Challenges of Rural Finance

Despite the success of microfinance services in many countries, access to financial services in remote rural areas remains a challenge. The three main challenges that contribute to rural poverty are:

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It has been repeatedly recognized that the majority of the people in rural areas depend on agriculture as a source of living. Agriculture is widely considered more risky economically than industry and trade. Weather, pests, disease and other natural calamities affect the yield of crops. Markets and prices are additional risks associated with agriculture. Many agricultural markets are imperfect, lacking information and communications infrastructure. Prices are also affected by the access to markets. Market and price risks can also be exacerbated by international market conditions and public policy decisions. For example, the creation or removal of tariff barriers in countries where goods are ultimately sold can dramatically change local prices, hence affecting rural farmers (Christen & Pearce, 2005). The precision of crop schedules generates a specific risk for agricultural finance. Loan disbursements need to be tailored to irregular cash flows, yet the timing of final crop income may vary, based on when farmers choose to sell. These characteristics require financial institutions to be efficient and physically close to their rural clients.

Yet, transaction costs are high and the volume of business in remote rural areas, where many poor people live, cannot support the cost of a bank branch. The problem is worsened by a low density of population and poor infrastructure in rural areas. From an institutional point of view, the main problems include:²

• Small size average farm size, low population density, higher loan servicing costs due to limited lending volume and high information costs
• No branches or a limited branch network in rural areas
• Lack of collateral or adequate security among rural people
• Lack of technical knowledge at the bank level to evaluate and analyze the creditworthiness of rural customers
• Risk correlation when lending to farmers: all borrowers are affected by the same risk, such as low market prices and reduced yields due to the weather
• Underdeveloped communication and transportation infrastructure.

Furthermore, when exploring solutions for appropriate financial service delivery in rural areas, it must be noted that the transactions between various parties (banks, traders, input dealers and farmers/consumers) are predominantly cash based and are very low in value. The cost of cash based transactions is higher (as compared to electronic/non-cash based transactions) due to the following additional costs:

Cost of idle cash: Idle cash, lying either with the bank branch, a merchant or a consumer, does not earn any interest and the party holding it has to bear the cost of interest lost. Thus higher the idle cash, the higher the cost of interest lost.

Cost of cash handling infrastructure: This includes cost of branch set-up, cost of manpower and the cost of cash security. This cost increases with the decrease in value of transaction and the decrease in the denomination of currency transacted.

Geographical spread of customers: If the current structure of the bank branches were to be used to cater to the needs of the rural population, it would mean setting up a bank branch in virtually every village. The cost of such a large network would not justify the revenues generated from it, given the nature of the transactions. Thus, the challenge for banks is to develop a lowcost network/delivery channel with a high outreach and flexibility with respect to the timing of its operation.

It can be observed that the main constraint related to institutional design and delivery mechanisms that contributes to the absence of functioning rural financial markets and institutions is the high transaction and supervisory costs. There is a trade-off between minimizing loan default and supervisory costs, but the nature of rural lending, especially in agriculture, makes transaction costs and supervision costs disproportionately high relative to urban lending. The large geographical spread of customers, coupled with poor transportation and communication infrastructure, increases supervisory costs for financial institutions and compliance costs for customers. In addition, it is extremely difficult to attract qualified and trained loan officers to work in rural areas without much higher compensatory benefits.

In order to extend microfinance services in rural areas, technology solutions have to address these challenges. The following section will give an overview of ICT innovations that have emerged in microfinance.

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Comment(s)

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1. Pratyush Agarwal
   (posted 12 June 2009 / 03:20:06 PM)
   
   A very good paper! It recognizes and abridges the technological usage for the bank. But, It has not dealt on the possibilities of using land-line phones, a prevalent technology in rural areas.