Portfolio Balancing: Rethinking our assumptions about the benefits

and costs of financial products for the poor

September 2012

Objective: Understand consumer logic on financial choices to offer better products and improve portfolios as a whole

Faulty assumption:

Over time, take up of formal products will naturally eradicate the need for informal products.

Result: Rather than weighing the merits of formal versus informal products, see both as complements in satisfying the complex financial needs of the poor.

Increased access to formal financial

tools

Increased formal financial usage

Decreased informal financial usage

Increased access to formal

financial tools

Increased financial options

to consider

Usage depends on current

financial needs

Instead, we suggest a paradigm shift:

Availability of formal financial services adds more options, which often have safer elements, but rarely offer an improvement over informal devices in every way.

Therefore, a completely rational and informed decision may be to continue using informal financial instruments in combination with formal instruments.

Underlying analytical insight: Full costs of financial services include time and risk, not just monetary costs

Monetary costs

Monetary costs comprise the largest portion of the transaction costs associated with formal savings.

Time costs• Time required to complete

transaction at the place it is made• Amount of time spent on travelling

to the place of transaction.

Time spent completing transactions is more costly than travel time.

Risk • Likelihood and amount lost in the past 10 years.

Formal Instruments are not risk-free in eyes of the users.

Definition Main Finding

Any fees, interest or premiums associated with the transaction Financial cost of transportation to the place of transaction.

CGAP commissioned Bankable Frontiers Associates to revisit the households from Portfolios of the Poor to understand changes in portfolio mix:

1. Leverage existing data on portfolios of financial instruments over time: Orlanda Ruthven, Stuart Rutherford and Daryl Collins collected data about how much households used financial instruments and what they paid in fees with the Indian, Bangladeshi and South African households that were the subjects of Portfolios of the Poor.

2. Gather new data: In 2010, we revisited the same households, updated our knowledge of their financial status and asked more detailed questions about loss and transaction costs.

3. Calculate: Fully loaded costs of using financial services (including travel and transaction time and costs)

4

Methodology: Financial portfolios of Indian, Bangladeshi, and South African households

RESULT: Concrete, detailed lens of the costs of financial services within complex portfolios

# of households in original SA sample 152

# of households in 2010 SA sample* 125

% rural 39%

Average per capita monthly income

(US$)**$152

Median per capita monthly income

(US$)**$104

*We lost 19% of urban sample and 17% of rural sample. **Converted to US$ at current market rates.

5

We start with South Africa, where we have the largest sample and diversified portfolios

Share of households that have at least one…

Formal 74%

Bank account 74%

Formal loan 22%

MFI loans or savings -

Credit arrangement* 41%

Formal insurance 52%

Informal 100%

Savings club 65%

Saving in the house 89%

One-on-one borrowing 73%

Informal insurance 66%

*Refers to credit cards (including store-specific cards), and credit at a store (general or for a specific good, like hire-purchase)

Clarifying what we mean by formal and informal

BORROWING

• Bank• MFI• Credit union/

cooperative• Credit card• Store card • Paying on

installments

• Family and friends (with or without interest)

• Moneylender

INSURANCE

• Life insurance • Medical insurance • Vehicle insurance• Funeral insurance • Crop insurance

• Burial society

SAVINGS

• Fixed deposit account

• Private long term investment

• Bank account• Credit union account

• Savings group• Savings in the house• Money guard

Formal Formal

Informal

Formal

InformalInformal

Borrowing: If we use a product-centric view, i.e. comparing product to product on annualized terms, formal looks much cheaper

Simple APR cost comparison:

But this fails to consider other costs / benefits which differ across loan types: • ESPECIALLY LOAN SIZE• But also duration• Frequency• Transaction costs• Other factors difficult to quantify (e.g.

likelihood that a loan will be given )

Common conclusion Choose formal options: The overwhelming economic cost is the main problem with informal instruments

So, we present a more appropriate comparison in the next few slides…

For a true cost/benefit evaluation, we must switch from a product-centric view to a portfolio-centric view

THE TYPICAL PORTFOLIO IS DIVERSIFIED ACROSS TIME:

…WOULD contain a formal credit card/line of credit. 41% of the sample had formal credit, with an avg. of one credit to pay off (avg.debt size: $270, avg

monthly repayment $27, duration: 8 months).

….would NOT contain a formal bank loan. Only 22% of the sample had a formal bank loan (avg size:

$540, duration: 2 years).

….WOULD contain a one-on-one loan. 73% of the sample had one-on-one loans, with an average of 3

loans per year(avg. size: $4, duration: 15 days).

…..would only contain sporadic moneylender loans. Only 26% of the sample had a moneylender

loan, on average 1 per year (avg. size: $28, duration: 42 days).

Illustration of a South Africa Financial Diaries budget: Expenditure over 4 months (in $)*

Avg. Jan.-Apr.

Avg. % of Income

Income 730

Store card 30 4%

Bank loan -- --

One-on-one loans 2 0.3%

Moneylender loans 5 0.6%

Diversification is often necessary: formal satisfies larger loan requirements, whereas informal can help during short term and small funding gaps.

* Figures in the table above are illustrative and based on calculated averages across the entire sample.

When assessing costs on a portfolio-centric view, the poor actually spend much less on informal loan instruments on a monthly basis

Cost comparison within an average monthly budget of $730:

Cost per month: $37

Cost per month: $5

Formal Informal

Informal options impose no travel and transaction costs and have lower interest costs. The few informal loans that charge interest are paid back within a month.

Note: This slide is not comparable to the previous slide because it compares full debt repayment and not interest cost alone. Our respondents were often unable to tell us how much of their payments were interest versus principle, particularly in a credit transactions. However, we feel this view better reflect the debt burden on households because it takes account of the fact that household repay debt in very different time frames - from one day to one year.

Debt repayment,

$5.41

How does this inform our perspective on formal and informal borrowing options?

Formal• Is not instantaneously accessible

(except for credit cards, once given)• Is more private• Is not flexible

Informal• Usually is instantaneously

accessible*• Is NOT private• Can have flexible payments

Rational Decision for Consumers?• Borrow informally until you need size (e.g. more than 1/3 of monthly income**);

until then, the associated transaction costs and the availability of flexible payments make informal the better choice.

Lesson for Formal Lenders?• For clients, knowing how much they will be approved to borrow ahead of time is

very useful• Ease repayment transaction time

Additional non-cost considerations:

*Knowing that they will be able to receive a certain amount is one of the key reasons why households reported they borrowed from moneylenders. **This is the average size of formal loan to income for those who have formal loans

Clarifying what we mean by formal and informal

BORROWING

•Bank•MFI•Credit union / cooperative•Credit card•Store card •Paying on installments •Family and friends (with or without interest) •Moneylender

INSURANCE

•Life insurance •Medical insurance •Vehicle insurance•Funeral insurance •Crop insurance •Burial society

SAVINGS

•Fixed deposit account•Private long term investment •Bank account•Credit union account •Savings group•Savings in the house•Money guard

Formal Formal

Informal

Formal

InformalInformal

Insurance: South African formal and informal funeral insurance are very different; but costs are nearly equal.

$47 per month $43 per month

Cost comparison within an average monthly budget of $730:

Note: Average portfolio has one funeral policy and one burial society.

Informal options and formal options have similar transaction time costs.

Formal funeral insurance offers the same value as burial societies, but premiums and payouts are on a higher (but still affordable) scale

Funeral Insurance (Formal)

• Avg. coverage per dollar contributed (i.e. VALUE)= $683= $12,980 payout for a $19 monthly premium

• Funeral insurance covers an average of 4 family members, or $3,245 per funeral.

Burial Societies (Informal)

• Avg. coverage per dollar contributed (i.e. VALUE)= $683 = $3,620 total payout for a $5.30 monthly premium

• Burial societies cover an average of 7 family members, or $517 per funeral.

While average coverage per dollar is equal for formal and informal insurance, the coverage per funeral is much greater for formal funeral insurance than for informal burial societies.

How does this inform our perspective on formal and informal insurance?

Formal Insurance• More difficult/concerning to claim• Money might not come when

needed

Informal Insurance• Easier, more confident in claiming• Helping hands at the funeral itself

Rational Decision for Consumers?• Treat formal and informal as complements: Informal insurance provides

immediate support, while formal insurance provides greater coverage (once received).

Lesson for formal insurance?• Need to offer size (i.e. be able to insure for more than 75% monthly income*)• Must promote credibility• Must make it easy to claim and easy to pay premiums – note that it takes just as

long to do a premium payment as it does to attend a burial society meeting, but the meeting is with your friends!

Additional non-cost considerations:

*This is the average total payout over income for those who have formal insurance.

Clarifying what we mean by formal and informal

BORROWING

•Bank•MFI•Credit union / cooperative•Credit card•Store card •Paying on installments •Family and friends (with or without interest) •Moneylender

INSURANCE

•Life insurance •Medical insurance •Vehicle insurance•Funeral insurance •Crop insurance •Burial society

SAVINGS

•Fixed deposit account•Private long term investment •Bank account•Credit union account •Savings group•Savings in the house•Money guard

Formal Formal

Informal

Formal

InformalInformal

Savings: Informal savings is much cheaper than formal, even though risk is high and privacy low

Cost comparison within an average monthly budget of $730:

$18 per month $4 per month

89% of the sample save in the house66% of households use savings clubs and save an average of 30% of their financial wealth there.

74% of households use banks and save an average 22% of their financial wealth there.

Note: Average savings flow/month: formal instruments (8%); informal instruments (12%)

Simply lowering travel time does not increase savings

But savings in banks stayed the

same

Policies targeting travel time and fees alone did not make a difference in bank savings.

Financial Sector Charter required branches to be within 20 km from low income areas.Result: Transaction times decreased by 25% and travel time to the bank decreased by 44%.

With more ATMs and branches, transaction times

dropped

With Mzansi, ledger fees were dropped

Automation results in increased savings

Only when direct deposit rates increased

Financial options to consider

Higher direct deposit rates resulted in increased savings in banks.

Increase in direct deposit of salary and grant from 29% to 43% of income.*

Conclusion? Automation matters as much as economic costs.

*The increase in direct deposit of salary and grant was not a result of income fluctuations.

Savings: Formal instruments are still perceived as risky for the user

Savings clubs: High Actual Losses

High loss: 6% of users lost an average of $346 in the past decade

Money “lost” =

– Other members don’t contribute their payments

– Borrowers don’t repay the club– Money is robbed at the time of

distribution

Bottom line: Effective savings mechanism but very real potential for loss

Banks: High Perceived Losses

High loss: 6% of users lost an average of $145 in the past decade.

Money “lost” =

– There was less money in the account than expected (due to monthly charges)

Bottom line: If banks improve consumer awareness of rules and fees, this perceived risk could decline dramatically.

Two examples of frequently used financial instruments:

How does this inform our perspective on formal and informal savings?

Formal Savings• When using formal savings, the time

making the transaction means waiting in line

• Doesn’t impose the same level of inflexibility as savings clubs

Informal Savings• When using informal savings, time

making a transaction means being in a meeting, usually with friends

• Savings clubs have a huge advantage in commanding discipline from members

Rational Decision for Consumers?• Use savings clubs to “save up”, use bank accounts to receive payments; use

savings clubs as much as possible to realistically reach savings goals; use bank accounts to receive and manage incoming funds.

Lesson for formal providers?• Convenience and low transaction times • Improve reliability AND ensure that clients understand how the products work• Commitment savings is valued – beyond risk and beyond cost

Additional non-cost considerations:

What if we broaden the view beyond South Africa?

• In South Africa, there is a tilt in balances towards savings – this seems to be one of the benefits of having such high participation in savings clubs

• In Bangladesh and India, there is a tilt towards debt – in the Bangladesh case this might be due to the higher presence of larger MFI debt to be paid off over a longer period

• The result is that the same challenges remain for these portfolios, which the formal sector might be able to address:▫ Lower transaction times▫ If properly explained, lower risk

South Africa Bangladesh India

# of households in original samples 152 42 48

# of households in 2010 samples* 125 34 36

% rural 39% 59% 68%

Average per capita monthly income

(US$)**$152 $28 $36

Median per capita monthly income

(US$)**$104 $23 $17

*In Bangladesh, lost only 1 rural household, but one third of the urban sample. In India, lost 4 out of 28 rural household, but 40% of urban sample. In South Africa, lost 19% of urban sample and 17% of rural sample. **Converted to US$ at current market rates.

From each of these households, we’ve collected a total of some 3000 data points over the past decade – a small sample, but deep data.

Who did we interview?

Bangladesh and India rely heavily on debt to form “lump sums”* while South Africa depends on savings

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Bangladesh India South Africa

Insurance

Loans

Savings

*Total number of sums: Bangladesh (94), India (139), South Africa (65).

Percentage of total lump sums

In pure monetary flows in South Africa, the outflows attributed to savings every month are still higher than those for debt payments, fees and premiums, but by a slim margin…

Food

Savin

gs o

utflo

w

Fees,

prem

ium

s and

deb

t pay

men

t

Trans

port

Energ

y

Telep

hone

0%

5%

10%

15%

20%

25%

30%

Percent of monthly average budget (% of monthly income, US$ above columns)

Formal devices

Informal devices

$197

$153

$134

$44 $44

$22

…But in Bangladesh, it’s the opposite – outflows for debt and insurance are higher than savings.

0%

5%

10%

15%

20%

25%

30%

35%

South Africasavings

Bangladeshsavings

South Africafees, premiums,

and debtpayments

Bangladeshfees, premiums,

and debtpayments

Informal

Formal and MFI

South Africa and Bangladesh comparative financial outflows (% of monthly income)

The cost of time is even higher in India and Bangladesh

Formal Informal Formal MFI Informal Formal MFI Informal0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%Total transaction costs for South Africa, India and

Bangladesh(% of monthly income)

Travel costs Implied transaction time* Implicit risk cost**

South Africa

IndiaBangladesh

Time costs are highest for MFIs, which are not as prevalent in South Africa.

*During the interviews on transaction costs, respondents were asked about money lost through financial instruments in the last ten years. Households could name as many losses as they had. The rate of incidence is the number of losses divided by the number of users of each type of instrument. Incident rate and average loss were combined by dividing the rate of incidence by the number of months in 10 years (120) then multiplying by the average amount lost in each instrument. These amounts were then divided by average income in each country to get a percent of income per month number. The ratio of losses in informal instruments compared to formal instruments is simply the ratio of the risk percentage of monthly income for informal instruments over formal instruments. In India and Bangladesh, formal instruments includes MFIs, weighting by use of MFIs versus formal instruments. WARNING: THESE NUMBERS NEED TO BE TAKEN AS INDICATIVE AS THESE ARE VERY SMALL SAMPLES AND MANY LOSSES HAPPENED EARLY DURING THE 10 YEAR PERIOD!

There is an even greater emphasis on the need for more reliable services

South Africa India Bangladesh0.00%

0.10%

0.20%

0.30%

0.40%

0.50%

0.60%

Implicit cost of risk(% of monthly income)

Formal MFI Informal

In South Africa, losses* in informal

instruments are nearly the same as the losses in

formal instruments

In India, losses* in informal

instruments are

3 times losses in

formal /MFI instruments

In Bangladesh, losses* in informal

instruments are nearly

4 times losses

in formal/MFI instruments

Conclusions and next steps

• When judged on portfolio-centric merits, there is no natural advantage of formal products over informal product ▫ Informal products often fill a need in portfolios (although not perfectly)

that formal products do not

• What formal service providers can do to improve their offering and help build better portfolios is to:▫ Ensure greater reliability across all products▫ Ensure more efficient transactions across all products▫ Offer size in insurance and loans▫ Offer commitment in savings

• Next steps – data from financial diaries in other countries will broaden our evidence base:▫ Mexico▫ Kenya▫ U.S.

Advancing financial access for the world’s poor

www.cgap.org

www.microfinancegateway.org