Capital is the building block of any business and a key factor in launching and scaling businesses that can catalyze private sector development and economic growth in emerging economies. Small and Medium Enterprises (SMEs), in particular, play a significant role in such economies. The World Bank estimates that formal SMEs in emerging economies are responsible for about 60% of total employment and 40% of national income. Taking into account the informal SMEs, the impact is much larger. Yet, the cost of capital, defined as the rate of return expected by those who provide the capital, can be prohibitively high for SMEs. One of the main reasons for the high rate of return required by investors is the cost associated with moral hazard – the party receiving the investment doesn’t have the same incentives as the investor to ensure its profitable use and the behavior and performance of the recipient is costly to monitor for the lender. The International Financial Corporation (IFC) estimates that the credit financing gap for formal SMEs in developing economies is close to a trillion dollars.
The Financial Sector Development (FSD) Initiative identifies and implements ways for financial institutions to profitably lower the cost of capital available to SMEs in emerging economies. FSD’s current research focuses on using remittances to lower the cost of capital for SMEs by mitigating the costs associated with the moral hazard problem
Remittances – the transfer of money by a foreign worker (remitter) to people, primarily friends or family, in his or her home country — amounted to $429 billion in 2016 according to the World Bank. The use of remittance money by the recipient can be for personal consumption and/or for investments in their businesses. In this case the lender (the remitter) has knowledge about the character of the person to whom the remittance money is sent to and has the social mechanisms to influence the recipient’s behavior which is outside the reach of formal lending institutions. Thus, remittances represent not only a transfer of capital but also a transfer of information about the behavior of the recipient. By addressing the moral hazard problem, remittances can lower the cost of capital to SMEs and create a new, financially viable market for lenders.
FSD engages in independent research to understand the investment interests and aspirations of diaspora for their home countries. We also work with faculty and students at the University of Michigan’s Stephen M. Ross School of Business on projects designed to develop innovative mechanisms that can lower the cost of capital. We seek to partner with institutions that are working to create innovative financial mechanisms using remittances and other private capital flows to benefit the SME sector in emerging economies.
We have developed a mechanism, Leveraging Remittances as Information (LRI), that uses remittances to increase access to finance for SMEs in emerging economies. We are looking for financial institutions in emerging economies and diaspora organizations in the United States to partner with us to develop a proof of concept. Click on the graphic below for more information about LRI.
For more information about our FSD Initiative and/or to seek partnership opportunities, please send an email message.
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Programs & Projects
Financial Products to Mitigate Risk in the Jordanian MSME Lending Market
Evaluating Student Microloan Products and Providing Recommendations on Scaling Student Microloan Program in Jordan
Designing Financial Products for Women-owned SMEs
Conducting Impact Assessment to Understand How Microfinance Can Help Victims of Typhoon Haiyan
Creating a Diaspora Financial Product Program for an Ethiopian Bank