Moreover, he needs an official document with a government stamp stating he’s the owner of the business. Gathering this document and receiving the stamp takes him 2 weeks. Lastly, the terms of the contract cover 4 pages and are hard to understand for someone without a financial background. Considering all this, the shop owner may decide not to take the loan and suspend the expansion.

Example Tomás owns a bicycle shop in Medellín, Colombia. He wants to renew his repair set and refill his tube inventory. Therefore he’s looking for a loan of 30m Pesos (around €8.500). Unfortunately, every bank he visited only provides business loans above 40m Pesos. One bank is willing to supply the loan, but only at an annual interest rate of 54%. Lower rates for small loans are not profitable for this bank. Tomás, quenched by the high borrowing costs, will need to find another way to fund his investments.

So, even though theoretically all entrepreneurs able to make a good return on capital should be able to receive a loan, this is not what is observed in reality. The main reasons are asymmetric information between the lender and the borrower, and the high transaction costs involved. This concerns operation costs, but also the costs and effort a borrower has to make in order to get the loan. These problems are the central issues microfinance institutions are trying to solve. The next post will cover the innovative solutions provided by the ‘founding father of microfinance’ Mohammad Yunus to reduce risk and transaction costs, as well as more recent technological developments such as alternative credit scoring by using sophisticated algorithms.

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