What’s Next? David Mckenzie on Risk Isn’t Just for Farmers, but isn’t all bad either

One of the big changes observed in discussions over microfinance in the past few years has been increasing emphasis on discussing microfinance, rather than just microcredit. In practice this has meant a lot of discussion about microsavings, with advocates pointing to studies showing greater impacts from offering savings accounts than from offering loans.

But finance is about much more than just savings and loans. As emphasized in Portfolios of the Poor, one of the issues with living on $2 a day is that incomes for the poor are incredibly volatile, so that the $2 a day average masks days of nothing and days of higher incomes. Building up precautionary savings offers one way to help smooth these shocks, while credit provides another. But some of the shocks experienced by the poor are large enough when they occur that they wipe out savings and leave people in a position where they will struggle to either obtain loans or be able to repay them straight away.

Insurance against downside risk

The obvious missing financial instrument is insurance. There has been much work on index insurance or rainfall insurance for farmers, and many microfinance organizations offer some form of catastrophic health insurance and/or life insurance. But weather and health are far from the only shocks affecting the profitability of small businesses.

What I would like to see is microfinance organizations innovating in ways to help insure business owners against many of the other types of risks firms face. This is especially important for urban businesses for which weather is unlikely to be the main risk. For example, firms that are heavily dependent on the tourist industry could purchase insurance against the number of tourist arrivals in the country dropping below a certain level; firms that are heavily dependent on electricity could buy insurance against extended blackouts or large increases in energy prices; etc. In one pilot experiment I am working with a microlender in a country that has recently gone through large political upheaval to insure firms against political and economy uncertainty – insured firms get payouts if the macroeconomy or political situation implodes.

The hope is that by better insuring firms against such risks, they might be more willing to make investments in riskier, but more productive technologies – as recent experiments in the agricultural sector have found. Since such products would be novel and untested, rigorously evaluating their impacts on firms would be important for knowing whether MFIs should expand such products and invest more in them.

But not all risk is bad, we also need financial products for upside risk

Often we focus too much on the risk that something bad will happen, and not enough on the upside of uncertainty – the possibility that something really good might happen from taking a risk. Indeed microcredit contracts, particularly group loans, have been criticized for potentially encouraging business owners to be too conservative, with the risk of not being able to repay straight away leading people to underinvest in new and innovative products and technologies. One approach is to modify the microcredit contracts to allow some more flexibility, which has shown some positive results in one randomized experiment.

However, where I would like to see more financial innovation is in designing products to help firms invest in projects which have say a 50 percent chance of failure, and a 50 percent change of really high returns. Such projects are anathema to microcredit with their desire for 95% plus repayment rates. The well-known problem here is that a credit contract does not capture enough of the upside risk to compensate for states of the world where failure occurs. An alternative is equity contracts. I don’t know of any organization doing micro-equity on a serious basis, but this is an area which I would love to be involved in and see more organizations testing.

Am I missing organizations doing exciting, innovative work in either of these two areas? If so, I would love to hear about them.