James Militzer

Understanding the ‘Invisible Finance Sector’: FAI Executive Director Jonathan Morduch discusses the U.S Financial Diaries’ research on informal finance – Part 1

Think of all the informal mechanisms – from savings groups to small loans from family – that underserved people use to meet their financial needs. It’s easy to assume that these tools are the last resorts of people who lack access to formal finance.

But that’s not what U.S. Financial Diaries (USFD) project has found. Undertaken by the Financial Access Initiative (FAI) at New York University, with the Center for Financial Services Innovation and Bankable Frontier Associates, the project tracked all the financial activities of 235 lower-income American households for a full year – “every single dollar spent, earned, borrowed, saved and shared,” as the FAI’s Executive Director and Co-Founder Jonathan Morduch put it. In the process, they discovered that among these households, informal financial mechanisms are not just obligatory workarounds for financial exclusion. Indeed, many families in the study continued using these tools even when they had access to formal alternatives.

Understanding the appeal of informal finance can help financial services providers and policy makers design products, programs and policies that better serve low-income customers. We spoke with Morduch about the USFD’s research and its issue brief: An Invisible Finance Sector: How Households Use Financial Tools Of Their Own Making. Part one of our interview is below.

James Militzer: You’ve studied a lot of households. What characteristics do they have in common?

Jonathan Morduch: There are some big patterns that jump out. The starting point is that very few households have much slack at all. They’re working hard but not saving much over time, so they don’t have much cushion when times get rough. The second pattern is that the households face substantial financial ups and downs during the year. Both income and needs are going up and down through the 12 months we spent with them. So rough times arise fairly frequently, and this drives the story of their financial lives. What’s striking is that we see the same basic pattern across the board, whether richer and poorer. What may have been once a story about poor families is increasingly a middle class story too.

JM: Talk a bit about the populations you studied.

JM: The sample is not random; it was deliberately created to reflect important experiences. In California, we’ve been working with Mexican families, some with members born in the U.S., others born in Mexico. In New York we’re working with Indian families, Bangladeshis, Ecuadorians, and Colombians. The rest of the sample is African American or white in different parts of the country – and they have been in the U.S. for many, many generations — in Kentucky, Ohio, Mississippi, and here in New York City.

JM: Did you try to set those percentages to be roughly what they are in the population at large?

JM: No, we didn’t. From the start, we decided not to build a representative picture of America. We’ve learned a lot from large, nationally-representative studies, but we didn’t want to get boxed in by creating another such study.

Instead, we wanted to get to know some communities well. We’ve followed families as they made big life choices, faced obstacles, solved problems, found new problems, found new solutions… We wanted the chance to stick with the families over a year, listen to their stories, and track their progress. Doing that was complicated. We looked for typical experiences, but we didn’t try to be representative in a statistical sense. But now that the data are in, we’re drawing connections to surveys that are more representative.

JM: About the informal finance brief: what kinds of informal instruments are being used, and how often are they put to use?

JM: The big finding is that informal finance is very common across the board, and the families that are using it also often have checking accounts and credit cards. So informal finance is not necessarily a substitute for formal finance. It’s often a complement to it. That’s surprised many people.

We see four different kinds of informal activities. We see savings groups in immigrant communities, and a lot of borrowing back and forth between family and friends – in every location. We see people saving at home in fairly large amounts fairly frequently. And to a lesser extent, we see people using money guards, giving money to others to hold for them.

The fact that informal finance matters so much tells us that the formal finance sector isn’t providing all the options that households want. That’s important because many people assume that informal finance is a second-best option for the unbanked. Our data say that, in fact, that’s not clear. Informal finance is being chosen by people who have other viable options as well.

(Above: Jonathan Morduch)

JM: What is driving the use of informal services among people who have access to formal ones?

JM: When it comes to actually getting a loan at a bank, it is a hassle, it’s inconvenient, you don’t know if you’ll be approved for the amount you want, and the interest rate could be high. The alternative is borrowing from a friend or relative, which can be convenient and quick, doesn’t usually carry interest rates, and is more flexible. It offers the ability to stretch repayment out if you need to, whereas the bank is going to be less accommodating. So it has product features that are more appealing – at least for the borrower. Of course, borrowers have to find someone willing to lend on flexible terms.

JM: Were the people in the study interested in formal alternatives, or were they just as happy to continue using informal finance?

JM: Often there’s a mix, but the families who use informal loans tend to be happy with them. Borrowing informally can be stressful, and not everyone wants to be an informal lender because it creates entanglements which can be difficult down the road. But where the loans work, they can really work well. We have individuals who use them a lot, and we have people who say, “I don’t want to get involved in that business. It’s not good for my family.”

JM: Since they can’t usually waive interest charges or provide completely flexible terms, how can formal providers compete with these informal approaches?

JM: There are some lessons for formal providers. One is that convenience matters, flexibility matters, and so building more of that into products can help. Banks might, for example, design an installment loan product that allows borrowers to skip an installment or two with minimal penalty. Banks don’t have to drop rules and contracts, but they could build in rules that allow for some flexibility. We’re seeing, for example, credit unions and others developing loan products which do what payday lenders already understand: providing simple, quick loans, just like with family and friends. They’re trying to reduce reporting burdens, trying to make lending decisions more quickly, and giving people greater convenience and control.

Another lesson involves getting to know customers. It’s common to think that the folks who are going to payday lenders, or who are maxing out their credit cards, don’t have other options. But what we see on the informal side is that, in fact, households have a fair number of options. They’re weighing them and navigating them. And that’s an important finding for banks trying to serve the under-served: if you’re building a product and you expect people to come and pay a lot of money for it because they don’t have other options, you might be surprised. People have options, but you might not see them.

Also, banks could pay more attention to the fact that some of their customers are heavily involved in informal activities. That way, they might be able to see that some folks with substantial experience with informal borrowing, lending and saving could be good, credit-worthy customers. And so, by taking that into account, they could build a richer profile of who their customers are.

JM: Could that include somehow tracking payment history on informal loans, or bringing that data into the formal system in some way, so that it contributes to that person’s credit history?

JM: Right. There are some organizations that are trying to do that. For example in California there’s an organization called the Mission Asset Fund, which is creating savings groups – ROSCAs, as they’re called – where everyone puts money into a pot weekly or monthly, and then one person gets it at every meeting. It’s a very traditional way of creating a form of finance. But Mission Asset Fund is doing this in a way that regularizes it, puts some structure on it, and then feeds members’ progress to credit reporting agencies. So the participants’ ability to make their monthly installments helps their credit reports.

James Militzer is the editor of NextBillion Financial Innovation.

financial inclusion, research