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RURAL AND URBAN MICROFINANCE ORGANISATIONS DESIGN ISSUE: AN ANALYSIS BY COMPARISON OF TRANSACTION COST IN INDIA

Microfinance from a Client-perspective: An Empirical Enquiry on Transaction Costs in Urban and Rural India

Thibaut Dehem: CEB (SBS-EM), Université Libre de Bruxelles (ULB)

Marek Hudon: CEB (SBS-EM), Université Libre de Bruxelles (ULB) ; CERMi, Burgundy School of Business

Abstract: Very little is known on the actual cost for microfinance clients to access these services, except interest rates. We give empirical evidences on the transactions costs of urban and rural microfinance clients. It uses individual data of 255 clients and group data of their 48 urban or rural groups in South India. The results suggest that transaction costs incurred by the rural microfinance customers are globally not higher than their urban counterpart. However, when considering a household total monthly expenditure level, microfinance TC of rural household constitutes a much higher expenditure pattern than their urban counterpart.

1. INTRODUCTION

The last few decades have seen the rapid emergence of the microfinance sector. The cost of microfinance services have always been contested since microfinance institutions (MFIs) typically charge a much higher interest rate policy than conventional commercial banks or former credit programmes (Armendàriz and Morduch, 2010; Hudon, 2009). This debate has been recently refueled by the financial crisis and the rising overindebtedness in some countries, and more especially in South India where a local government has strongly condemned MFIs because of their “unfair” rates and unethical practices (The Economist, 2010).

Moreover, while microfinance has often spread in cities, serving clients in rural area is one of the main challenges of the MF sector (Armendàriz and Morduch, 2010). Nevertheless, most recent empirical evidence address institutional issues on the efficiency of MFIs (Hudon and Traça, Forthcoming; Hermes et al., forthcoming, Caudill et al., 2009; Gutiérrez-Nieto and Serrano-Cinca, 2007;), their portfolio yield (Cull et al., 2009) or the risk of mission drift (Mersland, MF Mission Drift, Armendàriz and Szafarz, 2011). Little is however known on the cost for clients to access these services or for MFIs to penetrate a new area. Our main research questions will therefore be twofold: Is integrating the microfinance community in rural area more costly for an individual with financial needs? Inversely, is penetrating a rural area more costly for a microfinance institution? This is complicated issue since transaction costs, including real and opportunity costs, vary across lending methodologies (group and urban). Using the transaction cost (TC) methodology, we contribute to this debate by calculating and comparing TC in Indian urban and rural areas.

Contrary to most countries, microfinance in India has been predominantly rural-oriented with both the self-help group and Grameen principles models, working largely based on community trust and peer pressure. These principles seem to work well in rural areas where there is intimate knowledge of the transactions within families and where the living is in a community (Sriram, 2005). Hence, most of the initiatives including broad-based interventions have had their explicit focus on rural areas. Credit, thus, has largely remained less accessible for the lower income households in urban areas then to their rural counterparts. The reluctance of microfinance intermediaries to work among the urban poor is evident from their minimal presence in towns and cities (Friends of Women’s World Banking, 2008). The main reason for microfinance institutions to avoid urban areas comes from their lack of homogeneity of culture. Indeed, if there is not enough intimate knowledge of the transactions within families or within the community, the risk of overindebtedness increases. This is especially relevant when loan sizes are relatively high. As microfinance spreads to urban locations some of the basic premises of trust and knowledge get questioned.

However, a second point to consider when comparing Indian urban and rural microfinance implies a surge in interest for urban lending. The idea is that it is assumed that rural microfinance is somewhat expensive because of greater amount of travel, sparsely located groups and non availability of local resources to address the needs (both human and financial). In opposition, the urban counterparts could be somewhat inexpensive in terms of resources. Therefore, the apprehension about working among the urban population groups seems to have given way to optimism about the robust economics of intermediation in urban locations.

These differences in environments eventually driving microfinance institutions (MFIs) performances are expectations and mere suppositions so far. There exists an urgent need to clearly map differences in terms of customer profile, environment and community rules between both Indian rural and urban areas. Only on basis of this information, eventual affinities from particular environment characteristics towards an intermediation arrangement can be determined. The issue can be generalized as follow, it is questioned whether any banking methodology performs better in rural or urban areas and what are the reasons therefore. To this end, important lessons in terms of management techniques and product design will be highlighted.

Our study is inspired by Karduck and Seibel (2004) study for NABARD. Moreover, using a standard equality of mean test (Z-stat), we have calculated if the differences between urban and rural are significant.

The aim of this paper is essentially twofold. First, although the role of transaction cost in microfinance has been well understood and referenced, no systematic framework to estimate these transaction costs exists as such. The second task of this paper is to study rural and urban differences for microfinance operations. Our results suggest that transaction costs incurred by the rural microfinance customers are globally not higher than their urban counterpart. However, when considering a household total monthly expenditure level, microfinance TC of rural household constitutes a much higher expenditure pattern than their urban counterpart.

The rest of the paper is structured as follows. Section II sets clear the origin of the concept of transaction costs, and its role in the microfinance exchange. In particular, the trade off between customer and MFI transaction cost in put forward. Section III and IV respectively introduce the main hypothesis to be tested and the database. The dataset include individual information from 255 clients, and 48 group data from their respective 27 urban self-help groups (SHGs) and 21 rural SHGs. Section V sets clear the definition of rural and urban areas and specificities of the Indian context. Finally, Section VI proposes a framework for measuring transaction cost in the microfinance exchange for both, customers and microfinance institutions. The main results are discussed in Section VII. Finally, Section VII draws some conclusions.

2. TRANSACTION COST FRAMEWORK

1.1. Transaction costs in economic exchange

The transaction cost approach refers to the theory of the firm by Ronald Coase. In his paper “The Problem of Social Cost”, Coase (1960) explicitly introduces the notion of ‘Costs of Market Transactions’. He further clearly defined the concept as “the cost of using the price mechanism” (Coase, 1988, p. 38). From there a dichotomous literature began and has consistently focused on one part on the costs of trading across a market (‘neoclassical’ definition), and on the other part on the costs of establishing and enforcing property rights (‘property rights’ definition). Several papers outline this evolution of transaction cost analysis, for instance Rindfleisch and Heide (1997)

The neo-classical study of transaction costs focuses on costs appearing from exchange between actors (Hicks, 1935; Baumol, 1952; Hirshleifer (1973). This economic theory assumes that the legal, political, and informational aspects of an economy are given. Therefore in a neoclassical world contracts do not imply any costs and property rights are secure. Following their definition, transaction costs are costs resulting from the process of market exchange between firms or individuals, i.e. the transfer of property rights. The neoclassical approach to transaction costs dominates in finance and pure theory.

In contrast, the ‘property rights’ approach or also referred as the transaction cost economics, emphasize that the creation, monitoring, and enforcement of long-term agreements are risky. Their definition of TC can be stated as follow: transaction costs are the costs of establishing and maintaining property rights. Since institutions evolve to minimize transaction costs, transaction cost economics “examine the search for institutions that reduce the costs of exchange” (Kang, 2003, p.441). They argue that contract choice depends on the transaction costs of the different contracts. Closely related themes are property rights, informational asymmetries, and principal-agent models. Some papers using the property rights approach are Coase (1937, 1960), Cheung (1969, 1983), Alchian (1979), Barzel and Yoram (1985), and Weakliem (1989). Their literature on TCs usually builds on Coase’s original argument.

The fact that two literatures simultaneously claim ownership of the term creates ambiguity that surrounds the concept of transaction costs. However, there exists some kind of unanimity among researchers since other more or less independent theories like Williamson’s approach (1981, 1985, 2000) focusing on the existence of firms. He argues that what matters about transactions is to describe its impact on the behaviour of the firm and its relationship with the market. Williamson gives us a metaphorical explanation of transaction costs as the economic equivalent of frictions in physical systems. “Do the gears mesh, are the parts lubricated, is there needless slippage or other parts of energy loss? The economic counterparts of frictions are transaction costs: do the parties to the exchange operate harmoniously, or are there frequent misunderstandings and conflicts?” (Williamson, 1985, p.19) These frictions can occur either in a market exchange, or in an exchange within an organization. In the “Nature of the Firm” Cheung (1983) argues that the firm is a form of contractual arrangement.

From Dalhman (1979) a classification for a workable concept of transaction cost includes three types of transaction costs: search & information costs, bargaining costs, and policing & enforcement costs. Those are supposed to be globally applicable across various economic exchanges.

· Search and information costs are costs such as those incurred in proceeding with a market analysis and determine at what price the required service or product is available, or which provider do we have the choice from.

· Bargaining costs are the costs related to agreeing with the other party and fixing a contract. We find this concept back in game theory and in microeconomics where the transaction cost is function of the distance between the bid & ask, whereas in macroeconomics this would be demand & supply.

· Policing and enforcement costs are the costs incurred when assuring the contract is respected, and if not take appropriate action often through the legal system.

1.2. Transaction costs in microfinance exchange

As we have seen, “transaction costs are any costs that arise due to the existence of institutions and the appearance of an economic exchange” (Cheung, 1969). If we apply above definition to a microfinance exchange, the party that cannot provide a service “within the institution” would be a set of individuals with financial needs. They basically face difficulties to interact with each other because of information asymmetry and organizational problems. The other party -interested in an economic exchange- with which an agreement has to be reached would be the MFI. MFIs act as an intermediate to manage cash flow time issues, information asymmetry and organizational problems. Intermediation bridges the timing gap within the person’s own cash flows; it bridges the gap between differing needs for money at differing points in time and between reliability and trust, to enable exchanges with unknown people (Sriram, 2005). At the very moment of need for intermediation, this means when the set of individuals with financial needs cope with the MFI, there is appearance of transaction costs. Hence, financial intermediation through external network is an exchange mechanism implying unavoidable transaction costs.

MFIs are concerned about the cost of transactions involving the delivery of their service to customers. When the transaction costs associated with a particular contractual assembly of inputs are low, self-interested individuals are more likely to choose that method of organizing production.(Leffler, 2000). Microcredit programs vary in their transaction cost characteristics depending on their specific lending methodology and social contexts. Different individual or group lending arrangements impose different levels of transaction costs on borrowers and lending agencies. A critical factor in designing lending initiatives is to ensure that programs economize transaction costs for both lenders and borrowers (Bhatt and Tang, 1998). Dumping cost on clients dramatically reduces the benefits of micro finance by burdening poor clients. However, there are time-tested ways of minimizing the problem without resorting to the use of dumping the costs on the clients. For example, there is evidence (Schreiner, 2003; Dowla, 2006) that the Grameen model by its standardized and unique product service is able to aggregate and reduce transaction costs.

The relevance of TC studies lies in the analysis of trade-offs between the TC of clients, eventual intermediaries like groups or apex institution and banks. We will here focus on the two main actors of a micro-finance exchange: the microfinance institution itself and the individuals with financial needs. As outcome of this reasoning, there exist only one global way of reducing MFI’s transaction costs without spoiling their flexibility & service quality nor dumping costs on clients. It would be to make sure that every organization is well adapted to its environment and client needs. There is a need for “the right model at the right place” in the sense of an adapted intermediation.

3. MAIN HYPOTHESIS

It is assumed that rural microfinance is somewhat expensive because of greater amount of travel, sparsely located groups and non availability of local resources, both human and financial. In opposition, the urban counterparts could be somewhat inexpensive due to proximity of potential customers. There exist an urgent need to clearly map the differences between both environments; this will allow us to acquire a deep understanding of the respective interests, challenges and specifics of rural & urban microfinance.

Many authors (e.g. Gonzalez-Vega 2003) claim difficulties for implementing microfinance in rural areas. In particular, some characteristics seem to level up transaction costs appearing from microfinance exchange in rural areas. For example, low rural literacy rate would mean accounting cost for groups that need assistance for transactions. Similarly, long distances to bank and lower population density in rural areas would involve longer travel distances for customers. On overall, these factors are believed to drive transaction costs of rural customers up. A similar hypothesis can be made for MFIs that are likely to pay more in the rural area. This brings us to state the following hypothesis: “Transaction costs per monetary unit incurred by rural microfinance customers are globally higher than their urban counterpart”.

4. DATA SET

The data used in the paper were self collected in South India (Karnataka and Tamil Nadu) by one of the authors between September 2009 and January 2010. Both urban and rural clients analysed in the sample were clients of Sanghamithra Rural Financial Services (SRFS). SRFS was established in 1995 by Myrada. Myrada is a NGO working on Self-help Affinity Groups (sAgs) to mobilize savings from members and lends to members. It works together with NABARD on linking sAgs and the formal banking system. SRFS was incorporated as a Sec 25 Company as a constructive response to the inability or unwillingness of the banking system to provide credit to sAgs. The organization works with both rural and urban Self-Help Groups Promoting Institutions (SHPI). It currently provides microfinance services in districts in South Karnataka and few districts in Tamil Nadu.

Let us compare SRFS to a benchmark in order to situate its operations and assess its cost structure. The benchmark used here is provided by the MIX and consists of 283 Asian MFIs with an average of 12 years existence, comprising an average of 12 branches and 124 personnel staff. SRFS has a similar profile with about 10 years of existence, and has a network of 43 branches working in 18 district and 84 personnel staff in 2007-2008. The benchmark has 17,239 active borrowers, from which 93.8% are women, totaling 3,677,827 US$ gross loan portfolio. As end march 2008, SRFS counted a similar number of borrowers with 21,272 groups totaling 7,119,189 US$. This means that SRFS’s average outstanding loan is much higher than the benchmark with 335 US$ compared to an average of 166US$ for the benchmark. This can be understood by the fact that Sanghamithra lends only to SHGs and not individuals. SRFSs operational self-sufficiency ratio was at 128.5% in 2008, above the benchmark (113%). The number of ‘borrowers per staff member’ is quite high at SRFS with 178 compared to 132 for the benchmark.

Indian microfinance sector reached a total of about 59 million poor in 2008 spread all over India (Srinivasan, 2008), targeting a wide array of different customers, and working on basis of hundreds of different delivery systems. This means that each MFI face very different challenges, threats and opportunities in terms of product design or lending methodology. There is no way to approach this diversity and set of stakeholders in a standardized approach. Hence, this study is not statistically representative, samples were not randomly chosen. Rather, one bank representing the most used microfinance methodology in India, i.e. self-help group intermediation, has been selected.

This substantial different performance profile compared to the benchmark has to be explained by the fact that SRFS is not a traditional MFI. This MFI is particular as it does not form nor monitor self-help groups (this task is left to NGOs, state organizations or other associations) but rather propose an external loan directly to established SHGs. The MFI however assess the group repayment capacity by itself. The advantage of working with this type of MFI for our study relies in the fact that data from a wide variety of SHGs formed by different organizations is collected. This diminishes bias from working with only one institution. In addition, SRFS work with both rural and urban groups. In total, data from 27 urban SHGs and 21 rural SHGs, and respectively 143 and 112 member’s data have been collected. Of course, we cannot claim that the sample is statistically representative of the Indian microfinance sector. Nevertheless, individuals have been randomly chosen from SRFS clients. The data collected provides information on SHG data (e.g. monthly saving amount, meeting frequency, meeting place, presence of other borrowing institutions etc.) and on customers data (e.g. language skills, education level, economic activity, use of mobile phone etc.). In addition to that, extensive information has been collected for computation of transaction cost for both SHGs and customers.

General SHG info

No. Of SHG data

Average year of SHG

Average No. Members

Average time of meeting (24H)

Bank account

Urban

27

4.2

19.2

16.0

100%

Rural

21

4.8

18.3

17.7

100%

As shown in Table 1, both rural and urban sample are made of SHGs with similar age, number of members and meeting time.

Table 1: Authors’ calculation based on raw data

Let us further assess the representatively of our sample by comparing our sample with Indian population data from Census 2001. As the study was carried in Maharastra state, 89% of the members from our sample had Kannada as native language, and remaining members had Tamil (8%) or Urdu (3%) as native language. This is not representative of all-Indian population at all since the study is confined into one state. Concerning caste dispersion, about 2% of urban members and 6% of rural members disclaimed being part of scheduled caste (SC), and 12% of members in both areas as part of scheduled tribes (ST). Remaining members are part of castes classified as Other Backward Community (OBC) and in a minor part as minority and other castes. From Census data 2001, scheduled castes and scheduled tribes population over India accounts respectively for 16.2% and 8.2% of the population. Our sample is thus skewed with very few scheduled cast compared to Indian population, especially for urban area. Concerning literacy rate, about 87% of urban members appeared to be literate compared to 58% for rural members. This is more or less in line with literacy rate from Census data where 72.9% of females are literate in urban areas whereas 46.1% of females are literate in rural areas. Other education level indicators follow Census data tendency, for instance there was almost no graduate member found in rural area, although quantitative differences exist.

5. RURAL AND URBAN CLASSIFICATION IN INDIA

Since our goal is to compare urban with rural TC, it is important to be clear on the distinction between these areas. In India, the office of the Registrar General and Census Commissioner proceeded lastly with a Census in 2001 which will be used in the paper. Urban population accounted for 27.8% whereas rural population accounts for 72.2% of the total Indian population in 2001. Growths in both living areas follow similar evolution with a baby boom since the 50s – 60S. The dichotomy between rural and urban areas is essential as it permits presentation of any data separately. To differentiate both areas, urban area are usually strictly defined and rural area is then the residual category. This is also the case in India where settlements could satisfy the definition of urban area in two ways incorporating both administrative and demographic criteria (from 1981 Census and on):

1) all places with a Municipality, Corporation or Cantonment or Notified Town Area

2) all other places which satisfy the following criteria:

-a minimum population of 5,000

-at least 75% of the male working population is non-agricultural

-a density of population of at least 400 persons per km2

However, with respect to some other urban characteristics, exceptions cases exist where the state government and other officials have the power to declare a settlement urban. It is to be noted that the present categorization of rural does not comprise any transitional category in the urban definition, thus not taking into account the suburbanization process and hence underestimating the actual urban population. The categorization of semi-urban settlements has not been attempted officially, and will thus not be considered in this study.

The Indian categorization of urban area sets very high requirements as it combines three types of criteria. As mean of comparison, in the United States, where the urban population constitutes more than 75 per cent of the total population, the rural-urban distinction is based on the concept of an urbanized area (UA), which includes a central city and the surrounding urban fringe (suburbs) that together have a population of 50,000 or more and a population density generally exceeding 400 persons per km2. All persons living in urbanized areas as well as in places of 2,500 people or more outside the urbanized areas constitute the urban population while the rest constitute the rural population. No criteria concerning agriculture activity is thus in place (U.S. Census Bureau Geography Division, 2000).

The classification plays an important role as it is usually used as criteria for the implementation of developing strategies, we can think of programs such as water supply, roads, schools or healthcare. Based on this observation, some papers (Bhagat, 2005) examine the criteria and limitations of the rural-urban classification in India and it’s implication for governance. The other major difference in definition between rural and urban areas lies in their nomination of local governance system. “Different local bodies, namely Municipal Corporations, Municipalities, Notified Area Committees and Nagar Panchayats (town councils), govern the urban areas, whereas the rural areas are served by Gram Panchayats (village councils). The rural-urban distribution in local governance is based on the fact that rural and urban areas differ significantly in terms of socioeconomic and demographic characteristics and, therefore, could be subjected to different governance and planning processes» (Bhagat, 2005).

6. METHODOLOGY

1.3. Transaction costs on the customer side

Transaction costs of customers are made of two distinct parts: individual TC directly incurred by a member, and group TC incurred by all member together. Group TC has to be allocated on a proportional basis to every member.

To calculate transaction costs we use Karduck and Seibel (2004) who only consider transaction cost of users and do not take into account price costs of users, i.e. cash payment to a microfinance institution (for example a membership card or annual training). Transaction costs are here non-price cost borne by customers and are not revenue for the MFI. Hence, “transaction costs often swamp price costs” (Bhatt and Tang, 1998). Transaction costs include opportunity cost, such as the time spend at group meeting, and real costs, such as transport and stationery linked to the use of microfinance. Real costs are cash expenses to be paid on a certain frequency. Opportunity costs are non-cash expenses and relate to an alternative that must be forgone in order to pursue a certain action. In this case, it supposes the money the customer could be making during the time spend on MFI matters. They are computed on an estimation of daily wage where the average daily wage for rural woman amount to 30 Rs and the average daily wage for urban woman to 72 Rs.

Opportunity costs are largely fictitious for two reasons: there is no income foregone, except in rare cases; and the opportunity costs are more than offset by indirect and intangible benefits, such as self-confidence in private and public spheres, familiarity with financial matters, and personal access to banks and government programs (Karduck and Seibel 2005). However, both real costs and opportunity costs are considered in the study.

Total customer TC

Individual TC

Opportunity cost

Opportunity cost of travel meeting (Rs)

Opportunity cost of meeting time (Rs)

Opportunity cost of training time (Rs)

Real cost

Travel cost to meeting (Rs)

Individual pass book cost (Rs)

Picture & copy of ID proof cost (Rs)

Fine cost of missing a meeting (Rs)

Proportional group TC

Opportunity cost

Opportunity cost of bank related travel (Rs)

Real cost

Penal charge cost (from cheque bounce) (Rs)

Accounting support costs (Rs)

Meeting place cost (Rs)

Cost of stationery and books (Rs)

Bank related travel cost (Rs)

Cost of cheque book (Rs)

Table 2: Transaction costs on the customer side

Group real costs include penal charge (from check bounce), accounting cost (book writer or auditor), meeting place cost, stationery and book cost, and finally check book cost. Group opportunity costs consist solely of travel time. Individual opportunity costs consist of travel time, meeting time and training time. And individual real cost are made of fine cost of missing a meeting, picture & copy of ID proof cost, individual pass book cost, and travel cost to meeting. From there, average total costs will be calculated on both SHG TC and individual TC and finally the total customer TC can be easily computed.

Let us focus on the different cost pools of customer TCs:

· Opportunity cost of travel meeting: cost related to ‘go & return’ time to walk to meeting place.

· Opportunity cost of meeting time: cost related to the time spent attending meetings.

· Opportunity cost of training time: cost related to the time spent attending trainings.

· Travel cost to meeting: ‘go & return’ cost of journeys (rickshaws or bus) to access meetings.

· Individual pass book cost: SHGs members usually own a personal pass book for entries.

· Picture & copy of ID proof cost: MFI’s administration usually ask for picture & Id proof.

· Fine cost of missing a meeting: SHGs usually fine members for not attending a meeting.

· Opportunity cost of bank related travel: cost related to ‘go &return’ time to walk to the bank.

· Penal charge cost (from check bounce): Sanghamithra charge a 100 Rs for checks that cannot be processed because the SHG account has insufficient funds.

· Accounting support costs: SHGs lacking literates pay an auditor or book writer to help.

· Meeting place cost: some groups need to pay a fee for using a public place for their meetings.

· Cost of stationery and books: cost related to the purchase of eventual attendance register, minutes book, loan/saving ledger, cash book, general ledger, and bank pass book.

· Bank related travel cost: ‘go & return’ cost of journeys (rickshaws or bus) to access banks.

· Cost of check book: some banks make customers charge for check books.

It is to be noted that this list is not exhaustive. These are cost pools identified in the literature and from field observations. However, many more hidden costs might exist, depending on the environment and the type of group lending / promoting institution involved. As illustration, the list evolved alongside field observation as new cost pools were identified.

1.4. Transaction costs on the MFI side

The costs incurred by lending institutions can be categorized in three parts: the opportunity cost of the money that it lends, depending on the market interest rate; the cost of bad debts which is reflected by provisioning for loan defaults; and the actual transaction cost (Shankar, 2006). This study focuses on the latter, however we found necessary to include the cost of loan defaults into the total transaction cost as it reflects the quality of loan enforcement and contract monitoring. The recovery rate of any institution automatically depends on the policy & enforcement activity, hence both cost cannot be dissociated. In contrast, opportunity cost of the money has practically no link with transaction costs; it will therefore not be taken into account in this study.

Let us focus on the origins of the transaction costs and break it down into its parts. For first, as shown in Table 2 we can differentiate direct TCs, from indirect TCs. Indirect TCs are the costs related to overhead costs that need to be allocated.

Total TC

Search & Information

Direct TC

Delivery of Service

Policy & Enforcement

Management

Administrative & Other Expenses

Indirect TC

Depreciation

Provision For Doubtful Debts

Table 3: breaking down transaction costs on the MFI side

Direct TC

Direct TCs find their roots into particular activities in the loan & saving process. They are partly found on an inductive method from field observations, and partly on a deductive method from the literature. In any way, they should be considered as ‘standard activities’ in order to homogenize data and enable a TC analysis, but activities may defer distinctively from one institution to another.

Standard activities are further classified in four type of transaction cost by means of aggregation: Search & Information (activity informing either the MFI or customers); Delivery of service (activity with added value for the customer); Policy & enforcement (activity helping to make sure other party sticks to the term of contract); and Management (activity for the overall functioning of the MFI). Direct TC correspond exactly to personnel costs as staff members are the one proceeding with the different activities.

· Search & Information: Searching for customers/ hamlets with financial needs; Informing customers about product offer & Trainings; Information retrieval on clients; Identifying financial needs for clients; Credit Rating of clients (Appraisal)

· Delivery of service: Group formation ; Collection of savings and loan repayment; Loan disbursement (Cashier desks); Journey to customer

· Policy & Enforcement: Designing credit contracts; Assessing Loan/Saving applications; Monitoring and enforcing Loan/Saving contracts; Financial counseling; Monitoring group activities; Loan recovery process of overdue.

· Management: Providing training to staff; Meetings and external communication; Accounting issues; Financial analysis; Supervising staff; Operational implementation

In order to measure these activities and to estimate their monthly cost, this study made use of Activity Based Costs (ABC). ABC is a very useful tool, however, it is a very time consuming cost model as many interviews have to be given for computing the cost drivers. Activity based costing (ABC) is a costing model that is usually used to identify activities in an organization and assigns the cost of each activity resource to each product or service with respect to the actual consumption of resource. In this case, ABC has been chosen in a threefold goal. Firstly, it gives the opportunity to identify all activities performed by the microfinance institutions staffs, and further make it correspond to a ‘standardized activity’. Secondly, it enables to impute total personnel costs into four classes of transaction costs as seen above. Thirdly, ABC is the adequate tool to distinguish accounts and costs between rural and urban activities. The ABC process used in this study is summarized in Table 4. It starts with the staff interview identifying a particular activity and estimating the consumption of time in order to complete the activity. The staff further attaches a monthly frequency to the activity so as to compute the total monthly consumption of the activity. This total monthly consumption divided by the total time of all activities provides the percentage to estimate the activity cost.

Activity

Time (resource) consumption

Monthly Frequency

Monthly Consumption of activity

Percentage time of staff spend on activity

Monthly cost estimation of activity

e.g. 1) monitoring SHGs

e.g. 2) recovery of overdue

Table 4: Estimating direct MFI transaction cost by activity based costing (ABC)

Indirect TC

Indirect TCs consist of three main components: administrative & other expenses; depreciation; and provision for doubtful debts. Provision for taxation have not been taken into account as they are not captured into any part of the financial transaction. Detailed accountancy of all expenditures (out of P&L) and key cost drivers for allocation of overhead costs. Accountancy data is usually provided by MFIs annual reports with eventual complementary information from accountant staff. Cost drivers for allocation of cost are usually found in annual reports (e.g. loan portfolio), but some are collected during field observation (e.g. building floor space allocation). It includes: Administrative & other expenses; Depreciation; Provision for doubtful debts. Default repayment is considered an indirect TC as the cost is implied by the quality of the transaction. Calculation of provision= 1 to 5 % of Standard assets + 10 to 20 % of sub standard assets (overdue < 90 days) + 40 to 60 % of doubtful assets (non performing assets with overdue > 90 days).

7. FINDINGS AND DISCUSSION

The comparison of customer transaction costs studies respective costs incurred by customers in both areas. Is integrating the microfinance community in rural area more costly for an individual with financial needs? Inversely, is penetrating a rural area more costly for a microfinance institution? As a consequence of the results, we will draw and discuss differences between both environments for enabling a micro finance exchange.

1.1.1. Proportional group TC

We will start with the analysis of the transaction of customers related to the group methodology. Table 5 shows that total monthly proportional group TCs were found to amount to 8.5 Rs for urban groups and 12.2 Rs for rural groups. Most of it is due to monthly real cost amounting respectively of 7.1 Rs and 11.0 Rs. Group real costs include penal charge (from check bounce), accounting cost (book writer or auditor), meeting place cost, stationery and book cost, and finally check book cost. Group opportunity costs consist solely of bank journey travel time and amount to 1.4 Rs for urban groups and 1.2 for rural groups. Opportunity cost figures involve a double dynamic offsetting each other: rural groups take about 1.5 hours to deposit money at the bank as opposed to 1 hour for urban groups, but average hourly wages are almost double in urban areas.

Penal charge cost, meeting place cost and cost of check books are negligible as they all amount to less than 0.05% of loan (or a monthly 0.5 Rs per member). Moreover meeting place cost and cost of check books are similar for rural and urban SHGs. A slight difference exist between both areas concerning penal charge costs as the percentage of check bounces, i.e. the number of check bounces divided by the number of loans, range from about 20% for rural groups and 4% for urban groups. This difference between both areas might be explained by education level and higher custom to bank procedures in urban areas.

Urban

Rural


Rs 1.4

Rs 1.2

Total group proportional opportunity cost

Rs 1.4

Rs 1.2

Penal charge cost (from check bounce) (Rs)

Rs 0.3

Rs 0.2


Rs 0.3

Rs 2.2


Rs -

Rs -


Rs 4.5

Rs 3.2


Rs 1.9

Rs 5.3

Cost of check book (Rs)

Rs 0.1

Rs 0.1

Total group proportional real cost

Rs 7.1

Rs 11.0

Total group proportional cost

Rs 8.5

Rs 12.2

Table 5: Monthly proportional group TC

Major driver of proportional group’s TC lies in cost of stationery and books, accounting support costs and bank related travel costs. A minor difference exists between both areas in term of cost of stationery and books with monthly 4.5 Rs for urban and 3.2 Rs for rural members spent. This slight difference can be explained by generally higher prices of goods in urban shops as we have seen. A major difference between rural and urban group’s TC exist for bank related travel costs with only 1.9 Rs for urban groups and 5.3 Rs for rural groups. This is explained by relative long distance to banks (6 km compared to only 1 km in urban areas) that group leaders and / or other group members need to take by bus or rickshaw. Hence, average ‘go & return cost’ to the nearest bank for rural groups amount to 27 Rs in contrast with 11 Rs for urban groups where most walk to the bank. This difference is enforced by the fact that rural groups have a more regular meeting frequency. Accounting support costs amount to monthly 2.2 Rs per member for rural groups and are almost negligible (0.3 Rs) for urban groups. As explained above, rural members have a lower literacy rate and education level, and are thus more subject to help from auditors, book writers or from the SHPI.

In conclusion, rural SHGs have to face on average higher proportional group TC than their urban counterpart essentially due to longer distance to banks (bank related travel costs) and lower literacy level (accounting supports costs). This is only partially offset by higher prices of goods implying slightly higher cost of stationery and books.

1.1.2. Individual TC

Total monthly individual TCs were found to amount to 20.7 Rs for urban groups and 12.0 Rs for rural groups. Distributions here between real (respectively 15.4 and 8.8 Rs) and opportunity costs (respectively 5.3 and 3.2 Rs) are threefold in favor of opportunity cost in both areas. Individual opportunity costs consist of travel time, meeting time and training time. And individual real cost are made of fine cost of missing a meeting, picture & copy of ID proof cost, individual pass book cost, and travel cost to meeting.

Urban

Rural


Rs 2.9

Rs 1.6


Rs 10.3

Rs 6.1


Rs 2.2

Rs 1.0

Total individual opportunity cost

Rs 15.4

Rs 8.7


Rs -

Rs -


Rs 1.1

Rs 0.5

Picture & copy of ID proof cost (Rs)

Rs 1.7

Rs 1.7


Rs 2.5

Rs 1.0

Total individual real cost

Rs 5.3

Rs 3.2

Total individual cost

Rs 20.7

Rs 11.9

Table 6: monthly individual TC

Picture & copy of ID proof cost (1.7 Rs) and travel cost to meeting (nihil) are equivalent in both areas. Major differences of real cost of individual TC are to be found for one part at individual pass book cost with monthly 1.1 Rs for urban members and 0.5 Rs for rural members (similar price reason as group stationery cost); and for another part at fine cost of missing a meeting with on average respectively 2.5 Rs and 1.0 Rs fine a month per member. This is not so much related to the frequency of missing a meeting, but rather to the average penalty of missing a meeting that was found to range from 7 Rs in urban SHGs and 5 Rs in rural SHGs. Concerning individual opportunity costs, cost of travel meeting time (urban: 2.9 Rs and rural 1.6 Rs) and training time (urban 2.2 Rs and rural 1.0 Rs) are minor factors compared to meeting time (urban 10.3 Rs and rural 6.1 Rs). These factors are equivalent in time unit between both areas, but differ significantly because of wage estimation on which opportunity costs are based. This results in almost twice more direct opportunity TC in urban areas. In conclusion, urban SHG’s members face much higher individual TC compared to their rural counterparts. And this is mainly due to high opportunity cost from urban high wages.

1.1.3. Total customer TC

Total monthly opportunity cost for urban SHGs amount to 16.8 Rs for urban SHGs compared to only 10.0 Rs for rural SHGs. This substantial higher cost is in contradiction with relative more travel time to banks (all other cost pools are similar in time unit), but is explained by on average double hourly wage levels for urban workers. Total monthly real costs amount to 12.4 Rs for urban SHGs and 14.2 Rs for rural SHGs. Two counterproductive dynamics explain here almost similar figures: higher price of goods (due to higher purchasing power and wealthier customers) impact cost of stationery & books (including individual pass) and fine cost of missing a meeting; whereas greater distance and lower literacy level in rural groups impact bank related travel costs and accounting support costs. On the overall, there exist cross dynamics where opportunity costs and real costs, as well as indirect and direct TC, offset each other to obtain quite similar total monthly transaction cost per member. Although urban TCs are slightly higher with 29.2 Rs compared to 24.2 for rural members, because the effect of wage differential on opportunity cost is enormous.

In order to fully estimate the effect of total TC on customers, it is important to take into account the loan outstanding amount to which this TC relates to. Indeed, what makes microfinance expensive is the relative high transaction costs compared to the average small loan amounts. As shown in Table 6 Self-Help Groups from the sample usually had two types of loans outstanding: internal loans from within SHG the, and external loans provided by Sanghamithra Rural Financial Services.

The computation of yearly TC per member in percentage of loan outstanding has given following results (See Table 7).

Average external loan outstanding

Average external loan outstanding per member

Average internal loan outstanding per member

Average total loan outstanding per member

Urban

Rs 74,404

Rs 3,878

Rs 3,400

Rs 7,278

Rural

Rs 71,021

Rs 3,884

Rs 4,765

Rs 8,649

Table 7: sample average internal & external loan outstanding per member.

We can use these data to calculate the percentage of TC per outstanding loan. As expected, Table 8 shows that average higher total loan outstanding per member for rural SHGs have increased rural – urban TC gap even more with respectively a total of 3.35% and 4.81% annual TC per member in percentage of loan outstanding. Compared to the average interest rates charged by the institution for these clients, total TC are relatively XX

Results are consistent with Karduck and Seibel (2005), rural TC pilot study for NABARD on a larger database. They found out that annual transaction costs of SHGs were US$27 per group or 1.22% of loans outstanding to members (averaging US$ 2,230), comprising 51% real costs and 49% opportunity costs. TC of SHGs were found to be low, comprising real costs of 0.62% and opportunity costs of 0.60% of loans outstanding to members. Moreover, annual direct transaction costs of SHG members in their database were US$3.50 or 2.3% of loans outstanding (averaging US$148), mainly opportunity costs. Their study is based on rural SHGs and figures are very similar to ours rural SHG’s annually TC with 3.53% compared to 3.35% in our case. The only cost pool globally but only partially offsetting urban higher TC is the group real cost (especially because of bank related cost and accounting support).

Urban

Rural


0.48%

0.23%


1.69%

0.85%


0.36%

0.14%

Total individual opportunity cost

2.54%

1.22%


0.00%

0.00%


0.18%

0.07%

Picture and copy of ID proof cost (Rs)

0.27%

0.23%


0.41%

0.13%

Total individual real cost

0.87%

0.44%

Total individual cost

3.40%

1.66%


0.24%

0.16%

Total group proportional opportunity cost

0.24%

0.16%

Penal charge cost (from check bounce) (Rs)

0.05%

0.03%


0.05%

0.30%


0.00%

0.00%


0.74%

0.45%


0.31%

0.74%

Cost of check book (Rs)

0.02%

0.01%

Total group proportional real cost

1.17%

1.53%

Total group proportional cost

1.41%

1.69%

Table 8: monthly transaction cost per member in percentage of loan outstanding

In conclusion, our results contradict our hypothesis that transaction costs per monetary unit incurred by rural microfinance customers are globally higher than their urban counterpart. However, we have seen that opportunity costs are largely fictitious as no cash outflow is incurred. Moreover, two reasons support this statement: there is no income foregone, except in rare cases; and the opportunity costs are more than offset by indirect and intangible benefits, such as self-confidence in private and public spheres, familiarity with financial matters, and personal access to banks and government programs (Karduck and Seibel 2005). If considering only real costs, results amount to annual TC per member of 1.69% for rural SHGs and 1.41% for urban SHGs. One last factor need to be considered if wanting to push the study even further: differences in expenditure levels. We have seen that average monthly expenditure (MPCE) for rural households amounted to 559 Rs compared to 1052 Rs for urban household. If considering real transaction as a percentage of the cost spent out of this expenditure basket, figures amount to 2.5% for rural SHG members in contrast with only 1.2% for urban SHG member. This ratio is more than twice higher for rural households and reflects that TC for rural households represents an important part of their expenditure pattern.

1.5. Transaction cost on the MFI side

1.1.4. Transaction Cost Analysis

Data with no distinction on rural and urban loan outstanding. However, we know that:

· Credit officer in rural area has 136 SHGs

· Credit officer in urban area has 210 SHGs

( 154% more ‘credit officers’ needed for running rural operations

Assumption: portfolio made out of 50% rural and 50% urban. The only distinction for imputation of cost between rural and urban activities will be the resource of credit officers and portfolio managers.

Rural TC

Rural TC in percentage of rural loan portfolio

Urban TC

Urban TC in percentage of urban loan portfolio

Loan portfolio (outstanding)

Rs 246,554,570

Rs 246,554,570

Direct TC

Search & Information

Rs 169,228

0.1%

Rs 169,228

0.1%

Delivery of Service

Rs 1,844,628

0.7%

Rs 791,633

0.3%

Policy & Enforcement

Rs 879,943

0.4%

Rs 879,943

0.4%

Management

Rs 2,058,761

0.8%

Rs 2,058,761

0.8%

Total Direct TC

Rs 4,952,560

2.0%

Rs 3,899,566

1.6%

Administrative & Other Expenses

Rs 2,235,154

0.9%

Rs 2,235,154

0.9%

Depreciation

Rs 315,559

0.1%

Rs 315,559

0.1%

Provision For Doubtful Debts

Rs 666,685

0.3%

Rs 666,685

0.3%

Total Indirect TC

Rs 3,217,398

1.3%

Rs 3,217,398

1.3%

Total TC

Rs 8,169,958

3.3%

Rs 7,116,963

2.9%

( distance between SHGs in rural areas limits credit officer performances and makes rural lending more expensive

8. CONCLUSION

The concept of transaction cost has been widely used in the microfinance literature. However, there existed no empirical evidence of these transaction costs. Similarly, rural and urban differences for operating microfinance have been widely preconceived without any data verification. Difficulties concerning data access are here the cause as credit officers do usually not differentiate books between rural and urban activities.

This paper contributes to help the recognition that there are typical ‘urban’ and ‘rural’ characteristics that influence microfinance lending intermediation. The most rewarding achievement of this study comes from breaking the myth of rural and urban microfinance as both literatures claimed TCs to be higher in their own area of interest. This has important implications as rural and urban areas are very different environments that should be handled separately. Numerous and substantial difficulties impede both rural and urban financial market deepening.

In contradiction with the literature, no major difference has been found between TCs borne by customers in both areas invalidating proposition. More than that, average annual total TCs per loan outstanding is even higher for urban SHG customers (4.81% compared to 3.35%). However, when considering the part of real TC spent out of the total expenditure basket, it is shown that rural households have to allocate a part of their total consumption to microfinance TCs about more than twice urban household’s one (2.5% compared to 1.2%). Analyzing consequences on SHGs functioning has permitted to identify substantial higher meetings frequency in rural SHGs, it is thus possible to state that high illiteracy rates demands more assistance from the lending agency.

When comparing MFI transaction cost in an empirical way, it was found that rural activities were much more costly. The rural surplus is solely due to personnel costs. This is mainly because it requires long journeys to customers. Concerning intermediation arrangement affinities to their environments, as journeys to customers are less frequent (customers are managed as a group) and social knowledge is greater in rural areas, the SHG methodology is believed to be well suited for rural environment. In contrast, individual loans were found to correspond to urban inhabitants demand as they offer a more flexible and personalized service.

The case study shows that it is of uppermost importance to reengineer processes and intermediation arrangement pertaining to field operations and repayment collection to suit the needs of clients. Adapting the lending arrangements to the social context is the only mean to reduce transaction costs without shifting cost to consumers. There is no one model better than the other, but rather models need to be adapted to a given environment. Each model is therefore more appropriate to serve a particular market segment within the whole microfinance market. For instance, individuals with a good track record could further graduate from one model to another considering the evolution of their condition. The way models imbricate within one another has to be perceived as a timeline rather than mutually exclusive models.

Finally, our results also provide some major methodology and product design lessons. :

· Hire field workers from inside the community gives the opportunity to save on travel cost and gain on proximity to customers.

· Apply a systematic approach to journey planning in order to economize on travel cost.

· Being a full fledged bank by offering loan & saving products permits to assess potential borrowers and save on monitoring and enforcing cost.

· Group borrowing provides a good previous track record for providing individual loans to larger customers climbing the poverty latter.

X (multiplied)

� Self-Help Affinity Groups or sAgs is the equivalent to Self-Help Groups or SHG, sAgs is own SRFS terminology.

� The Microfinance Information Exchange, Inc. is a non-profit company dedicated to improving the information infrastructure of the microfinance industry in developing countries, by promoting standards of financial and operational reporting, offering readily accessible data, and providing specialized information services. For further information please visit www.themix.org

� Total loan outstanding of 331,300,000 Indian rupees converted using end of the year exchange rate (Thursday, December 31,2009) equivalent to 46.5362 Rs

� Useful extensive information (compared to sampling) is provided by Census 2001 data often making distinction between rural and urban activities (e.g. amenities, sex ratio, average household size, literacy rate, work participation, houseless population, asset detention, dwellings, migration etc.). A last source of information consists of surveys on consumer expenditure, indebtedness and employment-unemployment from The National Sample Survey Organisation (NSSO) that has been carrying out All-India surveys on a quinquennial base. These extensive information will allows us to study the representatively of our sample.

� The Indian caste system at the origins describes the social stratification of the population history and hereditary rules. Politics have partly taken the caste system over to target social development in various forms like employment schemes, subsidies, lower fees, provisions etc. The caste system has thus survived in modern India, and is referred to as ‘the modern status of the caste system’, a sort of mutation from the past.

� Source: rural wage from (Karduck and Seibel, 2004) as stated by 78 SHGs Women; and urban wage on basis of rural wage and a 2.4 ratio from (Bucci, 1993).

� About 68% of our samples are non-working housewives in rural areas and 71 % in urban areas.

� An average interview for ABC purpose takes about one to one and a half hour. Knowing that you need at least two interviews for back-up, and that there are about five to six staff types in a MFI, number of interviews sum up from 10 to 15 interviews in order to compute an ABC analysis for an MFI.

� This results are in line with some rural data from Gonzalez-Vega (2003): “the median distance to the nearest financial institution ranges from 2 km (post office branches) to 5 km (commercial banks, cooperative banks); the median time taken to travel to the nearest commercial bank, cooperative or RRB is thirty minutes (post offices are available at closer proximity).” In our case, we consider only commercial banks as we are working with SHGs.

�Study based on 78 SHGs with 1160 members in Karnataka State.

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