Financial Literacy

Introduction One of the lessons global policymakers have drawn from the recent sub-prime crisis is the importance of financial literacy. Countless borrowers did not fully comprehend the intricacies of adjustable interest rates and were caught unprepared when their monthly mortgage payments increased. President G.W. Bush even created a Council on Financial Literacy to address the apparent lack of financial skills and savvy amongst many adults. If financial illiteracy can undermine educated, middle-class Americans, what are the implications for microfinance clients and others in less developed environments?

This packet contains two papers that discuss financial literacy through the lenses of microfinance, India and the wider economic development context. The first paper presents a conceptual overview and an analysis of the empirical research thus-far on financial literacy, while the second presents results from Centre for Micro Finance field research on how microfinance clients understand their loans. In India, many recent discussions within microfinance policy and regulatory circles have centred on the extent to which small borrowers understand their loans and the financial liability implicated therein. Especially as microfinance offers an expanding portfolio of products, introducing new layers of complexity for clients and repayment schedules, financial literacy has garnered newfound attention.

Abstracts for the two papers are provided below and full versions of the studies can be found in this packet.

We hope that you find this research pertinent and thought-provoking and we, the authors, are eager for feedback and additional questions.

- Centre for Micro Finance, November 2008

Assessing the Importance of Financial Literacy Authors: Shawn Cole, Nilesh Fernando This Centre for Micro Finance article, which originally appeared in the September 2008 edition of the Asian Development Bank Quarterly Newsletter Finance for the Poor, expounds upon the definitions, measurement metrics and empirical evidence (thus far) of financial literacy. It weaves together results from studies, both in India and abroad, citing the possible connections of financial literacy with specific financial behavior and economic well-being. The authors, however, are guarded in their endorsement of financial literacy as an unequivocal cause of household development and suggest further future research.

How Do Microfinance Clients Understand their Loans?

Authors: Akhand Tiwari, Anvesha Khandelwal and Minakshi Ramji This Centre for Micro Finance paper aims to provide an explanation of how MFI clients understand their loan contracts and the implications for policy. Deriving from the results of first-hand field research, we find that small borrowers are able to identify the size and duration of the loan and their weekly instalment on their loan. However, they know very little about the interest rate and total interest expense on the loan. The results of this survey indicate clients think about their loans in terms of how much they actually owe on a weekly basis.

Assessing the Importance of Financial Literacy Shawn Cole, Nilesh Fernando Centre for Micro Finance

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This document was originally published in September 2008 by the Asian Development Bank in their Quarterly Newsletter Finance for the Poor. The original document can be accessed here http://www.adb.org/Documents/Periodicals/ Microfinance/finance-200803.pdf Shawn Cole is an Assistant Professor at Harvard Business School and Nilesh Fernando is a Research Associate at the Centre for Micro Finance.

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Introduction Financial decisions can be difficult. Comparing savings or borrowing options with different interest rates and term structures can be difficult for those without financial savvy—and even a knowledgeable individual may need to rely on calculators or spreadsheets to make truly informed decisions. Yet, many households are not knowledgeable, and often receive little assistance when making these decisions. Moreover, unlike the decision to visit a restaurant or purchase a particular car, customers may not receive useful feedback about the value of the product they have purchased, making the typical learning process even more difficult.

Financial literacy—the ability to process financial information and make informed decisions about personal finance--has received growing attention in the developed world, and recently, in the developing world, as a potentially important determinant of household well-being.

A compelling body of evidence demonstrates a strong association between financial literacy and household well-being. Survey after survey shows that households which demonstrate low levels of financial literacy are those that tend not to plan for retirement (Lusardi and Mitchell, 2007a), borrow at high interest rates (Stango and Zinman, 2006), acquire fewer asset levels (Lusardi and Mitchell, 2007b). This has led policy makers in the developed and developing world to advocate increased expenditure on literacy education, in hopes of increasing household savings, increasing financial market participation, with the ultimate goal of reducing poverty and improving welfare Indeed, the Asian Development Bank holds the view that financial literacy education is important.

In the keynote speech at a recent conference, the managing director, Rajat Nag, noted: “Financial literacy allows people to increase and better manage their earnings - and therefore better manage life events like education, illness, job loss or retirement. It also promotes understanding and acceptance of important political reforms, such as health care or pension reforms. While the significance of financial literacy has not yet been fully articulated and recognized by the international development community - or by policy makers and practitioners in developing countries - measures to promote and improve financial education are becoming more frequent. ” In this paper, we define financial literacy, and describe how it is measured in practice. We describe why financial literacy may matter in a variety of contexts relevant to microfinance institutions and their clients. A small but growing number of institutions and organizations are providing financial literacy training: we describe some current efforts. We discuss the evidence on the efficacy of these programs, with a critical view. We conclude with what we feel are a series of important, unanswered questions.

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http://www.adb.org/printer-friendly.asp?fn=%2FDocument s%2FSpeeches%2F2007%2Fms2007089. asp&news=none

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Financial Literacy is Limited The diversity of financial products available in developed and developing countries has increased rapidly in the past decade. In the US, for example, households may choose from a dizzying array of mortgage options (Woodford, 2003), and among thousands of mutual funds. In developing countries, the expansion of microfinance, often accompanied by micro insurance and savings products, has vastly increased: a household may have the choice of a loan product from several different MFIs, as well as insurance products for health, livestock, life, and even index-based weather derivatives.

Many of these products are complex, and a growing body of evidence suggests that low levels of financial literacy may prevent consumers from making good decisions about financial products.

Much of this evidence is from the United States, a country with an unusually wide array of financial products. For instance, one study (National Council on Economic Education, 2005) gave students an average grade of “F” on when answering a short questionnaire which included topics in economics and personal finance. Adults faired somewhat better, receiving a “C.” Research carried out by the Jump$tart Coalition for Personal Financial Literacy showed that U.S. high school students (Mandell, 2004) fared poorly on questions about credit management and personal finance. A survey of Australian consumers (OECD, 2005) revealed that only 28% were able to correctly calculate compound interest; the figure for American consumers was even lower at 18% (Lusardi and Mitchell, 2007a) Research on levels of financial literacy in developing countries remains comparatively slim. However, a small number of studies show even lower levels of financial literacy. A study conducted in Zambia by the Department for International Development show that only half the adult population knew how to use basic financial products (DFID, 2008). A second study in seven African countries showed that only 29% of adults had a bank account and that approximately 50% use no financial products whatsoever, not even informal financial products (DFID, 2008). In Asia, an Indian survey found that a majority of laborers surveyed saved by storing cash at home, even as they held loans from money lenders at very high interest rates. (Financial Express, 2008).

How is Financial Literacy Measured?

A challenge to understanding the importance of financial literacy is measuring it. There is no standardized measure of financial literacy. Many studies start with questions first popularized by Annamaria Lusardi: •

Imagine that you saved $100 in a savings account, and were earning an interest rate of 1% per year. If prices were increasing at a rate of 2% per year, after one year, would you be able to buy more than, less than, or exactly the same amount as today with the money in the account?

•

If 5 people all have the winning number in the lottery and the prize is 2 million dollars, how much will each of them get?

•

Let’s say you have 200 dollars in a savings account. The account earns 10 percent interest per year. How much would you have in the account at the end of two years?

•

Is it safer to invest in one stock, or in many stocks?

While the above questions may strike the reader as very simple way to measure literacy, even an individual’s ability to answer these questions serves as a powerful predictor of financial decisions.

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More detailed tests have been developed: for example, Mendell (2007) describes a test administered to US high school students that encompasses dozens of questions about the economy, personal finance, and financial planning.

Yet, it is not always clear what financial literacy measures. Financial literacy test scores, for example, are highly correlated with math test scores, suggesting that financial literacy tests may in fact, in part, measure an innate or acquired ability to solve problems in general (Mendell, 2008). If this is indeed the case, then teaching financial literacy may have limited effect: the more fundamental skills of addition, multiplication, and division may matter more.

A recent paper by Stango and Zinman (2008) links poor financial decisions to a well-documented behavioral bias: the human tendancy to view exponential growth as a linear trend. They demonstrate that households that underestimate the cost of borrowing using information about weekly repayment amounts are precisely those individuals who tend to borrow at high interest rates.

Consequences of Low Levels of Financial Literacy: Financial Market Participation One of the most straightforward consequences of limited financial literacy may be limited financial market participation. Households that are not familiar with the workings of a bank, for example, are unlikely to open a bank account, and may instead choose to store cash in the home, or invest in other stores of value (such as gold), which may offer unattractive returns.

A tremendous strength of microfinance has been its ability to reach out and interact with individuals in their own village or home, and thus greatly reducing the barriers to access. Indeed, microfinance programs themselves often begin with a multi-session course on financial literacy, though often with a narrow scope: borrowers are instructed on how to calculate loan repayments, how to compute fee schedules, and perhaps how to manage household budgets to be sure they can make their payments on time.

Declining to participate in financial markets may well be the optimal decision for an individual with limited financial literacy: if she were to choose the wrong savings product at a bank, for example, she may end up with an illiquid instrument which charges substantial fees to withdraw. A borrower unable to truly understand the terms of a loan may borrow too much, exposing herself to risk of missing a payment, and potentially incurring substantial penalties.

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At the request of Lusardi and Mitchell, the U.S. government added some of these questions to a national household survey.

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Field experience suggests that financial literacy is even more important with respect to insurance contracts. Many households considering micro-insurance policies are buying insurance for the first time, and may not have a good understanding of the probability that insurable events will occur, or how the payouts will be calculated. Households with greater levels of financial literacy may better understand the advantages and disadvantages of insurance policies, and make better decisions.

Savings and Investment Decisions Given that many developing countries have a large number of their population engaged in agriculture, such communities are especially vulnerable to income shocks which result from weather risk and price volatility in the goods they produce. As such, savings can be critical in allowing households to smooth consumption and support longer-term investments in human and physical capital.

While research connecting financial literacy to household savings decisions remains limited in developing countries, a rich strand of research exists for developed countries. Lusardi (2004), using data from the Health and Retirement Study shows that attending employer sponsored retirement planning seminars are associated with increases in both financial and total net worth, particularly for families at the bottom of the wealth distribution. The increases were as much as 20%, and those with low education.

While much of the attention on financial literacy in the US focuses on investment decisions.

Economists regularly wonder why, for example, S&P 500 index mutual funds survive in the market, charging relatively high fees, when very low-cost alternatives exist. A consumer may not perceive a big difference between two funds, each earning 7% before fees, but with one charging .20% per annum in fees, and another charging 1.2% in fees. However, $10,000 invested in the former would yield $71,968 after forty years, while the latter would yield only $54,271: a difference of over 30%.

The ability to understand these nuances can dramatically change the financial well-being of an individual. Such calculations are important in developing countries as well. Inflation risk is often substantial, and financial literacy is required to understand which assets provide protection against inflation. Similarly, a nuanced understanding of the importance of how the value of various assets correlates with each other can help households diversify risk efficiently.

Interventions in Increase Savings and Improve Literacy: The Academic Evidence While many organizations have provided documentary evidence suggesting that financial literacy education is effective, there is surprisingly little rigorous, academic evidence. Indeed, we are aware of no completed study in emerging markets testing the value of financial literacy education.

Perhaps the most effective program identified to date to encourage savings is by changing the “default� option for enrolling in retirement plans for employees. While not strictly a literacy program, we mention it because it is one of the few financial programs shown to have dramatic effects. Choi, Laibson, Mandrian and Metrick (2001) demonstrate that automatic enrolment can increase participation rates by 50 percentage points or more. Putting this experience into practice, a microfinance program seeking to encourage savings might by default offer clients programs in which the loan cycle extends by several periods, and these extra payments are automatically deposited into a savings account.

The evidence linking financial literacy training to savings and investment behavior is weaker. The academic field of program evaluation concerns itself with understanding the causal effect of

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interventions designed to achieve specific goals. This is often a difficult question to answer, as it is not at all easy to disentangle causal relationships (e.g., literacy training causes people to make better decisions) from correlations (e.g., people who are smart, aware, and dynamic enough to seek out literacy training, also make better decisions.)

Indeed, the main concern with many studies of financial literacy is that problem of selection: individuals who choose or are better able to acquire information about financial products may be different than those who do not. If people with high levels of financial literacy are different than those with low levels of financial literacy, then difference in observed outcomes such as savings levels may be due to these unobserved differences, rather than financial literacy. For example, Meier and Sprenger (2007) demonstrate that those who chose to participate in credit counseling have strikingly different discount rates than those who decline credit counseling. Discount rates are important determinants of savings: it is therefore very difficult to determine how much differences in savings are driven by differences in financial literacy, and how much they are driven by differences in discount rates.

A well-cited paper by Bernheim, Garret, and Maki (2003) links high school financial literacy training programs in the United States to household savings decisions, finding that the programs significantly increased savings rates. However, further scrutiny by Cole and Shastry (2007) suggests that the correlation is in fact spurious, as states that were growing quickly were more likely to enact mandates.

That high school education may not be effective is supported by evidence in Mendell (2007), which finds high school students who have taken financial education do not demonstrate higher levels of financial literacy than those who have not taken such courses.

The most convincing evidence on the role of financial education can have an effect comes from Duflo and Saez (2003), who conduct a randomized evaluation of an intervention at a United States university. In the experiment, they sent letters (at random) to staff, encouraging the staff to attend an employee benefit fair. (Those receiving the targeted letters who did attend received a small payment.) The authors find that enrollment in retirement plans increased significantly in the departments in which letters were received. The size of the effect is quite small, an increase of approximately 1.25 percentage points.

We are not aware of any completed rigorous evaluations of financial literacy programs in the developed world; two ongoing studies are expected to yield results within a year. Researchers from Harvard University are working with SEWA in Ahmedabad, India, to evaluate SEWA’s financial literacy training program.

In ongoing work, Cole, Thompson, and Zia (2008) evaluate a financial literacy program designed to teach unbanked individuals how to open bank accounts. Randomly selected unbanked households were offered a one-day long course covering the costs and benefits of banking services. Preliminary results suggest that the financial literacy program was not effective in increasing the use of banking services among households.

One related study, by Karlan and Valdivia (2006), studies the efficacy of offering a business training program to female microentrepenuer clients of a bank in Peru. While the content of the course falls outside the standard definitions of financial literacy, the spirit was similar: provide education for individuals making household decisions. They found that the treatment resulted in higher repayment and client retention rates, but no impact on business income or assets.

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Is there a Market Solution?

If financial literacy is very important to household well-being, why do firms not enter the market, offering training or advice in return for payments? After all, private schools and tutoring for hire are quite common throughout the developing world? While we are not certain of the answer to this, we posit several answers: First, consumers may not realize the extent to which they lose because of limited financial literacy. Consumers unable to correctly evaluate loan offers will also not understand how much is to be gained by choosing the optimal loan. Second, individuals with high levels of financial savvy often command high wages, and may choose to work in the financial sector, rather than by providing financial education. Finally, many financial advisors earn commissions for products they sell—a consumer may actually be worse off if she is advised to take decisiosn that benefit the advisor, rather than the advisee.

Efforts to Improve Financial Literacy Some governments have devoted efforts to improve financial literacy In the U.S., many state governments require high school students to take financial education courses; the first such requirement took effect in Nevada in 1957. The Reserve Bank of India has recently undertaken a program promoting financial literacy as well.

Private foundations are stepping up as well. The Citi Foundation, funded by Citigroup, has supported a number of initiatives that look to improve financial literacy throughout the world. Currently, the program is headed by Microfinance Opportunities, a microenterprise resource center that promotes client-led microfinance, and Freedom from Hunger. The financial literacy initiative is currently being implemented by Pro Mujer (Bolivia), Teba Bank (South Africa), Al Amana (Morocco), Equity Building Society (Kenya), SEWA Bank (India), CARD Bank (the Philippines) and the Microfinance Centre (Poland), among others.

In Appendix A at the end of this paper, we provide a non-exhaustive list of resources available for firms and organizations interested in promoting financial literacy.

Conclusion Where does the review of the evidence leave us? It is our opinion that financial literacy is important, and that better educated consumers will make better decisions. The benefits of better financial literacy may be great. On a personal level, individuals may save more, and better manage risk, by purchasing insurance contracts. There may even be general equilibrium effects: increased demand by households for financial services may improve risk-sharing, reduce economic volatility, improve intermediation, and speed overall financial development. This in turn could facilitate competition in the financial services sector, and ultimately more efficient allocation of capital within society.

Yet, we are not yet convinced that the case for massive investments in financial literacy education is well-established. Certainly, microfinance clients should receive careful explanation and training before they purchase products that are new to them, such as insurance contracts. And, just as the school system and government teach individuals about hygiene and math, so too should they provide information on basic financial decision-making.

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http://www.rbi.org.in/scripts/PublicationDraftReports.aspx?ID=526

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But, the bulk of the evidence linking financial literacy to household behavior documents correlations, rather than causal relationships. It may be that financial literacy is a secondary, or even tertiary, determinant of individual financial behavior. Or, it may be that empowering individuals with the ability to make informed financial decisions can have a dramatic impact on their savings and investment decisions, and dramatically increase their welfare. We simply don’t know.

We applaud the firms and organizations that are developing and delivering financial literacy education around the world. But we conclude by stressing that even the academics and policy makers concerned about financial literacy must educate themselves, in order to make informed decisions about how to invest limited resources to improve the lives of the poor worldwide.

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Appendix A: Resources on Financial Literacy Jump$tart Coalition for Personal Financial Literacy (www.jumpstartcoalition.org) provides a broad range of resources for teaching financial literacy to school age children and youth, and contains over 70 free publications.

Financial Freeway: A Financial Responsibility Curriculum for Young Adults is an interactive program, consisting of a video (27 minutes) and guide, it is designed to teach young adults about financial responsibility and credit. Using the simulated purchase of a car, it provides an introduction to auto selection, banking, credit, personal budgeting and insurance. The cost of the material is $25.00 and is available from Cornell Cooperative Extension online at: http://www.cce.cornell.edu/publications/finance.cfm “Financial Education for SEWA Bank Members,” 2003. http://www.coady.stfx.ca/resources/abcd/SEWA%20Financial%20Literacy%20Manual.pdf December, 2003 Consumer Action [http://www.consumer-action.org] offers a wide selection of financial literacy resources in several languages. The publications range from how to select a checking account to investing and managing debt.

A Penny Saved is a short comic-style booklet that illustrates the importance of distinguishing between various types of savings instruments. The booklet is designed for high-school and adult learners and is available from: http://app.ny.frb.org/cfpicnic/frame1.cfm Banking Basics is a 30-page booklet which provides and introduction to banking, allowing young people to become acquainted with a system that may be intimidating. It is best suited for middle and high-school age readers. www.bos.frb.org/education/html/edpub.htm Source: Federal Reserve Bank of San Francisco (2002): “Guide to Financial Literacy Resources”.

Available from: http://www.frbsf.org/community/webresources/bankersguide.pdf

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Bibliography: Organisation for Economic Co-operation and Development (2005):”Improving Financial Literacy: Analysis of Issues and Policies.”

Lusardi, Annamaria and Olivia S. Mitchell (2007a): “Financial Literacy and Retirement Preparedness: Evidence and Implications for Financial Education.” Business Economics, January 2007, pages 35-44.

Lusardi, Annamaria and Olivia S. Mitchell (2007b): “Financial Literacy and Retirement Preparedness: Evidence and Implicationss for Financial Education.” Business Economics, January 2007, pages 35-44.

Stango V. and J. Zinman (2006): “Fuzzy Math and Red Ink: Payment/Interest Bias, Intertemporal Choice, and Wealth Accumulation” Working Paper Department for International Development (2008):, “UK Backs Lessons in Banking to Help Africa’s Poor.” Available from: http://www.dfid.gov.uk/news/files/alexander-lessons-in-banking.asp Financial Express (2008) : “How India Earns, Plans and Saves, 2008”, Max New York Life – National Council of Applied Economic Research publication.

National Council on Economic Education (2005): “What American Teens and Adults Know About Economics.”

Woodward, Susan E. (2003): Consumer Confusion in the Mortgage Market. Working paper, Sand Hill Econometrics, Menlo Park, California Bernheim, B. Douglas and Daniel M. Garret (2003): “The Effects of Financial Education in the Workplace: Evidence from a Survey of Households,” Journal of Public Economics, 87 (7-8): 14871519.

Mandell, Lewis (2004): “Financial Literacy: Are We Improving?”, DC: Jump$ tart Coalition for Personal Financial Literacy, 2004 Mandell, Lewis and Linda Schmid Klein (2007): “Motivation and financial literacy.” Financial Services Review, Vol. 16, 2007, pages 105-116.

Lusardi, Annamaria (2004): “Saving and the Effectiveness of Financial Education” in Pension Design and Structure: New Lessons from Behavioral Finance, edited by O. Mitchell and S. Utkus, Oxford University Press, 2004, pp. 157-184. Reprinted in the Journal of Financial Transformation, issue on Wealth, Volume 15, December 2005.

Duflo, Esther, and Emmanuel Saez (2003): “The Role of Information and Social Interactions in Retirement Plan Decisions: Evidence from a Randomized Experiment”, Quarterly Journal of Economics, 118(3), 815-842.

Karlan, Dean S. and Martin Valdivia (2006): “Teaching Entrepreneurship: Impact of Business Training on Microfinance Clients and Institutions”, Yale University Economic Growth Center Discussion Paper No. 941

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Cole, Shawn and Guari K. Shastry (2007): “If You’re So Smart, Why Aren’t You Rich? The Effects of Education, Financial Literacy and Cognitive Ability on Financial Market Penetration.” Preliminary paper, Harvard University.

Bernheim, Douglas, Daniel Garret, and DeanMaki (2001): “Education and Saving: The Long-Term Effects of High School Financial Curriculum Mandates”, Journal of Public Economics, 80, 435465.

Meier, Stephan, and Charles Sprenger (2007), “Selection into Financial Literacy Programs: Evidence from a Field Study,” Discussion Paper No 07-5, Federal Reserve Bank of Boston.

Choi, James, David Laibson, Brigitte Madrian, and Andrew Metrick, “For Better or for Worse: Default Effect and 401(k) Savings Behavior,” National Bureau of Economic Research Working Paper No. 8651, 2001.

How Do Microfinance Clients Understand their Loans?

Akhand Tiwari, Anvesha Khandelwal and Minakshi Ramji Centre for Micro Finance

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The authors are Research Associates at the Centre for Microfinance (CMF). To learn more about CMF, you may visit their website at http://ifmr.ac.in/cmf. A summary of these results appeared in an article in the CMF newsletter Eye on Microfinance, volume 8, “How Do MFI Clients Understand their Loan Contracts?� available here: http://ifmr.ac.in/cmf/ eomf8-Mullainathan.html Thanks are due to Professor Sendhil Mullainathan at Harvard University under whose guidance this study was conducted.

Valuable inputs in designing the study were provided by Sudha Krishnan at Ideas 42, Harvard University and Annie Duflo, currently Research Network Director at Innovations for Poverty Action, New Haven, USA. The authors express their heartfelt gratitude to the two microfinance institutions BSS Microfinance Private Limited and Sonata who participated in the study and their staff for extending their support during the implementation of the study and providing us with valuable insights into the workings of their respective organizations. Special thanks are due to Dr. Ramesh Bellamkonda and Mr. Panchakshari at BSS and Mr. Anup Singh, Mr. Ashish Gupta and Mr. Rakesh Dubey at Sonata.

Executive Summar y In recent years, discussions on microfinance policy and regulation in India have tended to centre on the extent to which small borrowers understand their loans and the financial liability implicated therein. The paper aims to provide an explanation of how MFI clients understand their loan contract and the implications for policy. We find that small borrowers are able to identify the size and duration of the loan and their weekly instalment on their loan. However, they know very little about the interest rate and total interest expense on the loan. Additionally, a majority of the clients find what are commonly viewed as coercive collection practices to be acceptable. The results of this survey indicate clients think about their loans in terms of how much they actually owe on a weekly basis.

Thus, top-down regulation which hinges on the assumption that borrowers are able to calculate and understand their interest rates, would likely not succeed in protecting small borrowers.

Financial Literacy

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Introduction

In recent years, discussions on microfinance policy and regulation in India have tended to centre on the extent to which small borrowers understand their loans and the financial liability implicated therein.

Lack of financial awareness can lead to over-indebtedness and greater economic vulnerability for the very clients that microfinance seeks to help. These concerns were first brought to the forefront in India by the face-off between microfinance institutions (MFIs) and the district administration in Andhra Pradesh. MFIs in the area were accused of predatory lending, overburdening poor and illiterate women with loans which they may not have been able to repay and using coercive collection practices to ensure repayment. Indeed, the voluntary code of conduct developed by Sa-dhan after the Andhra Pradesh crisis in 2005 recommends that MFIs be fully transparent in the communication of loan details, interest rates and the calculation thereof. Thus, improving financial awareness as a means of protecting the small consumer has become a key policy focus in microfinance.

This study aims to understand how MFI clients understand their loan contract and exactly what it means for an MFI client to be informed. This study goes beyond assessing whether an MFI client knows the terms of his loan. Rather, it explores which aspects of their loan terms are important to MFI clients and what are the implications thereof for regulation.

This study is particularly relevant in today’s context when financial literacy has become the new buzzword in the arena of access to finance, both globally and in India. One reason financial literacy has become so central is the dizzying array of financial products from which households can choose. It has also been alleged that the recent sub-prime crisis originating in the US was precipitated in part by the lack of financial acumen of the sub-prime borrowers. In India, potentially incendiary situations arose in Andhra Pradesh, most famously, as well as in Orissa and Karnataka, when MFIs were accused of overburdening poor and illiterate borrowers with loans they could not repay. Various solutions have been proposed including more stringent regulation, capping MFI interest rates, mandating precise disclosure rules for MFI interest rates and stipulating that they provide scrupulous details to their clients and policymakers on how they arrive at the interest rates they charge. However, if clients do not understand interest rates or see their loans in very different terms, regulation could potentially backfire. These concerns and their policy responses beg the following questions: •

How well and in what terms do poor borrowers understand their loans?

•

How do poor borrowers view collection practices and which ones do they find coercive?

•

To what extent is regulation consistent with the understanding that MFI clients have of their loans and MFI collection practices?

Our results suggest that small borrowers are able to identify the size and duration of the loan and their weekly instalment on their loan. However, they know very little about the interest rate and total interest expense on the loan. Additionally, a majority of the clients find what are commonly viewed as coercive collection practices to be acceptable. The results of this survey indicate clients think about their loans in terms of how much they actually owe on a weekly basis. Thus, top-down regulation which hinges on the assumption that borrowers are able to calculate and understand their interest rates, would likely not succeed in protecting small borrowers.

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Sa-dhan is an association of microfinance institutions in India. The voluntary code of conduct is available here: http:// www.sa-dhan.net/corevalues.pdf

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MFI loan contracts are typically extremely simple, keeping in mind the clientele they serve. The assumption that transparency would increase by forcing MFIs to describe their interest rates in detail and enable clients to understand their loans better may not necessarily be true. Any regulation based on this assumption may backfire. We also conclude that training which promotes various different aspects of financial literacy like budgeting, understanding one’s financial rights, understanding debt and sources of debt better may be important.

While this study is an important step in understanding how to formulate policy that is responsive to microfinance clients and their needs, it is important to keep in mind that the small number of respondents in our survey makes it difficult to generalise the results. We conclude that more studies are needed which document existing levels of financial awareness and elucidate how greater financial literacy could improve their access to finance.

This paper begins with a short literature review of some the major issues in financial literacy programmes and their evaluation. Then we describe the methodology and two MFIs which participated in this study. Part V and VI provides a summary and discussion of the results. Part VII concludes.

2.

Financial Literacy: Definition, Measurement and Evaluation

Financial Literacy has been defined as the ability to process financial information and make informed decisions about personal finance. In the last few years, with increasing focus on access to finance as an important determinant of household-level economic development and its accompanying positive consequences for empowerment (Basu, 2005), financial literacy has become an important issue for practitioners and policymakers alike.

There are very few studies which look at levels of financial literacy, especially in developing countries. Yet the existing studies show that financial literacy levels are low across the world. Data from OECD countries shows that very few consumers regularly use basic financial management skills such as budgeting, developing a plan for saving or retirement planning (Miller et al, 2008).

In Australia while 67% of respondents indicated that they understood the concept of compound interest, only 28% were able to actually calculate compound interest. In developing countries, the situation only degenerates. In India, over 50% of the labourers surveyed indicated saving cash at home while simultaneously borrowing at high rates of interest from moneylenders (Financial Express, February 8, 2008). In Zambia and other countries in Africa, only a third of adults have access to bank accounts and about half do not use any financial products (DFID, 2008).

Why is financial literacy important? Firstly, financial literacy can be an important determinant of access to finance (Cole & Fernando, 2008). Low levels of literacy may prevent the take-up of more complicated financial products such as insurance since clients may be hesitant to buy a product whose utility they do not fully comprehend. Even for a less complicated financial product, such as a bank account, a financially illiterate person may not understand the importance of formal savings. Lack of financial literacy may also be compounded by a lack of access to a range of financial products (Miller et al, 2008).

Secondly, microfinance, in the last few decades, has had the effect of exponentially increasing access to credit for poor and marginalized households. Given the increasing commercialization of

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microfinance and the entrance of for-profit players in this sector, financial literacy has acquired a new importance as a means to enhance consumer protection. While consumer protection is necessary to ensure that consumers have the information they need to make an informed decision , financial literacy gives them the competence to evaluate that information (Rutledge et al, 2008).

Regulation on consumer protection usually revolves around promoting truth-in-lending practices to ensure transparency to the microfinance client and protecting consumers against abusive lending and collection practices (Microfinance Gateway, 2008). Both these issues are intimately related to financial literacy and awareness. While it is important for microfinance clients to receive full information about their loans, we need to examine whether “quantity” of information necessarily implies “quality” of information (Microfinance India, 2008). Similarly, the appropriate collection practices can also only be determined once existing levels of financial awareness are known. Thus, financial literacy is an important tool to enhance consumer protection. For instance, in various countries including Central Africa and Panama, MFIs are required, by law, to state the Annual Percentage Rates in their loan contracts (Porteus & Helms, 2005).

In India, the Sa-dhan Code of Conduct, referred to earlier in this paper, exhorts its members to disclose the interest rate and funding costs to clients by posting them inside their offices. Further, the code provides for a dispute resolution mechanism whereby microfinance clients can call a central authority to air any grievances they may have. While these efforts are laudable, it is also important to appreciate that unless MFI clients in these countries understand interest rates and can calculate those rates, these regulations are meaningless and will have no impact. Similarly, the Sa-dhan redressal mechanism assumes that rural microfinance clients will have the ability and the wherewithal to make a phone call. Thus, education efforts must take into consideration what clients already know and do not know.

A third reason to discuss financial literacy stems from to the movement to protect borrowers from usury by legally capping interest rates. Yet interest rate ceilings tend hurt the ones they seek to protect the most by decreasing their access to credit (Basu, 2005). From a practitioner and policymaker perspective, innovative ways to improve financial literacy and consumer protection may be a strategic way to offer a positive alternative to interest rate ceilings (Porteus & Helms, 2005).

Finally, one of the issues that countries across the world are now grappling with is the extent to which clients are overburdening themselves with loans they cannot repay. While this point is related to the previous discussion of consumer protection, it bears repeating. One instance where people do not appreciate the complexity of the product they have bought relates to a mortgage product that has small, fixed payments in the beginning, but a large “balloon payment” towards the end of the loan tenure. While this innovation is based on the assumption that with time, people will earn more and be able to pay more on their mortgage, it is not good for people on fixed incomes. These demands and payment schedules are crucial for clients to truly comprehend before making a commitment to a product.

Given its importance in today’s context, financial literacy programmes have mushroomed and much of the conversations on policy also focus on how to improve financial literacy. For financial literacy providers, Braunstein & Welch (2002) point out that some of the key questions include •

Who to target and how to assess their information needs?

•

What does this target audience need to know in order to understand their current financial situation, pinpoint future goals and adopt behaviour that will allow them to achieve these goals?

•

How can effectiveness and impact of financial literacy programmes be measured?

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Let us address the third question first. One of the big obstacles in designing research which evaluates financial literacy programmes is determining how to measure success. Most of these programmes aim to improve the overall ability of participants to make financial decisions for an overall impact on their economic well-being. Some programmes have very particular goals such as improving savings or reducing default on loans, while others are much broader. For the programmes which have specific outcomes, success can be defined by metrics such as lower rates of default on loans or changes in confidence levels on financial matters. For the broader programmes, it is difficult to come up with a parameter to measure success, although some studies look at the overall confidence level of participant households in financial matters. Furthermore, measuring ‘success’ is also complicated by the multidimensional process that determines the takeup of sound financial habits; these extend beyond financial literacy to various psychological and environmental factors. Finally, while many studies establish a correlation between financial training and improved savings or other target criteria, there are very few studies which rigorously establish a casual effect between training and behaviour (Cole and Fernando).

Today, financial literacy is measured typically by testing arithmetic ability. Indeed, as Cole and Fernando (2008) point out, financial literacy test scores are highly correlated to math test scores.

This would imply that if financial literacy is based on mathematic ability, financial literacy programmes would do well to focus on the basic arithmetic skills like addition, subtraction, multiplication and division. However if in fact, financial literacy is not based simply on arithmetic skills, then this measure of financial literacy is not worthwhile and we must look for alternatives measures.

Although the need for financial literacy has been well documented (cite here), there is conflicting evidence on whether or not financial literacy training actually changes financial behaviour for the better. There seems to be some evidence that programmes targeting very specific competencies, such as how to calculate compound interest or how to save more, are able to have a greater impact than those which focus on the broader themes of financial management (Braunstein& Welch, 2002). The training, the format, and the information provided during the training and quality of trainers are all important determinants of how financial literacy programmes impact the participants. For instance, Freddie Mac conducted a study of close to forty thousand mortgages from the years 1993 – 1998 under an affordable mortgage loan programme. Some borrowers received pre-purchase counselling from different sources (govt agencies, mortgage insurers, nonprofit groups etc). The results demonstrated that those who received counselling had a 19% lower default rate that those who did not. Similarly, those who received individual counselling had much a lower incidence of default over those who received classroom training. Telephone counselling had no impact on default rates. The study concludes that reduction in default rates was attributable to the type of counselling format (Hirad & Zom, 2001). Yet another Freddie Maccommissioned study found that consumers benefit most from practical and applied lessons, rather than learning about financial management in the abstract. The study also showed that across groups, people believed that the major source of financial learning was through a difficult financial experience (Bradley et al, 2001).

Additionally, as discussed earlier, there is evidence to show that individual character and psychological traits such as risk aversion or over-confidence have an impact on how messages from financial literacy programmes are internalized by the participants (Mullainathan & Thaler, 2000). The crux of this literature rests on the fact that in spite of having clear information, which should lead to better financial management, people do not act in their best financial interest. Some of these “irrational.” economic behaviours include investing in the absence of complete information, altruism or giving to charity without any apparent benefit to themselves, and not acting consistently with expressed preferences (Braunstein & Welch, 2001). Specifically in the context of poor borrowers,

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several studies have shown that consuming one less cup of tea a day and instead investing that money in their business could have dramatic implications for their overall income. Yet consumers choose not to act in a rational manner. A study conducted in South Africa showed that potential borrowers were more likely to take-up offers which had the simplest terms. In the case of male borrowers,, a picture of a woman on the loan offer letter made loan take-up more likely. These results were fairly consistent across education and income levels and even for those who have a history of credit (Bertrand et al, 2006).

In short, the literature seems to recognize that there is a need for financial literacy and that a wellplanned, thoughtful literacy programme which takes into account the needs of the beneficiaries it seeks to serve can be useful and have a positive impact for financial management. However, what the also literature reveals is that there is a paucity of research which looks at current levels of financial awareness. Further, there is no work on how to build upon current levels of awareness to enhance the financial lives of lower income groups, particularly with those who may not have easy access to financial information. This study seeks to bridge this gap to some degree.

3.

Research Methodology

This study was conducted in two phases through the implementation of two surveys. The first phase, consisting of 299 respondents, was conducted with first-time rural microfinance clients of two microfinance institutions in distinct geographical locations, rural Karnataka and rural Uttar Pradesh. Respondents were asked to complete a survey which measured current levels of financial awareness. Particularly, this phase looked at how clients understood their loan contracts, the repercussions of default and lastly, clients’ comprehension of interest rates. The second phase consisted of interviews with forty rural respondents in Madhya Pradesh, who were clients of the same partner organisation in Uttar Pradesh. In this phase, in an attempt to understand how clients choose between loan sources , respondents were asked to compare between two loans and pick the cheaper loan. They were also asked questions which tested their arithmetic ability.

The study was implemented wholly in rural areas since most of microfinance in India currently takes place in rural areas. It was also decided to restrict the study to first-time borrowers since so that we would have a sense how people who have never had access to microfinance understand their loans. For precisely this reason, we were compelled to use different respondents for phase 2 since many of the respondents from the first phase would have graduated to their second loan.

4.

Overview of MFI Research study Partners

Respondents for phase 1 of this study were randomly chosen from amongst the clients of Sonata in the Uttar Pradesh and BSS Microfinance Private Limited (BSS) in Karnataka, respectively. For phase 2, respondents were chosen randomly from Sonata clients in Madhya Pradesh. A short description of each of the two organizations and their lending methodology follows.

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4.1 BSS Microfinance Private Limited BSS Microfinance Private Limited (BSS) has been involved in microfinance operations for over a decade and recently converted in April 2008 to a Non Bank Finance Company. They operate in twelve districts of Karnataka and have approximately 150,000 active clients. At the time of the study, BSS’s lending consisted wholly of group liability loans, exclusively to women. Each BSS group consists of about five women, seven to twelve such groups form a centre and about 80 to 120 centres form a branch. Each centre meets separately on a weekly basis and is assigned a Centre Manager (or a loan officer). Each branch has a Field Office Manager.

Before receiving a loan, every group must undergo a Compulsory Group Recognition Training. During this training, punctuality, the necessity of paying weekly instalments on time and joint liability are emphasized. Group members also learn the ‘member’s pledge’. By repeating this pledge, members promise to come to every meeting without fail, utilize the loan for the said purpose, pay in a timely manner, take group and centre responsibilities seriously and also acknowledge that everything they say has been witnessed by the home God . There is no explicit financial literacy training.

First time loans range from between Rs. One Thousand to Rs. Ten Thousand. The loan tenure is always 50 weeks long. Every member receives a passbook which shows the amount due every week and the corresponding total principal and interest outstanding on a weekly basis. The interest rate on the loans is 15% flat, without any upfront fees.

BSS was also collecting a security fund of Rs. 10 every week from all groups less than a year old. The security fund typically earned around 6% annually and was paid out to members on a monthly basis. Members also paid insurance premium of Rs. 2 on a weekly basis. This insurance is to protect the loan in the event of death of the borrower. If, at the time of passing, the client does not have a loan, her family receives a pre-determined amount (Rs 3000), towards funeral expenses, while if she does have a balance outstanding, the balance will also be paid through this fund.

4.2 Sonata Finance Private Limited Sonata Finance Private Limited (Sonata) is a relatively new Non Bank Finance Company whose operations are concentrated in Uttar Pradesh (UP) and Madhya Pradesh (MP). Sonata is headquartered out of Allahabad in UP. In UP, Sonata has twelve branches in five districts. At the time of the Study, Sonata’s lending consisted wholly of group loans to women. The lending methodology is modified grameen style lending. Every group in Sonata consists of ten to twenty members at the centre level.

Before receiving a loan, the group undergoes Compulsory Group Recognition Training, as in the case of BSS. During the training, social collateral, the relationship between group members and joint liability, adequate use of loans are strongly emphasized. Sonata’s member pledge is similar

3

A Non Bank Finance Company (NBFCs) is one of the two for-profit legal entities which can provide microfinance services in India. According to the Microfinance India Review 2007, NBFCs account for 50% of microfinance services provided in India. NBFCs are not allowed to collect savings without meeting stringent requirements. For more information about NBFCs, see MCRIL (2005).

4

The ‘home God’ is the deity that they the women pray to in their house. This pledge demonstrates how important it is for MFIs to ensure repayment and the ways in which they do so.

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to BSS’s, with one difference. As part of training, Loan officers make sure the borrower knows the interest she pays per month on every Rs.100 borrowed from Sonata. Once again, as in the case of BSS, there is no explicit financial literacy training for clients.

First time loans range from between Rs. Two Thousand to Rs. Eight Thousand. All loans have tenure of 50 weeks. The interest rate is 18% flat or 36% declining, accompanied by an up-front payment of Rs. 100 for processing fees on the loan and facilitate borrowers to buy Rs.100 term policy from insurer. Sonata has a Collection Deposit Sheet (CDS) which enumerates how much each member owes and how much was paid every week. There are two copies of this sheet, one with the loan officer and one at the Center as for record . Interestingly enough, the Sonata loan document provides a comparative pricing for other sources of credit by explicating stating the effective interest rates from a Scheduled Commercial Bank (10-20%), Self-Help Group Bank Linkage Programme (12%) and Sonata (36%). Sonata follows a No Cash carry Policy for payment of loan instalments. In other words, the group leaders or their representative must go to the branch office/ designated bank account of SONATA to make payments on behalf of the group at least a day before of centre meeting day.

The table below presents a comparison of terms that BSS and Sonata offer to their clients.

Table 1: Summary of First Time Loan Terms Loan Terms

BSS

SONATA

Loan Amount

Rs. 1-10 Thousand

Rs. 2-8 Thousand

Tenure

50 weeks

50 weeks

Interest Rate

15 % Flat

18% Flat

Processing Fees

n/a

Rs. 100 up-front

Security Fund

Rs. 10 weekly

n/a

Insurance

Rs. 2 weekly

Rs. 100 up-front

5.

Findings from the Survey

This section presents findings from the two phases of the study. The first Phase of the study looks broadly at how clients understand the loans, while the second phase looks specifically at whether or not microfinance clients are able to pick cheaper loans.

5.1 Phase 1: How do clients understand their loans?

We begin by discussing what clients knew about their loan contracts and what clients did not know. Next, this section looks at how clients view what would be considered coercive practices in policy circles. Lastly, we look at who clients turn to when they require information regarding their loans or when they have grievances against their lender.

5

Explain Grameen style lending with a citation

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5.1.1 What Clients Know

Clients are able to state how much they have borrowed, for how long they have borrowed and finally, their weekly liability on the loan, as evidenced by the tables above.

Table 4 seems to indicate that less than half the respondents are able to state their weekly liability on their loan. However, this number is misleading since BSS also collects for the security fund and insurance worth Rs. 12 every week from its clients. Adjusting for this, we find that the number of people who know their weekly amount goes up. Finally, over 80% of those surveyed were within a 10% range of their weekly amount.

The survey also asked non-hypothetical questions regarding respondents’ liability on the loan, and looked to tease out whether joint liability played a factor.

Indeed, the sense of joint liability and working as a group seemed to be prominent among clients. For the question on whether or not joint liability was part of their loan contract, 80% consider group liability as part of their loan contact. When asked how respondents felt about paying for their group members, 38% felt obligated to pay for others and 45% showed it as obligation as they know other group members would help them in time of their repayment difficulties.

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5.1.2 What Do Clients Not Know Clients had a fairly limited understanding of their total liability in Rupees over the time of their loan.

As we see in Table 6, even after accounting for a 10% range in the answer, only about 39% were able to state with any degree of accuracy what their total liability on the loan was.

The ability of respondent’s to identify the interest rate they were paying, either as a percentage or as an amount was severely limited as we see in the graphs below. While the correct answers were 15% and 18% at BSS and Sonata, respectively as percentages, and Rs. 150 and Rs. 180 per Rs. 1,000 of loan at BSS and Sonata, respectively as amounts, only a handful of respondents were able to indicate these numbers. Interestingly, about 34% of respondents specified 1.5% as the interest rate, which is essentially the monthly flat interest rate paid by clients at Sonata.

While this may ostensibly indicate that clients have some awareness of interest rates, this may not be the whole truth. As we saw earlier, clients at Sonata learn this interest rate as part of their Compulsory Group Training.

Even though clients are not able to identify their interest rates appropriately, it is clear that taking the cheapest loan possible and low interest rates are of prime importance. The tables below indicate that interest rate and expense are of considerable importance to these economically weaker households.

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5.1.3 Arithmetic and Numeric Abilities Given that financial literacy is often measured by arithmetic ability, our survey included questions which tested numeric skills. We started with simple arithmetic questions and further asked them to calculate rate of interest and compare different loan products too. While initially most could answer the simpler questions, almost all lost interest when the difficulty level increased. Below is the summary of some of the relevant results.

Table 9: Numeric Ability (% of respondents that answered correctly) MFI/Math Question

3+9

Word 8000/10 4500*18 Problem 3*5

5500+ 1800

Word Problem

BSS

81%

79%

21%

Sonata

81%

67%

Total

81%

73%

Word Word Problem Problem 100-47 10% of 4500

5%

34%

21%

66%

28%

12%

0%

28%

19%

47%

11%

17%

3%

31%

20%

57%

19%

While the next phase delves into the issue of numeric ability more profoundly, these results show that measured solely by numeric ability, levels of awareness are low. For more complex questions related to interest rate calculations, more than one third of respondents chose not even to attempt the questions. Furthermore, this engages with the results from the previous section to raise the question of whether, even when respondents know what their interest rate is, they are able to calculate their liability over a period of time.

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In this context, it would be relevant to look at the levels of educational achievement of our respondents. As we see from the chart below, with some geographical diversity, educational levels are low with majority of our respondents not having attended school. While 74% of respondents in Karnataka had received some form of formal education, 75% of the respondents in Uttar Pradesh on the other hand had never attended school. Consequently, the mathematical understanding of respondents in south was higher than those in north.

5.1.4 Coercive Collection Practices As discussed briefly in the introduction to this paper, MFI collection practices have become a central part of the debate on consumer protection for small borrowers. Part of the response has been to advocate for greater transparency on the part of MFIs and to promote awareness amongst clients on their rights.

In our survey, we presented various different scenarios to our respondents. In the aftermath of the Andhra Pradesh crisis, these scenarios were typically presented, with some reason, as coercive collection practices which cannot and should not be tolerated by mainstream media and industry leaders.

As we see in the table above, there seem to be mixed feelings regarding coercive collection practices. When presented with each of these scenarios participant reactions ranging from “Its wrong but he has to do it,” “Its wrong and he should not do it,” “Yes, it’s alright,” “It may be right, but it would be preferable if he doesn’t do it,” and “It doesn’t matter it will not enforce repayment.”

In fact for all scenarios, except for Scenario 3, “Yes, it’s alright” was the most popular answer. While at first glance the answers seem to demonstrate a remarkable acceptance of coercive collection practices amongst microfinance clients, a closer look reveals otherwise. The second most popular response was “It’s wrong and he should not do so.” The scenario which received the highest acceptance amongst clients was Scenario IV, where the defaulting client’s assets were seized. This is particularly intriguing since the crux of microfinance rests on uncollateralized lending.

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The survey also asked non-hypothetical questions with respect to respondents’ responsibilities in the event of default, either by the respondents or by their peers. Once again, there was a remarkable level of acceptance with the seizing of assets, particularly in the North. Close to 60% of borrowers in north supposed that according to loan contract, in case of non-repayment, their assets would be confiscated by the MFIs. On the other hand, around 50% of MFI clients in South thought that the legal action would be taken against them in case of non-repayment. This may not necessarily imply that assets are in fact confiscated by MFIs in the event of default. The threat of confiscation might be an empty one, used by loan officers simply to force defaulting clients to repay their loans, although this doesn’t necessarily condone the use of such threats.

Alternatively, clients may simply using their knowledge of other types of loans such as bank loans or moneylender loans where confiscation of assets may be du jure.

What this data reveals is the clients understand that microfinance loans are not free loans. They are loans which require repayment and result in undesirable consequences upon default. What is disquieting is that most of these scenarios, in particular Scenario IV, go against the spirit of microfinance. This data may point towards two things: firstly, clients understand the gravity of what it means to take a loan; secondly, this data may indicate that regulation needs to be more proactively focused on disclosure of collection practices, rather than simply collection practices. In other words, instead of stepping in when clients complain their assets have been seized by MFIs, perhaps regulators need to set rules regarding what MFIs and their staff may or may not disclose to their clients with regard to default.

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5.1.5 How do Clients Learn About Their Loan Contracts

Given the information we now have regarding how clients view their loan contract, it becomes important for us to understand the sources of this information. Below is the summary data in this regard.

30% of the clients believe that all the rules relating to the borrowing are stated verbally to them and 41% said the rules were mostly oral.

Clients stated that the loan contract was explained to them by MFI staff. Most of the respondents were also happy with the way the contract was explained to them.

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Chart 7: Would you like to attend training session on interest rates?

Chart 8: Would you pay to participate in this training session?

76% of respondents (65% in South and 87% in north) showed their willingness to participate in the training session to learn about calculation of interest rates and weekly installments. Out of these 67% were willing to pay to participate. Willingness to pay was higher in north (62%) than in south (38%).

In case of doubts, the respondent in north stated they either went to their centre leader or discuss their problems with their husband. Whereas, in south around 25% said they discussed their doubts with the MFI staff. Remaining either discussed with the other group members or with centre group leader. But to settle their grievance against loan officers’ clients approach their centre/group leaders. Centre leaders are frequently cited as playing important role in the villages. They help the MFIs to set up their centre in the village most are considered as point of contact between MFIs and clients. Centre leaders put forwards clients perspective to MFI staff members.

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Chart 9: Whom would you go to in case of doubt in the loan contract?

5.2 Phase 2: How do clients pick loans?

The results from Phase 1 indicate strongly that clients have limited information about their loans and limited ability to calculate interest rates. Nonetheless, interest rates are important to them and they are eager to pick the cheapest loan possible. Finally, there is a high level of tolerance for coercive and non-microfinance practices amongst microfinance clients. How then do they choose which loans to pick, given that using conventional norms of financial literacy (that is, numeric skills), they possess a low level of financial literacy?

In order to elucidate the answer to this question we conducted a second and much shorter survey with forty respondents in about eight villages around Jabalpur in Madhya Pradesh. In the second round, respondents were asked to pick the cheaper loan between two available choices. The two choices were presented in terms of interest rate plans or frames. The interest rate plan frames varied between monthly, weekly, annual, absolute amount, flat and declining.

For this phase, the pilot exercise was significant. During the pilot, most respondents were able to pick the correct loan schemes, which was surprising given the fact that people performed badly in the arithmetic sections of the first phase of the study. Consequently, an arithmetic section was added in this survey as well.

Educational achievements were low amongst respondents. 33% of the respondents had never attended a school, while only 40% were able to read and write. Out of an average of 5 persons per household, 3 persons were able to read and write, while around half of adult persons had completed high school leaving certificate exam.

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This section is divided in two parts. The first part provides a summary of the respondents’ numeracy skills, while the second part goes into some detail about the ability of respondents to pick cheaper loans, given a pair of loans.

5.2.1 Arithmetic Section The chart below describes how respondents performed in the Arithmetic section. The problems they were asked to solve are given in the chart in ascending order of complexity. During the survey, it was noted that respondents use mental calculation and did not accept any offers of a pen and paper, which were offered to them twice during the survey.

What we note, as in the previous section, as the questions increase in complexity, the ability of respondents to answer correctly falls drastically.

5.2.2 Choosing the Cheaper Loan One would assume that the ability of respondents to pick the cheaper loan would be highly compromised by the poor arithmetic skills amongst our target population. Surprisingly, in this section, we discovered that in nine of the twelve comparisons between loans respondents were asked to make, that is, in 75% of the cases, over 50% of the respondents were able to pick the cheaper loan.

As mentioned earlier, in this section, respondents were given two loans where interest rates were presented in different frames. Respondents then chose the cheaper loan. Following is an example of a question in this section: Table 14:

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The two frames in the question above are the ways in which the interest rate is presented. Thus Frame 1 is interest given in terms of a weekly amount, while Frame 2 is interest given as an annual flate percentage.

A summary of the results are given below. What the table reveals is that there seems to be no way of predicting which comparisons respondents were able to make accurately.

Table 15:

Let us use the illustrative example of asking people to compare between flat monthly vs. monthly declining, two different scenarios elicited different levels of accuracy – 53% for the first question and 85% for the second. Similarly for declining annual and flat annual, 65% picked the cheaper loan while between annual declining and flat monthly only 43% could pick the cheaper option.

Three comparisons between weekly amount and annual rate, placed at different places in the questionnaire gave three different answers. First time 68% picked cheaper loan, in second 28% picked cheaper, while it increased to 85% third time. 28% of the respondents were correct in choosing the right loan from a weekly and monthly amount repayment schedule while 85% got the comparison of a declining monthly and flat monthly right. The later is definitely more complex calculation than the former.

Clearly, respondents are using their intuition and some level of guesswork in order to arrive at the right answer. Thus, it becomes difficult for us generalise exactly how respondents arrive at the correct response. However, what is interesting is that individuals with very low literacy levels and numeric skills were able to pick cheaper loans three quarters of the time.

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6.

Discussion of Results

This study was an attempt to examine how clients understand their loans, in the context of rising concerns over financial literacy, consumer protection and reckless lending. The results from this study are intriguing in demonstrating that clients have a limited understanding of their loans.

However, in spite of their weak numeric skills, when presented with two sets of loans, microfinance clients are able to pick cheaper loans. While looking at the results of the study, it is worthwhile to note that the findings are constrained by the small number of respondents in our study, particularly in Phase 2.

Clients are able to understand only certain things about their loans. They understand how much they have borrowed, for how long they have borrowed and their liability on their borrowing on a weekly basis. They also understand that joint liability, paying for their centre/group members, is a central aspect of their loans. Clients do not seem to know what their interest rates are. Those that do know their interest rates have an extremely limited arithmetic ability and are unable to calculate actual interest amounts using the rates. Our respondents also accepted many collection practices which one would consider coercive (such as the seizing of assets in the event of default) to be an acceptable penalty for non-repayment. Additionally, in spite of their partial misunderstanding of their loans, they expressed a high degree of satisfaction with the way they understood their loans. Finally, our respondents, although of poor educational backgrounds, were able to pick the cheaper loans out of a given pair of loans, even when the interest rates were expressed differently in each loan.

What do our findings indicate for financial literacy and its impact on small borrowers? From our survey, it is clear that access to finance was an important issue since clients state that one of the reasons for borrowing from their respective MFIs was its availability. From our findings it is not clear that access is affected by current levels of financial awareness. As we see from Phase 2 of our survey, clients were still able to figure out the cheaper of two loans. This conclusion merits a few caveats. Firstly, here we refer only access to microfinance which is a fairly standard and simple financial product. Access to more complicated products such as insurance may still require higher levels of awareness than we discuss here. Secondly, Phase 2 of our project consisted only of forty respondents, which is too small a number to generate results that can be generalised. Thirdly, access to finance is affected by more than just ability to pick the cheaper loan. It may also be affected by ability to budget in order to pay repayment instalments, amongst other things.

This paper discussed the importance of financial awareness to consumer protection. Policymakers both in India and abroad have been pushing for MFIs to explicitly state their interest rates to the extent that some have asked for breakdown to show clients the different components of the cost to the end user. The results from our survey show that clients do not think of their loan in terms of interest rates, although interest rates are important to them. They also do not have the ability to compute interest rates. A second concern in the area of consumer protection is to what extent small borrowers understand their financial rights. Here it is clear that there is some work to be done in regulating the disclosure of default penalties by MFIs. We see that majority of our respondents felt that that confiscation of their assets was not only warranted, but in their loan contract, in the event of default. While this answer may indicate towards informal threats by the loan officers simply to motivate clients to repay, this may indicate that policymakers need to regulate the disclosure of these penalties, rather than wait for these events to take place.

Financial literacy is typically measured by measuring arithmetic ability. While this study is by no means a comprehensive measure of financial literacy, it is clear that microfinance clients do not

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necessarily need to have high arithmetic ability to pick cheaper loans. While this study does not necessarily shed light on this issue, financial literacy training involves not only change in levels of knowledge about financial products, but also an attitudinal and behavioural change. The latter is much harder to measure. This study indicates that more work needs to be in understanding how financial literacy training can incorporate current levels of financial awareness to induce positive changes in financial behaviour.

The results underscore the importance of social ties in microfinance. Loan Officers and Centre Leaders are the first source of information for most of the respondents. Thus, it may make sense to equip these ‘elites’ especially Centre Leaders with greater information which they can then pass on to other microfinance borrowers. This suggestion is made in light of the fact that financial literacy training is often time-consuming and expensive. If a small number of influential women can be trained, there may be positive externalities for the community as a whole.

7.

Conclusion

This data provides us with some interesting leads to answer the question of what it means for a client to be informed. In this instance, small borrowers are able to identify the size and duration of the loan and their weekly instalment on their loan. Many of the borrowers also recognize that non-repayment can have potentially harmful consequences. However, they know very little about the interest rate and total interest expense on the loan.

This study argues for regulation which would require financial institutions to provide that information to clients, which they are able to understand and use. The data here shows that clients are able to understand the liability on their loan in terms of weekly repayments, rather than in terms of interest rates. A majority of the clients seem to find what is commonly viewed as coercive collection practices to be acceptable.

In conclusion, the results of this survey would indicate that the way we currently think about how clients understand the loans may not be reflective of ground realities. Firstly, clients think about their loans not in terms of interest rates and interest expense but rather in terms of how much they actually owe on a weekly basis. Secondly, it is both unreasonable and unrealistic to expect small borrowers to have a deeper understanding of their loans than borrowers who have greater access to information and finance. Thus, top-down regulation which works on the assumption that borrowers should be able to calculate and understand their interest rates, would not succeed in protecting small borrowers.

Finally, this study, while useful for preliminary understanding of how small borrowers think of their loans, is limited in scope. For instance, one can speculate that this group of respondents are not unique in any way, that a survey of middle-class borrowers would elicit a similar level of financial literacy. As such, there is much greater research which is required in this area examining in greater depth how small borrowers understand their loans and how they use this understanding to make financial decisions.

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Financial Literacy

References Abdighani Hirad and Peter M. Zorn, ‘‘A Little Bit of Knowledge Is a Good Thing: Empirical Evidence of the Effectiveness of Pre purchase Homeownership Counselling’’ (Freddie Mac, May 2001).

Basu, Priya (2005). “A Financial System for India’s Poor.” Economic and Political Weekly. September 10, 2005. pp. 4008 – 4012 Bertrand, M et al (2006) “What’s Psychology worth? A Field Experiment in the consumer credit market” working paper dated 6 Sept 2006 Cole, S & Fernando, N (2008) “Assessing the Importance of Financial Literacy” ADB Finance for the Poor, September 2008, Volume 9, Number 2 DFID, “UK Backs Lessons in Banking to Help Africa’s Poor” (London: DFID, January 25, 2008). http://www.dfid.gov.uk/news/files/alexander-lessons-in-banking.asp.

Donald Bradley, Abdi Hirad, Vanessa Gail Perry, and Peter Zorn, ‘‘Is Experience the Best Teacher?

The Relationship between Financial Knowledge, Financial Behavior, and Financial Outcomes,’’ paper submitted to the Rodney L. White Center for Financial Research, University of Pennsylvania, Workshop on Household Financial Decision Making, March 2001.

Financial Literacy: An Overview of Practice, Research and Policy Sandra Braunstein and Carolyn Welch, Federal Reserve Bulletin, 2002, 88: 445 Helms, B & Porteus, D (2005) “Protecting Microfinance Borrowers” Focus Note 27, Consultative Group to Assist The Poor Max New York Life, “How India Earns, Plans, and Saves, 2008” (New Delhi: National Council of Applied Economic Research, 2008). Reported in the Financial Express, Businesswire India, February 8, 2008.

Micro-Credit Ratings International Limited (MCRIL). (2005). A study of the Regulatory Environment and its implications for choice of legal form by Microfi nance Institutions in India. Sa-Dhan, New Delhi.

Microfinance Gateway, Compiled by Deborah Burand “How does Consumer Protection Relate to Microcredit?” Available here: http://www.microfinancegateway.org/resource_centers/reg_sup/ consumer_protection Miller, Margeret; Godfrey, Nicholas; Levesque, Bruno & Stark, Evelyn (2008). “The Case for Financial Literacy in Developing Countries: Promoting Access to Finance by Empowering Consumers” Joint note by World Bank Group, Department for International Development, Organisation for Economic Cooperation and Development and Consultative Group to Assist the Poorest, CGAP. Organisation for Economic Co-operation and Development (2005) Improving Financial Literacy: Analysis of Issues and Policies. OECD. Rutledge et al (2008) “Good Practices for Consumer Protection and Financial Literacy in Europe and Central Asia: A Diagnostic Tool” The World Bank: Washington DC. Sendhil Mullainathan and Richard H. Thaler, ‘‘Behavioral Economics,’’ NBER working paper w7948 (National Bureau of Economic Research, October 2000).

Taking Stock Consumer Protection in Microfinance – A Non Regulatory Approach Elizabeth Rhynne October 2003