Poor Economics: Rethinking Poverty & the Ways to End it

by Abhijit V. Banerjee

In order to be able to collect on the loan, the lender needs to know many things about the borrower. Some are things the lender would like to find out before deciding to lend, such as whether the borrower is trustworthy. Others, such as the borrower’s whereabouts and nature of the borrower’s business, help in collecting on the loan should there be a problem. The lender may also want to keep an eye on the borrower, visiting her from time to time to make sure the money is being used as promised and nudging the business in the desired direction if need be. All of these efforts take time, and time is money. The interest rate has to go up to cover them. Moreover, many of these expenses do not scale with loan size. There is no way to avoid collecting some basic information about the borrower, even if the loan is very small. As a result, the smaller the loan, the larger the monitoring and screening costs will be as a fraction of loan size, and because these costs have to be covered by the interest collected, the higher the interest rate will be.