7-Compariso KBL &amp FMBL

Challenges in Microfiance Banking Sector of Pakistan
Comparative Analysis of Khushali Bank & First Microfinance Bank

CHAPTER NO.1
INTRODUCTION
Microfinance is an emerging financial service. It fills an important gap for

consumers by providing them with a risk management tool that, when properly
designed and delivered, can reduce the vulnerability of low-income households.
Microfinance is not merely downsized versions of existing financial services,
however. It is a subset of financial that provides the poor with financial protection
against certain risks in a way that reflects the cash constraints and coverage
requirements of the low-income market. Because Microfinance is highly technical, a
careful assessment of market demand prior to its design and delivery is essential.
This demand study is one element of a larger Microfinance service development
process that PMN is undertaking. The full process consists of several sequential
steps: Microfinance course – to raise awareness of the issues surrounding
Microfinance services. This was conducted by the Microfinance Centre in November
2004.
1. The demand study – the subject of this thesis, undertaken by Microfinance

Opportunities in October/November 2005.
2. A supply-side study to assess existing and planned Microfinance services – to
(1) refine what should be offered, (2) identify potential financial institutions
and other partners that MFs could work with, and (3) uncover information
about the processes, marketing and efficiencies of various options.
3. Financial institution partner selection
4. Design of service prototype(s) based on the demand and supply studies
5. A short, quantitative study to determine the demand for the service prototypes
6. Preparation and then implementation of the proposed service – includes
training, systems preparation, and documentation of procedures.
7. Pilot test review and evaluation
8. Service rollout
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PMN is interested in promoting Microfinance services among its member

organizations i.e. First Microfinance Bank & Khushhali Bank etc. It commissioned
this study to obtain market research that its members could use to design and deliver
Microfinance services for low-income micro entrepreneurs throughout Pakistan.
Using a set of practical tools, the study obtained information about key financially-
stressful events and risks, and the respective coping mechanisms used by
microfinance clients in Pakistan. It evaluated the effectiveness of available coping
mechanisms and examined the range of formal and informal financial options
available to the poor. Based on this information, it then formulated and tested several
Microfinance service concepts as part of PMN’s comprehensive Microfinance service
development. In the end, although the research focused initially on the demand for
Microfinance, the data revealed a demand for risk-managing financial services
defined more generally. Thus, this thesis recommends other risk-managing services
such as savings and emergency loans where appropriate.
My thesis is organized as follows. First, I present a brief overview of

introduction about microfinance and the methodology used to carry out the research.
Then, we review the literature regarding the risks and economic stressors that
microfinance clients face and comparing the performances of main microfinance
institutions i.e. First Microfinance Bank & Khushhali Bank etc. After that discussion
of respondents’ principal risk-management strategies and their effectiveness for
coping with economic shocks follows comprising analysis of people who help in
research. We then present service concepts that the research team developed and
tested with a small sample of clients. We close with a summary of the thesis, findings
and recommendations for PMN and these two banks. The recommendations
emphasize the need for: client financial education; a better working relationship with
the financial institutions; and a systematic service development process for
Microfinance.
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1.1 RESEARCH OBJECTIVES
The study sought to learn about the risks those microfinance clients in
Pakistan face, and the risk management techniques that they use to mitigate those
risks, in order to advise the Pakistan Microfinance Network on potential microfinance
services for its member organizations. To this end, the study defined the following
key questions:
1. What are the most frequent and financially stressful situations faced by poor
microfinance clients? What types of financial stress are associated with these
events?
2. What coping mechanisms do microfinance clients currently use and how
effective are they?
3. What are the formal and informal microfiance mechanisms currently used by
the poor?
4. How satisfied are microfinance clients with the existing microfinance
services?
5. What opportunities are there for microfinance services to fill the gaps in
microfinance clients’ risk management strategies?
6. What are the next steps for PMN, First Microfinance Bank & Khushhali Bank
etc to take to develop microfinance services?
The responses to the above key questions informed the formulation and testing
of several microfinance product concepts. They will serve as a basis for further
microfinance services development efforts at PMN and within its network i.e. First
Microfinance Bank & Khushhali Bank etc.
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1.2 BACKGROUND OF THE STUDY
In the beginning, people consumed what they grow. But with the passage of
time human invented modern methods of cultivation and started to get surplus food.
This surplus food gave birth to trade. People start to exchange things in return for
food. As people became sufficient in the food supply, they had also started trade in
terms of money.
This factor of money brings a new dimension in the socio-economic structure

of the society. The most defining moment in the history of the mankind is the
Industrial Revolution, which took place in the seventeenth century in Europe. This
revolution changed the history of mankind significantly. Europe started making
progress by leaps and bounds because of this revolution. They influenced the whole
world and finally became the master the whole world. After the industrial revolution,
financial institutions came into being. They came into existence as a result of the fact
that some people had excess of money and others had scarcity of money. Financial
institutions started to play an important role in the development and progress of the
people.
Like everyone else, most poor people need and use financial services all the
time. They save and borrow to take advantage of business opportunities, invest in
home repairs and improvements, and meet seasonal expenses like school fees and
special day celebrations. The financial services available to the poor, however, often
have serious limitations in terms of cost, risk, and convenience. Moneylenders, for
example, often charge high interest rates on loans. Buying goods on credit is far more
expensive than paying in cash. Local rotating savings and credit circles take deposits
and give loans only at rigid time intervals and in strict amounts, and often result in the
loss of members' money.
Commercial Banks were focusing on a very limited part of the community

because they considered it risky to finance the poor rural people who cannot offer
heavy collateral securities against bank loans The risk perception of the micro finance
market emerged from the attitudes that the poor are not bankable, to the general lack
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of credit discipline in the over all economy and to the low ability of contract
enforcement. Micro Credit industry came into existence as a source for the massive
communities of the 3rd world countries who were deprived of even the basic needs of
food, health and shelter. Up-till now 44 countries made use of micro credit
programmes and there were 36 million clients of micro credit all over the world
(Micro credit Summit1997).
1.3 STATEMENT OF THE PROBLEM
The present study is about the issues and challenges of micro financing
institutions in Pakistan. Service quality offers a sustainable competitive advantage to a
bank because it creates value and also customer satisfaction. However, service quality
is reduced drastically by service breakdowns. The results of service breakdowns are
customer dissatisfaction and possibly customer defection depending on the customer’s
trust, knowledge and the availability of alternative service provider. In the banking
sector, to maintain and having a closer relationship with the entire or existing
customers are very important.
The maintenance of consumer trust in the microfinance banking industry is of

considerable importance as it can impact on the likelihood of retaining existing
customers and attaining new ones. Furthermore, trust in a bank can also be more
important to a bank customer than price and mark up. So, each bank must make sure
that their services fulfill their customers’ needs and wants.
The focus on this research is to identify the common relationship marketing

underpinnings such as trust, commitment, empathy, values and conflict handling on
customer loyalty in banking sector. This research will also look whether all
dimensions mentioned contribute equally or differentially towards the loyalty of the
customer. My thesis is concerned on mainly issues issues and challenges of micro
financing institutions in Pakistan because they acquire service with certain
expectations, and, for any number of reasons, those expectations were not met. First
Microfinance Bank & Khushhali Bank help in this scenario controlling delays,
failures and troubles like problems to the customers of microfinance services. First
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Microfinance Bank & Khushhali Bank can fill the gaps between the empowerment
opportunities and customers, so this is total concern of my thesis that how and when
First Microfinance Bank & Khushhali Bank can impart their knowledge and role in
microfinance and prosperity of the nation..
1.4 RESEARCH QUESTION
1. What functions, products or services offered by Micro finance institutions in

Pakistan?
2. What are the issues and challenges faced by Micro finance institutions in
Pakistan?
1.5 OBJECTIVES
The main objectives of research include the following;
 To make a comparative analysis of the two micro finance banks, which are
The First Micro, finance Bank and Khushhali Bank..
 To analyze the functions, products and services offered by The First Micro
finance Bank and Khushhali Bank
 To suggest the recommendations to make the working of micro finance banks
more effective
Hypothesis
H0 = First Microfinance Bank & Khushhali Bank activities do not

have any impact on visionary objectives of microfinance and
prosperity of poor segment of country.
H1 = First Microfinance Bank & Khushhali Bank have impact on visionary
objectives of microfinance and prosperity of poor segment of country.
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1.6 SIGNIFICANCE OF THE STUDY
The project is significant in a way that after studying through all the contents
of the research project, the user can effectively judge that how effectively Micro
Financing is being done in Pakistan along with the important issues, problems and
challenges faced by it in Pakistan.
1.7 DELIMITATION
Reliance upon secondary source of information as the data had to be gathered

more from the employee’s experiences and observations rather than focusing on all
the borrowers from micro finance banks in Pakistan. General overview of micro
finance sector due to unavailability of data in the books, articles or journals as well as
on internet because the topic is more about applied research than basic research.
Difficulty in contacting the staff of The First Micro finance Bank and Khushhali
Bank.
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CHAPTER NO.2
REVIEW OF RELEVAT LITERATURE
Microfinance began as a series of experiments in how to use finance to

empower the poor, and has now evolved into a robust movement and industry. Today,
microcredit for investment (particularly for working capital) remains the sector’s core
product, but other financial services such as microsavings and microinsurance are
emerging as powerful complements to loans.
As we observe the recent waves of innovation in microfinance, particularly in

Bangladesh where the “Grameen Family of Companies” is an especially robust
laboratory for pioneering approaches to social business enterprise, at Grameen
Foundation have begun to talk about microfinance as a platform for multiple
development and business ventures, rather than as a financial product or suite of
products. We stand in awe of what Professor Muhammad Yunus has accomplished
and continue to celebrate his richly deserved Nobel Peace Prize. Furthermore believe
that the collective infrastructure of people, facilities, relationships, and knowledge
that the microfinance movement has amassed can and should be used for more than
provision of financial products.
The potential of microfinance to serve as a platform for launching

complementary approaches to addressing the needs and opportunities facing poor
families, particularly their health and educational attainment, is not obvious to
everyone. I was therefore very pleased when, during my initial conversations with
Marge Magnerc via some emails, she immediately grasped the potential of this
paradigm and was one of the most articulate proponents of it I had ever heard. As
arguably the most accomplished female banker in world history, I was eager to have
her go on record with her views since I thought it could influence the dialogue going
on in the microfinance sector about this and related issues. Her roles as a business and
philanthropic leader (who chaired the Citigroup Foundation for many years) make her
uniquely credible and informed on this issue.
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During the course of the research, I interviewed many microfinance

practitioners, including Professor Muhammad Yunus (a few weeks before his Nobel
Peace Prize was announced), Anne Hastings of Fonkoze and Carmen Velasco of Pro
Mujer via emails. I also consulted with business leaders including Ed Scott, the
founder of BEA Systems. Each interviewee articulated their vision of microfinance
and how it can be a platform and network to support social change, and in so doing
shaped this paper. Given time and additional resources we would have talked to many
others who believe in this approach.
If we are going to reach the Millennium Development Goal of halving poverty

by 2015, we will need to not only grow the microfinance movement but also
reimagine it. We see latent and yet unexplored capacities of the network of 113
million poor families currently served by MFIs, and the MFIs themselves, to be a
force in shaping the political economy of the 21st century. We therefore call on
microfinance practitioners, academics, business leaders and others to think and act
with creativity and urgency in leveraging this capacity to accelerate progress.
Our world remains mired in a global poverty crisis. But there is hope. Our
sector has quietly assembled arguably the largest network of poor people in world
history, a network that is touched by the microfinance institutions that serve them on a
weekly basis in most cases. Let Marge’s words inspire us to seize the opportunities
before us and bring closer to reality Dr. Yunus’ vision of putting “poverty in a
museum” as this generation’s legacy to the next.
2.1 Microfinance in World’s Eye
The phrase “Customer is King” may be an oversimplified cliché in business,

but –stripped of all its bells and whistles – this phrase represents the essence of a
consumer business. A business’s survival depends on serving and meeting customer
needs and demands. Businesses have to focus on their customers, their needs, their
behaviors, and a multitude of other factors that impact their lives. A successful,
thriving business can no longer be an isolated business; it must adapt to customers and
© Adnan Rasheed 9
the marketplace. Increasingly, businesses from differing sectors— from technology to
entertainment to retail and even to banking—are partnering with each other to cater to
the same customer base or extend their own client access. Today, people can access
banking products and services practically anywhere – post offices, online, and
through mobile devices. In addition, financial service providers offer financial
education, consumer awareness, and even training and seminars on managing
personal finances as well as small businesses. Based on this same concept, we believe
that microfinance can better serve its clients by extending services to meet their life
demands.
Over the years, microfinance has demonstrated that its impact goes beyond
providing individuals with access to capital; it has also helped to protect, diversify and
increase their sources of income and assets that enable them to make their way out of
poverty. It has shown that when we provide capital to poor individuals with
entrepreneurial ideas and spirit, they will utilize that capital to generate income for
themselves and their families – offering them the potential of a life that is poverty
free. To date, microfinance has touched the lives and communities of more than 100
million families, and has helped lift many of them out of poverty or at least put them
on a pathway to a poverty-free life. However, more than three billion people still live
on less than two dollars a day; more than a billion have no access to electricity; and
three billion have no access to safe sanitation. For these individuals, microfinance is a
tool that must continue to be deployed and leveraged to its maximum potential.
Access to capital has provided people with the opportunity to climb the
economic ladder. Nonetheless, we have witnessed that simple access to capital, while
paramount, is often not enough to realize the kind of rapid poverty reduction that is
needed to reach the Millennium Development Goals. For some, capital is the missing
element in their struggles against poverty. For others, capital is overshadowed by non-
financial factors that also contribute to poverty. Therefore, to create solutions that
address poverty and to enhance the existing use of microfinance, we need to
understand that poverty is a result of a multitude of factors that encompass more than
merely a limited income. According to the Chronic Poverty Research Centre, “chronic
poverty is typically characterized not only by low income and assets, but also by
© Adnan Rasheed 10
hunger and malnutrition, illiteracy, the lack of access to basic necessities such as safe
drinking water and health services, and social isolation and exploitation.”
Because poverty encompasses more than just finance, microfinance—a

purpose-driven business—needs to look beyond just offering credit or banking
services to the poor. To properly serve clients’ needs and fulfill its purpose,
microfinance needs to do more to address the underlying factors of poverty than
simply providing access to capital. This paper argues that although microfinance is an
effective poverty alleviation tool, it should be utilized as a platform for multiple
empowerment approaches, building on the successful models being pioneered by a
few microfinance practitioners. In other words, microfinance should leverage its
position in the field and relationships with clients to deliver other social and
development services. By integrating different approaches and models to deliver a
variety of basic poverty alleviation services to the poor, these individuals will have a
greater chance of lifting themselves out of poverty, and, more importantly, staying out
of poverty.
2.1.1 Overview of Microfinance
Because the term microfinance is used in many different contexts, it can

sometimes be oversimplified and viewed in a skewed or narrow perspective. At its
core, microfinance can be viewed as an innovative segment of the banking sector to
provide financial products and services, primarily credit, to the poor – bridging the
gap that commercial banking has not been able to fulfill, and where philanthropy has
not been able to go beyond pilot approaches to reach meaningful scale. However,
microfinance itself was conceived with a different purpose than just providing the
poor with access to capital. Microfinance and micro credit do not provide consumers
with loans to simply increase their consumption; instead, they provide loans for the
specific purpose of creating self-employment for the poor, thereby enabling the poor
to build their own micro enterprises and move themselves out of poverty. In short,
microfinance is an income producing tool rather than a consumption aid.
What was simply thought of as just providing poor individuals with access to
capital has revolutionized the development world, proving that loans as small as $50
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or $100 in the poorest countries, and somewhat larger ones in middle-income
developing countries, can transform lives. Through microfinance, we have witnessed
those poor individuals, when given the opportunity to start their own business, can
provide for themselves and their family with basic necessities and also generate
sustainable income. If they can maintain that income, it can lead to improved living
standards, and for some, a means to escape poverty. If individuals achieve economic
freedom, it can lead to a series of improvements—improving the well-being of
families, communities and society-at-large.
The exact benefits that microfinance brings to individuals and society may be
difficult to measure from a technical standpoint, which is why there are relatively few
rigorous studies about impact compared to the reach of microfinance. From studies
and research, however, it is apparent that microfinance is an important catalyst for
poverty alleviation. One such study on two major microfinance institutions, BRAC
and Grameen Bank, found that participants who have continued access to loans have a
lower rate of poverty than those without access, 57 percent compared to 76 percent,
respectively. Another study, by S.R. Khandker, found that the poverty levels in
villages with microfinance programs have declined more than in villages without
these programs. Among program participants who had been members for six
consecutive years, poverty rates declined by more than 20 percent (about 3 percent
per year). Khandker estimated that more than half of this reduction could be directly
attributed to microfinance. He had calculated that microfinance accounted for 40
percent of the entire reduction of moderate poverty in rural Bangladesh. These studies
and numerous others indicate that microfinance can improve overall income, increase
decision-making power, and provide general self-empowerment.
From its tremendous success as a poverty alleviation tool, microfinance as an

industry has gained momentum and expanded its scope and reach. The awarding of
the Nobel Peace Prize to Muhammad Yunus and the Grameen Bank will only
accelerate its growth. To ensure that the poor not only have access to credit but other
financial services, micro credit has expanded over the years to include a variety of
financial products such as savings, insurance, transfer payments, and even micro-
pensions. Where regulations permit, savings can be a very powerful tool since it
allows the poor to conveniently amass liquid assets that can be used to self-finance
© Adnan Rasheed 12
education, health care, or disaster relief while also giving the MFI a source of capital
for on-lending. Microcredit, or what is now more aptly called “microfinance,”
attempts to address the multitude of the poor’s financial needs. With this expansion of
purpose, the field itself has increased its reach. By the end of 2005, according to the
Microcredit Summit Campaign, there were over 3,000 MFIs serving over 112 million
people worldwide, of which more than 82 million were among the poorest people in
the world (i.e., earning less than $1/day) when they became clients.
As the sector has evolved to meet the growing demands for its services, it has
been reinventing itself to ensure sustainability at the institutional level. MFIs and the
organizations that support them have taken lessons learned from the banking sector
and the business world to improve efficiency and sustainability. (Perhaps no
reinvention has been as dramatic and influential as the launch of Grameen II in 2003,
and its rigorous but highly favorable evaluation by SafeSave.) We have witnessed
firsthand MFIs improving their loan disbursement and collection methods in order to
reach more clients faster and better. They are becoming better trained and better run
to meet the growing demands for their services. As the field continues to evolve in its
business model and operations to increase institutional efficiency, it is also critically
important that the field focus on its client success and effectiveness.
2.1.2 Inhibitors to Success
At its core, microfinance is not terribly different from mainstream consumer

finance. From accessing funding to managing the disbursement and collection of
funds, microfinance operates like any consumer finance business. But because
microfinance serves a very different client segment – the world’s poor – we cannot
ignore the different set of challenges these clients face and the implications these
challenges have on the organizations serving them. Unlike customers of mainstream
consumer finance, who tend to be middle class and live in relatively stable
environments, microfinance customers live under more dire circumstances and
contend with a different set of factors, such as poor health, lack of education and
access to basic necessities, and unexpected threats such as natural disasters that
endanger their everyday lives. Because these factors are so entrenched in their lives,
© Adnan Rasheed 13
we cannot ignore their influence on an individual’s economic ability to access, use
and repay a microfinance loan.
Clients may be able to gain access to microfinance and may even start a
business, but they may be unable to convert this credit into sustainable income.
According to one study of three large MFIs in Bangladesh, approximately 5 percent of
microfinance program participants lift their families out of poverty each year. This
finding of impact in particular does bring to our attention that microfinance does not
result in overnight success for many clients; with current product offerings and costs,
progress for most clients appears steady, but slow. In the current models being used, a
certain percentage of clients are never able to generate sufficient profits to completely
escape poverty or even to improve their conditions at the margins. An alarmingly high
percentage drop out (5-30 percent annually in many cases) and many ultra-poor
families never join in the first place (i.e., they self-select out). According to some
studies, it takes 5 to10 years for a poor client to work her way up above the poverty
line, and even longer before she has sufficient productive assets to function
independently from the micro credit institution (although continued participation with
an MFI is not necessarily an indicator of failure on the part of the client or MFI, and
in fact may be correlated with the success of both, in the sense that it may be that
many formerly poor clients continue to have robust investment opportunities and the
MFI has products that are relevant to those opportunities).
What are the factors that hold back microfinance clients from overcoming
poverty more quickly than is currently the case? In other words, why do some people
move out of poverty and others fail to do so or make progress slowly – even though
both participate in a microfinance program? In assessing the research and speaking
with numerous practitioners, we identified three elements that diminish microfinance
participants’ chances for being successful in a program: poor health, natural disasters,
and lack of education. Because the poor live in a state where even the smallest
misfortunes threaten their survival, these three elements are critical factors in
determining the performance of their loans, their progress out of poverty or lack
thereof, and ultimately the long-term sustainability and profitability of the MFI.
© Adnan Rasheed 14
Health
The loss of income due to sickness and incapacitation of a borrower or a

family member, and the high cost of health treatment are detrimental to individuals
and families in the developing world. Therefore, it is not surprising that illness and
death of family members are among the most common reasons why microfinance
participants remain mired in poverty, default on their loans and/or drop out of a
microfinance program. According to a survey of Zakoura Microcredit Program,
problems beyond clients’ immediate control, which were most frequently an illness or
a death in the family, were the principal cause of client drop out in 28.6 percent of
cases in one sample. In a study of long-term clients of the Grameen Bank by Helen
Todd, ill health was the key factor differentiating those families that had emerged
from poverty and those who had not.
She writes: “[A] serious illness in the family…almost always forced them to liquidate
assets in order to pay for medical treatment and/or keep the family afloat… The
disaster of illness struck ten of the 17 Grameen Bank families who are still in the
poverty group, or 50 percent. Among the families who are no longer poor…only 18
percent... [had] been hit with a serious illness.
While the figures above are alarming, they are not surprising. Illness and
injury are common drivers of bankruptcy in the developed world as well. According
to a 2005 study conducted jointly by Harvard Medical School and Harvard Law
School, approximately half of all individuals declaring bankruptcy in the United
States cite illness and medical bills as the primary factors leading to bankruptcy.12 The
major difference between these two groups (borrowers in developed countries and
microfinance borrowers) is one of vulnerability. For an individual in a developed
country, bankruptcy can be an enormous life challenge leading to significant lifestyle
changes. But developed countries have safety nets and established legal and social
infrastructures such as bankruptcy laws, as well as other public and private
institutions that help people to get re-established and get back onto their feet. In
developing countries, these types of infrastructures and programs either do not exist
or are limited in their reach. Therefore, for a microfinance borrower living on one to
two dollars a day, illness can lead to hunger, deprivation, or even death.
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Natural Disasters
Like ill health, natural disasters are another area of vulnerability for the poor.
Research shows that when disaster strikes, the poor are not only in a greater danger of
falling victim, but suffer disproportionately greater losses. For poor people, the
resulting lost income may force them to sell their land, livestock or their tools, send
their children to work rather than to school, or eat less. Such drastic measures may
mean survival, but they make it much harder for vulnerable households to escape
poverty.13 According to Salvano Briceño, Director of the UN/ISDR Secretariat,
“Investing in disaster risk reduction reduces the vulnerability of people to hazards and
helps break the vicious cycle of poverty. We need to engage the microfinance
community into a dialogue on reducing the impact of natural hazards on populations
and livelihoods."
Education
The third critical factor that prevents some borrowers from sustaining a
successful business is lack of education. Most borrowers of microfinance are
incurring debt and operating a business for the first time. And, as we know, the
responsibilities that go along with these two endeavors are great. It requires
understanding the fundamentals of credit and how to manage a complex business.
Without the appropriate support and education, a borrower can find herself unable to
manage a growing business, which can contribute to backsliding into poverty and/or
defaulting on a loan. Providing adult literacy and/or financial literacy modules to
microfinance clients can therefore represent a long-term investment in the well-being
of the client and the MFI that serves them, even if it increases costs in the short run. In
addition, facilitating higher educational attainment among clients’ children, arguably
a more cost-effective and realistic goal in most cases, can help ensure that at least one
household member involved with the family business is literate, and that a wage-
earning offspring is available to support a client when they reach old age.
Because these three factors, among others, are key impediments to a

borrower’s success in the microfinance context, it only makes sense that microfinance
© Adnan Rasheed 16
incorporates some prevention and mitigation measures into its business model.
Improving the health of clients as well as helping the poor to prevent and/or respond
more effectively to these inhibiting factors can contribute to sustainability at both the
client level and the institution level. A healthy client is more capable of managing her
business and generating income for her family. This income generation translates to
an increased ability to make payments on the microfinance loan. This improved
repayment should benefit the lender as much as it does the borrower – leading to a
cycle of economic strength for both.
2.2 Microfinance & Pakistan
Pakistan has scarcity of skilled labor force in other vital sectors also, which
could be fulfilled by the huge number of idle but willing work force among the men
and the women in Pakistan. It may be pertinent to mention here, that there is a scope
of 0.3 million additional jobs for women in the garment sector of Pakistan.
The Government of Pakistan and many other developing countries now consider
micro finance as an important component of the country's financial system and
recognize the private sector's role in the poverty reduction strategy.
The sustained commitment exhibited by the government to ensure a conducive

policy environment for the development and growth of the sector has started yielding
results in the form of gradually increasing outreach and the increased investor interest
in the sector. The government is now supporting financial service access to the
majority of the population to advance and provide economic opportunity and access
for the poor, especially, those who work in micro enterprises. Poverty is one of the
few challenges that every single country in the world has to deal with it.According to
the World Bank, 3.0 billion people lived on less than $2 a day in 2006. Despite the
difficulties involved in changing this situation, there are solutions and microfinance is
one of them.
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The Asian Development Bank (ADB) has defined Micro Finance as:
Microfinance is the provision of a broad range of financial services such as
deposits, loans, payment, services, money transfers, and insurance to poor
and low-income households and their micro enterprises.
In Pakistan, Micro Finance is not a new concept. However, after Micro

Finance Ordinance 2001 in for achieving UN Millennium Development Goals
(MDG’s), micro Finance culture is now development rapidly. After the government
sector, private sector is also involved in Micro Financing.
The Micro Finance market is now a mature market but it remains too limited
in scale. In Pakistan it has been estimated that about 6.5 million households need
assess to Micro Finance services, while the sector service only 0.5 millions. Over 90%
potential clients are then left out. The concept of Micro Financing is getting more
recognition, especially in countries like Pakistan where majority of the population
needs access to micro financing services. Majority of the population is unaware of
banking services which could be made available to them, but they are unaware of
these services.
In 1960 and 1970, subsidized micro credit was provided in rural areas but it
failed because of unsustainable system. In 1980, Aga Khan Rural Support Programme
was established in northern region to build community based organizations and
infrastructure. Orangi Pilot Project (OPP) was developed to provide individual
lending methodology by targeting entrepreneurs in the region of Karachi. In 1990’s
organizations like KASHF, Taraqee and Daman, etc was opened. There scope is
limited because of narrow institutional base, slow progress, sustainability and lack of
efficient benchmarks. Since 2000 many organizations have started their operations
like Pakistan Poverty Alleviation Fund (PPAF), Khushhali Bank, etc. An Ordinance
called as “Micro Finance Ordinance 2001 has also been promulgated for efficient
working of micro finance banks and organizations.
The First Micro finance bank is the first bank in the private sector to start
micro financing in Pakistan. According to the World Bank, 3.0 billion people lived on
less than $2 a day in 2006. Despite the difficulties involved in changing this situation,
© Adnan Rasheed 18
there are solutions and microfinance is one of them. Taking all the facts into
consideration, a need arises to see the functions, products and services of micro
finance institutions in Pakistan and to make a comparative analysis between Micro
finance institutions.
2.3 Informal Finance Markets
Informal finance markets (IFMs) have a long history pre-dating formal

markets and a strong presence in most of rural and urban Pakistan. The informal
financial sector is that part of the economy in which financial contracts and
agreements are conducted without official regulation or monitoring.
In one view, these markets exist because financial markets as a whole are
incomplete and with their expansion, informal markets would cease to exist. Another
view maintains that the informal sector does not just exist due to the limitations of the
formal markets but has a comparative advantage in some market segments. Informal
institutions either provide services that formal institutions cannot provide or have a
cost advantage over their formal counterparts. Indeed, some part of the demand for
informal finance comes from the desire to operate outside the formal, documented
economy in order to avoid paying taxes and is sometimes linked to the underground
economy.
However, urban IFMs and small and medium enterprises (SMEs) face
constraints in getting access to institutional credit. Bari and Faheem report for this
study that SMEs are 'credit constrained' in the sense that while they are willing to
borrow and/or borrow more at prevailing interest rates, they do not have access to
funds and thus get credit rationed. Lack of well-functioning financial markets has
disproportionately adverse consequences for the poor who have credit requirements
but few assets that can serve as collateral. They are thus shut out of formal finance
markets and this perpetuates poverty. Richer rural households have better access to
cheaper institutional credit whereas poorer households depend mainly on expensive
informal or non-institutional sources.
© Adnan Rasheed 19
Informal markets cannot be strictly classified. They are generally stand-alone
markets operating without the links that characterize well integrated financial
markets. The multiplicity of informal finance markets is reflected in the observed
diversity of transactions in these markets, such as lending and borrowing among close
relations, rotating saving and credit associations (RoSCAs), moneylending,
interlinked financing and suppliers' credit, among others Urban financial markets are
different from rural ones in certain important respects. Many urban markets catering
to traders, especially wholesalers, have a long history and are quite well developed in
terms of the amounts of funds intermediated, the speed and efficiency of the
intermediation and the sophistication of participants as well as the market as a whole.
Suppliers' credit is a common feature: in old markets with established players,

as much as 90 per cent of transactions are carried out on suppliers' credit resting on
good faith. A chit (parchi) is the norm for making business transactions and is not
dishonoured; it represents a convenient and flexible method that allows business to be
conducted at arms-length and does not require documentation or entail tax liabilities.
Informal finance markets are very common in the transport business. In some urban
areas, moneylenders mostly provide credit in the shape of goods to clients. The annual
interest rate for credit in the shape of goods varies depending on the financial position
of the borrower and his previous track record. Default rates in transport financing are
said to be very low because social linkages help overcome screening and monitoring
problems, reduce the risk of default and ensure availability of multiple channels in
case of repayment problems. Similar patterns were observed in the shoemaking
industry and in the dairy and livestock industry in different cities and different
markets.
2.3Implications For Policymakers And The Microfinance Sector
It is not possible to wish away informal finance markets. Policymakers need to

realize that so long as institutional finance has limited access and does not fully meet
the demands of the client, the informal financial sector will continue to flourish. A
better economic response to the existence of such markets may be to develop more
© Adnan Rasheed 20
linkages between the formal and informal markets, to speed up financial liberalization
and encourage deepening of formal finance markets.
One response to recognition of the informational advantages of informal

financial markets can be to try and encourage them rather than replace them by
expanding formal finance to economic agents who are likely to use these funds in
informal markets. Another response is to actually design and help expand
microfinance institutions (MFIs) that will take advantage of local level information.
In terms of urban informal sector financing, access to credit is only one of

many constraints, most of which can only be addressed through changes in the
investment climate aimed at reducing the cost of doing business. A study of informal
finance markets can help MFIs understand their market, develop their core niche,
explore the options for cross-subsidisation between markets and developing viable
and demanddriven products and practices. This can help the sector outgrow its current
small outreach to a more sustainable size. But microfinance cannot be a solution for
all the financial intermediation needs of the poor. In the long run even the
sustainability of microfinance requires a shift away from a supply focus to a demand-
driven market system. MFIs can also reap the advantages of clustering. Clustering
represents a mechanism for reducing the transaction costs of doing business and
obtaining access to credit either through financing cooperatives/associations of cluster
firms, or financing of individual firms in clusters while using the cluster associations
for generating external economies. In Pakistan there is tremendous potential for MFIs
to collaborate with public or private agencies through targeted, competitive and
market-driven public interventions in upgrading existing clusters or catalyzing the
growth of a new cluster. MFIs can collaborate with either commercial banks or public
agencies on cluster development programs.
The Pakistan Microfinance Network (PMN) can facilitate this process by

conducting studies on existing clusters and by suggesting models of such
collaboration. Another option for MFIs is to tie into the entire suppliers' chain through
institutions providing embedded services as part of their business strategy or mission.
Finally, MFIs have a unique opportunity at present to venture into the area of SME
lending by trading on the soft information available with them by either renting out
© Adnan Rasheed 21
their ability to use social collateral or by going into SME lending on their own. In the
first option, MFIs can become information providers to and/or partners of banks and
the second is for MFIs to go directly into SME lending. This option carries higher
risks but promises higher returns as well and implies a significant change in its
organizational structure, client base and priorities. This may not suit MFIs trying to
reach the very poor but could work well for MFIs that fund existing micro and small
businesses. The Pakistan Microfinance Network can take a lead in this initiative and
initiate a dialogue as well as further research their prospects.
2.3Underground Economy
Some transactions in IFMs - especially in urban areas - are linked to the

underground economy, which can be loosely defined as that part of the economy that
goes unrecorded in official statistics and includes activities which are concealed from
the tax authorities in an attempt to evade taxes. Many self-employed persons are
involved in tax evasion and underground economic activities because there is no
formal system of documentation for self-employed persons and their activities. The
Pakistan Institute for Development Economics (PIDE) reports (1998, 2003) show that
the size of this economy has been growing faster than the formal economy and
estimate that it grew from about 20 per cent of the gross domestic product (GDP) in
1973 to 54.5 per cent in 1998 but then declined to 37.25 per cent by 2002. Estimates
of tax evasion show similar trends. The report ascribes the decline to changes in the
overall economic activity, smuggling, documentation of the economy, adoption of the
anti smuggling policy and so on. However, it must be remembered that these
estimates do not yield precise measures but only broad indications of trends.
2.3Size Of The Informal Finance Sector
The informal sector accounts for as much as a quarter of the GDP in certain
countries. In Pakistan, despite the substantial expansion of formal credit institutions,
the predominance of informal rural credit is manifest from its reportedly high share in
total credit extended to the rural population in cash and/or in kind. Clearly,
institutional credit grew in Pakistan during the 1970s and 1980s. On an aggregate, the
© Adnan Rasheed 22
institutional sources which were responsible for about 10 per cent of total borrowing
for all cultivators combined in 1973 rose to account for nearly 40 per cent in 1985,
mostly due to increased lending by the Agriculture Development Bank of Pakistan
(ADBP, now the ZTBL). The importance of borrowing from friends and relatives
among non-institutional sources declined in this period while that of commission
agents and merchants remained about the same. A comparison of the share of
informal rural credit in Asian countries shows that this share is high in all countries,
especially Pakistan.
The share along with the reporting year is: Philippines, 71 per cent (1978);
India, 70 per cent (1972); Bangladesh, 63 per cent (1974); Pakistan, 73 percent
(1985); Malaysia, 62 per cent (1986); Thailand, 52 per cent (1985); Indonesia, 52 per
cent (1985); South Korea, 50 per cent (1981) (World Bank, 1996).
2.3Implications Of IFMS For Poverty
The lack of well-functioning financial markets has disproportionately adverse

consequences for the poor: with credit requirements but few assets that can serve as
collateral, they are shut out of formal finance markets. As a result, the poor have
strictly limited possibilities for consumption smoothing in response to income and
other risks, for financing production enterprises and longer investments through
saving, lending and insurance. Worse still, the severe asset inequalities and lack of
well-functioning financial markets in Pakistan are not offset by access to financial
services which in turn forces the already dependent people to search for security
within the 'moral economy' through the system of patronage and patriarchy. Poverty is
thus perpetuated by further narrowing the ability of the poor to exploit economic
opportunities.
All the available evidence from Pakistan suggests that richer rural households
have better access to cheaper institutional credit whereas poorer households depend
mainly on expensive informal or non institutional sources. This is in line with
international empirical evidence which shows that richer people borrow more and pay
lower rates of interest and that bigger loans are associated with lower rates of interest.
© Adnan Rasheed 23
The National Human Development Report (NHDR, 2003) shows that people below
the poverty line tend to increase consumption by taking loans and selling their assets.
But since their access to credit is limited and they have few assets, they suffer from
extreme nutritional deficiencies and rely on transfers to supplement their incomes.
Furthermore, the NHDR data also shows that the indigent have very high
ratios of loan dependence on landlords and this dependence declines proportionately
for the poor and the non-poor. Absolute levels of indebtedness show a similar pattern
but are generally far higher in the rural areas compared to urban areas when measured
as a percentage of income.
Indeed, this high rate of indebtedness is a major hurdle in poverty alleviation

programmes based on credit alone. The NHDR data shows that most loans in both
urban and rural areas are taken for meeting consumption needs. Since institutional
creditors do not officially provide loans for consumption purposes, the report reveals
that friends and relatives are the major lenders. The Survey of Informal Lenders
(1996), however, states that approximately 90 per cent of the total credit disbursed by
lenders was given for production and investment purposes and that only shopkeepers,
landlords and moneylenders extended some loans for daily consumption. But since
information on the purpose of the loan was provided by lenders, it is possible that the
ultimate use of the credit was not known for certain.
Other surveys show that although farmers are generally able to get informal
loans in times of need, such lending is available only for certain uses (for example,
small consumption loans from friends and relatives) and not for long-term productive
investments (for example, land improvement, land purchase or land leasing). In rural
areas, this is illustrated by data indicating a paucity of fixed-rent leases, which require
upfront rent payment. In an environment where over a third of all cultivated area is
leased out, this is particularly significant, and suggests that the informal credit market
is by no means adequate and bears adverse productivity implications for poor and
landless farmers. The low/no interest loans from friends and relatives are obtained
largely by better-off households. Marginal and small owners and landless tenants have
the bulk of their credit needs met by lenders other than friends and relatives.
© Adnan Rasheed 24
2.3History Of Informal Finance
The indebtedness to informal lenders in the rural areas is not a new

phenomenon. Thorburn (1886) vividly depicted the dominance of moneylenders in
the Punjab. Darling (1925) reported high levels of indebtedness from surveys of
Punjabi proprietors and found that debt was more widespread and deeper in the
Punjab than in the rest of India. He discovered that there were 40,000 moneylenders
in the province, over 80 per cent of Punjabi proprietors were in debt and the average
debt per indebted proprietor was equal to about three years of his net income.
According to his estimates, a large part of the debt was unproductive, being
either compound interest or spent on extravagant expenditures such as marriages and
that “only the smallest fraction, almost certainly less than 5 per cent, is due to land
improvement.”
Moneylenders have been an integral part of the rural economy since ancient times and
have historically played a vital role in smoothing consumption and financing village
transactions. But with the advent of British rule, the power of moneylenders increased
significantly due to a decline of the earlier vigorous village communities, replacement
of communal ownership of land with individual rights and the establishment of civil
courts which facilitated contract enforcement. Moneylenders further consolidated
their growing power by resorting to widespread malpractices in maintenance of
accounts.
The moneylender ensured repayment primarily through social sanction and

failing that, through civil court decrees. The instrument of mortgage, which became
widespread during the early period of British rule, resulted in massive land transfer
from the landowners to the moneylenders. Out of 742 families examined during an
enquiry by Thorburn in 1896, “only in 13 cases did a once involved man recover his
freedom.” Thorburn reports that similar conditions prevailed in the NWFP and Sindh
where the big landlords were all deeply encumbered in debt. Such conditions
prompted the British government to intervene with the 'free' operation of IFMs in
pursuance of its political objectives. The British sought to protect the interests of its
loyalist agricultural owners/indebted landlords through the Sindh Encumbered Estates
© Adnan Rasheed 25
Act 1876, and the Punjab Alienation of Lands Act 1900, which prohibited the
purchase and alienation of lands from 'agricultural castes' and thus reduced the threats
to mortgaged lands.
Similarly, during the depression of the 1930s the British protected several
large estates (landholdings) from a change in ownership due to heavy indebtedness
and insolvency owing to the downturn in agricultural prices and rents. In the Punjab,
for instance, protection was sanctioned through The Punjab Relief from Indebtedness
Act 1934. Presently, the money lending business is legally covered under The Punjab
Moneylenders Ordinance 1960 under license from a collector who can also cancel it
in case of forgery, fraud, conviction or excessive interest. But this ordinance is
practically redundant and no records are currently maintained by the revenue
authorities. Some people believe, however, that its repeal will lead to a decrease in the
actual incidence of money lending. Recently, a private bill introduced in the Punjab
Assembly seeks to ban all private money lending.
2.3Providers Of Informal Finance
There are a large number of informal finance markets and each generally
operates singly without the links that characterize well-integrated financial markets.
The multiplicity of IFMs is reflected in the observed diversity of transactions in these
markets: lending and borrowing among close relations, rotating saving and credit
associations (RoSCAs), money lending, interlinked financing, suppliers' credit and so
on. Lending and borrowing among relatives, neighbors, friends and other socially
close lenders is very common for financing needs, especially for consumption-
smoothing purposes. Such transactions have the advantage of being collateral-free
and, in most cases, free of interest as well. These transactions rely on the principle of
reciprocity and represent informal social insurance schemes; both the lender and the
borrower gain from the transaction and the process become self-sustaining.
The borrower is able to finance urgently needed expenditures quickly and with
little transaction costs since there is no lengthy appraisal process involved, little or no
paperwork or travel time and the terms of transactions are well understood. A study of
© Adnan Rasheed 26
the informal sector's role in the NWFP (Integrated Development and Entrepreneurship
Advisory Services [IDEAS] 1999) found the greatest volume of financing came
mostly from friends and relatives. The study found that there is no additional cost or
interest when borrowing from relatives and friends except in some cases where a
profit-sharing arrangement has been made. Shopkeepers are another important source
of lending, especially in rural areas and among low-income households.
While money lending is still a big source of funds for those rationed from
formal finance markets, most moneylenders actually have a different principal
economic activity. This diversification helps them cope better with the risk and
uncertainty in their incomes. Interlinked contracting, another common mode of
informal financial arrangements, usually takes the form of tied credit where the
supply of credit in the form of cash or input supplies is linked to the purchase of the
produced output at a highly discounted price. Money lending and interlinked finance
are discussed in detail later.
In a rotating saving and credit association (RoSCA) or committee, as it is

commonly known, a group of participants puts contributions into a pot that is given to
a single member and this process is repeated over time until each member has had a
turn, with order determined by list, lottery or auction. The member gains demand
deposits, once the saving is committed, but it cannot be drawn immediately and the
member is required to wait his/her turn. The main goal of a RoSCA is to mobilize
savings and channel them to borrowers in some pre-specified order, thus fulfilling an
important intermediation function. In RoSCAs, individuals pool their savings on a
regular basis to generate loan able funds primarily for its members. Not only are the
organizational and monitoring costs very low, default rates by the very nature of
RoSCAs are low as well. RoSCAs exist in almost all developing societies and in some
developed countries as well under different names and have very long lives. But the
essential features of RoSCAs, in terms of a revolving fund for financing lump-sum
expenditure, are similar.
Generally, it usually involves a group of people coming together and

contributing a fixed sum of money after every specified time period. This pot is then
allocated to one of the members of the group. This process continues till every
© Adnan Rasheed 27
member has received the pot. After that the group can disband or start again. There
are a number of ways of allocating the pot (random selection, pre-set order or
auctions) and a number of ways of setting up the group, selecting members and
enforcing discipline. Some RoSCAs even have discounts built into them to take care
of costs for later recipients. But the essential features of the revolving fund carry
across all RoSCAs. For any relationship where payment is made now and repayment
is made over time, the possibility of default is always present. Banks avoid this
through collateral, but committees do not require physical capital as collateral.
RoSCAs work in societies and groups that have strong reciprocity relationships which
allows for the selection of trustworthy members and the avoidance of default.
Moreover, ostracisation in its various forms acts as a sufficient deterrent. If a

society has a very efficient, complete and well-structured financial system, RoSCAs
would not be needed. Banks and other formal sector institutions would then be able
to, in theory, serve all who were willing and able to pay the requisite financial costs.
But the financial system is not complete, has large asymmetries of information and
rations a significant proportion of the population. Under these circumstances,
RoSCAs present one way for these populations to provide for themselves by allowing
people to save and access funds for those buying large consumer items and sometimes
for financing working capital or project finance requirements. From housewives to
businessmen and among the lower and lower middle classes, RoSCAs are a widely
used institution in Pakistan for financing capital expenditures. It is an institution that
'forces' people to save. “It performs a dual purpose of credit as well as saving. For
early receivers, it is a credit, i.e., if one has contributed 100 Rs. and has received
1,200 Rs. which he is supposed to repay in interest-free instalments of 100 Rs. per
month. For late receivers, however, it is a saving which somehow or other comes into
the category of compulsory saving … The method lacks any intervention of the
formal credit and saving institutions. A small saver does not have to hide the cash at
home or to deposit it with some relative for safety. Another advantage may be the
availability of the interest-free credit for the early receiver, which is hardly available
in any other method.
The receivers may also exchange their turns through mutual consent if
someone needs the money immediately,” (Waheed, 1996). Auction RoSCAs, on the
© Adnan Rasheed 28
other hand, involve fairly complex dynamic auctions and the bidding system outcome
is often lending at a market-determined interest rate. As a part of this study, several
auction based committees were observed in different markets. One of these was an
auction-based committee of 125,000 rupees with 125 members each contributing
1,000 per month. In the month observed, the committee was auctioned for 61,500
rupees leaving a saving of 63,500 rupees. This saving was added to the savings from
the previous month, which equaled 32,500 rupees, and then a second committee of
96,000 rupees was auctioned. This second-round committee was bid for 63,000 rupees
and the saved amount of 33,000 rupees was carried forward to the next month. The
process continues till all members receive a committee. In some markets, committees
are only operated during the peak season.
In a survey conducted for this study in the urban markets of Lahore, RoSCAs
were a fairly common phenomenon. (However, committees as a means of financing
business were found to be unsuccessful in some markets due to high default rates
caused by weak contract enforcement once defaulters began using court injunctions or
stay orders to stop paying.) Similar findings were observed in other markets in
Peshawar, Karachi and elsewhere and some markets still have auction based
committees. Most of the respondents reported that women from their households were
also participating in RoSCAs for household needs, although these involved much
smaller amounts.
2.3Urban Finance
The informal sector refers to economic activities that are organised outside the
penumbra of the state's judicial and administrative machinery. In the absence of state-
provided institutional infrastructure, agents in the informal markets often devise or
adapt institutional mechanisms to reduce their costs of transacting. It generally
includes a vast and heterogeneous array of small-scale, family-based, unregistered,
petty trades and casual labour activities that are marked by relative ease of entry,
flexible structure and hours of operation, simple and relatively labour intensive
technologies, and low formal skills.
© Adnan Rasheed 29
Often regarded as a kind of fallback, the informal sector acts as a cushion or a
social safety net that provides employment to those unable to get jobs in the formal
sector. Another view stresses its positive role in providing employment and incomes
as well as its potential role as a source of productivity leading to economic
development. There is wide agreement that SMEs play a vital role in the structural
transformation from low to middle income levels and in providing employment and
output in the early and middle stages of the transformation. But this does not appear to
be the case in Pakistan. “In Pakistan the SME sector has acted neither as a significant
engine of growth, nor as an important conduit for structural change. Judging from
international experience, Pakistan might represent a case where the potential of SMEs
has not been adequately exploited” (World Bank, 2003).
Owing to mass urbanization - especially the proliferation of peri-urban areas

and development of major urban systems - and the inability of the formal sector to
cater to the needs for settlements, employment and service delivery, the informal
sector seems to have mushroomed in Pakistan in recent decades. Nonetheless, various
studies indicate that its growth is seriously constrained by low access to capital which
is exacerbated by its non-legal and unregulated status, lack of authorized business
locations, collateral requirements and perceived risk of operation. Indeed, a majority
of establishments in the non-agricultural sector are micro-enterprises. In the Punjab
alone, the private sector provides close to nine-tenths of total employment while an
overwhelming share of private sector employees work in units with less than 10
employees. Thus the livelihood of the majority of the population depends
overwhelmingly on the small enterprises, particularly in the informal sector. This
highlights the fact that poverty reduction is closely linked to improving productivity.
Urban financial markets are different from rural ones in certain important
respects. The former are characterized by closer proximity and greater mobility of the
participants which has implications for information flows and socio-economic
dynamics. Players in urban markets also tend to be wealthier, resulting in a greater
ability to bear risks and to offer tangible collateral. The rural and urban financial
markets are also marked by an asymmetry: a borrower and lender in an urban market
today may be in the reverse situation tomorrow but, in rural IFMs, lenders and
borrowers have generally distinct identities and the same individual is the principal or
© Adnan Rasheed 30
agent in all repeated transactions. The nature of power relations among the respective
participants is also different in rural and urban IFMs. Many urban markets catering to
traders, especially wholesalers, have a long history and are quite well developed in
terms of the amounts of funds intermediated, the speed and efficiency of the
intermediation, and the sophistication of participants as well as the market as a whole.
The larger of these markets also set interest rates and the terms of transactions which
are then followed by the smaller and relatively less-developed markets.
A common feature of all urban markets is suppliers' credit, with as much as 90

per cent of transactions in old markets with established players. Its prevalance is
attributed to liquidity constraints and the avoidance of handling cash and tax
documentation. There is generally a two to four percent discount built in for cash
payments. Richer parties often have the advantage - a symptom of class segmentation
- because they are able to get better prices on cash as well as better deals even on
supplier' credit. Meanwhile, immediate financing was also found to be available in
urban IFMs through moneylenders on personal guarantees. In many markets, a chit or
parchi is the norm for making business transactions and is seldom dishonoured. This
system represents a convenient and flexible method that allows business to be
conducted at doorsteps without the hassle of documentation or tax liabilities. It was
found that most businessmen maintained their accounts through chits, partly due to
the lack of skills for maintaining a modern accounting system but also because of a
fear of tax authorities. Most shopkeepers privately admitted that tax evasion is a
common phenomenon which is why a large number of businessmen maintain double
accounts: there is a margin between cash and credit sale which varies from party to
party as well as duration.
The role of market associations, according to most respondents, was very

crucial. These associations not only help mediate disputes through moral persuasion
and social pressure or boycott but create a congenial atmosphere in which to conduct
business through collective action - a significant function since honour and personal
guarantees rather than written contracts are the custom. In a study of Delhi's urban
markets, Srivastava (1990) reports: “participants in these markets often have access to
diverse institutions, such as market-wide organized associations that can create,
maintain, and enforce complex contractual mechanisms that lower costs of transacting
© Adnan Rasheed 31
for individuals.” A general rule followed by many market associations is that when a
defaulter approaches any shop for a business transaction (generally to sell his
product), the shopkeeper is obligated to pay the defaulted party. The respondents also
felt that in markets where associations are not as strong, there tended to be far more
instances of fraud either through reneging on contracts or by supplying low-quality
goods.
Transactions in wholesale markets are facilitated by the fact that many traders
have had their business handed down to them through the generations and they thus
have links across the markets as well as the country. In most of these markets, the
risks associated with arms-length transactions have been countered through
institutional innovations and human contact and trust. The fact that such markets are
dominated by certain business families such as the Sheikhs helps build trust (signaling
effect) through informational advantages from social flows and personal relations.
Most respondents said that they interact with their business partners socially as well
and they would trust a partner more if he were from the same community or if they
had greater interaction with him.
Although such social interaction helps gather information needed for

conducting business transactions, it also acts as a barrier to the entry of new players.
In certain IFMs, there are fairly well-functioning forward markets that link input
suppliers, manufacturers and wholesale traders. The shoemaking industry was
observed in different cities and different markets in Charsadda, Lahore, and Karachi.
In the shoe market of Shah Alami, Lahore, for instance, small manufacturers who
supply shoes to the wholesalers get IOUs which can be redeemed after one month.
Since these manufacturers need working capital to purchase inputs but their liquidity
constraint means that they cannot wait for a month to be repaid, they approach a
secondary market in Shah Alami to redeem the IOU for cash at a discount of 10 per
cent. Thus an IOU pledging a payment of 10,000 rupees is redeemed for 9,000 rupees
in the same market. Similar practices were also observed in Karachi.
In markets with a large number of new players, however, business is largely

conducted in cash since the default rate is very high and sale on credit is only done
with trustworthy parties. This makes it difficult for newcomers to break in and acts as
© Adnan Rasheed 32
a barrier to entry. Most of the shopkeepers involved in the wholesale and retail
business were members of RoSCAs while the small, informal producers were mostly
engaged in seasonal RoSCAs. When interviewed, all the small informal producers
responded that access to credit at market rates would help them make more profit and
expand their business since it would enable them to purchase inputs on cash at better
prices and to run their production cycle more efficiently.
Meanwhile, the textile business is facilitated by the presence of brokers and

investors at every stage - from cultivation to processing, manufacturing and finishing.
These brokers mainly act as a liaison between the concerned parties and charge a
commission. In terms of enforcement of contracts, in Faisalabad for example, the
broker receives a slip from the weaver and pays the spinner. This slip is equivalent to
any cheque or bank draft. This 'trust' has developed because of repeat transactions
since everyone knows everyone and no one can participate without a reference.
Everyone also knows the scale on which the concerned parties are working and their
reputation in the market. Firms have to make their payments on time because if they
do not, no one would be willing to work with them and they would soon be cold
shouldered. A mapping of IFMs in the textile sector was carried out by the Punjab
Economic Research Institute (PERI) for this study.
In the transport business as well, informal finance markets are quite common.
In some urban areas, moneylenders mostly provide credit in the shape of goods - in
these case vehicles - to clients. The registration of the vehicle remains in the name of
the lender until the client pays the entire amount with interest. Lending through
vehicles is popular due to the ease of impounding in case of default. The annual
interest rate for credit in the shape of goods varies on the financial position of the
borrower and his previous track record. The most widespread value of monthly
installments is 5,000 rupees per month for every 100,000 rupees.
Interviews with three major financiers hailing from the tribal areas of the
NWFP in the transport business revealed that they considered lending on interest to be
un-Islamic, but regarded commodity and transport financing as legitimate. According
to them, more than 90 per cent of commercial vehicles (mostly trucks) were operating
on the installment system with repayment durations averaging between five and eight
© Adnan Rasheed 33
years and with a gross mark-up over total financing (current price minus down
payment) ranging from 50 per cent to 100 per cent, depending on the level and
number of installments. A second-hand truck costing 1.6 million rupees, for example,
was observed to be sold with a 200,000-rupee down payment for 2.4 million rupees
(carrying a gross mark-up of one million rupees) with installments mutually agreed at
40,000 rupees per month. Normally, since the lenders are more concerned with cash
flows, the interest rate does not explicitly enter the contract. Interest is instead implied
in the contract, which only shows the actual cost of vehicle, the profit margin of the
lender and the number of installments. Thus a loan of one million rupees in the shape
of a vehicle may carry an interest rate of 20 per cent if the repayment period is one
year and 30 per cent if it is two years.
Default rates in transport financing were said to be very low. In their personal
experience, the respondents said that they had witnessed only eight to 10 cases of
default out of hundreds of transactions. In case the borrower-owner wants to sell the
vehicle, he usually introduces a prospective buyer to the financier. The prospective
buyer then arranges a guarantor to the satisfaction of the financier and a deal is struck
between all the parties on the outstanding transactions. Similar financing patterns
were observed in the tyre business where the turnovers are much faster although the
margins are lower. The financiers largely hail from the NWFP or the tribal areas and
the borrowers are also mostly from the same community.
The social linkages thus help overcome screening and monitoring problems,
reduce the risk of default and ensure availability of multiple channels in case of
repayment problems. Transport financing on installments is also available at many
places in Lahore. Some financiers now resort to insuring vehicles while many drivers
who worked earlier on a daily-wage basis now get their own vehicles. However, while
the easy availability of vehicle financing and leasing has mostly ended informal
lending in new cars, it is still done for second-hand vehicles. The terms of agreement
differ with each party. In each market, brokers act as middlemen who also offer a
commission to the potential borrower/buyer if he is acting as the agent of another
party (a case of principal-agent divergence of interests). The higher the installment the
lower the interest charged: if the installment goes up to 8,000 rupees, for instance, the
interest charged goes down to 20 per cent. Needless to say that a client with a good
© Adnan Rasheed 34
past history is offered better terms. A default of two or three installments means that
the vehicle is seized and then either a revised contract is worked out with the old
owner or it is sold and the new purchaser and the old owners then share the loan. In
the dairy and livestock sector, traders advance credit to the buffalo owners and in turn
exercise a right to the produce from the animals and charge a commission over it.
In case of default, the issue is adjudicated by a panchayat. In Karachi, for

example, a group of six buffaloes costing 180,000 rupees was sold for 250,000 rupees
on installments to be repaid within six months. The extensive prevalence of urban
informal lending was confirmed by the Survey of Informal Lenders (1996) which
found that except landlords and shopkeepers, most informal lenders were
concentrated in towns which they used as bases to extend their operations to
surrounding villages. It reported that on average, the business of commission agents
was spread over 19 villages, while that of moneylenders and landlords over two
villages each.
2.3Informal Savings
While savings are needed by all households for smoothing income and
consumption flows, they are especially vital for the poor. Being excluded from the
formal credit markets, they need savings to mitigate risk and make productive
investments in their farms or informal enterprises. The poor save in a variety of
financial and non-financial forms: farmers save at harvest time to get through the pre-
harvest lean season. Similarly entrepreneurs with businesses that have high and low
seasons save for the low seasons during the high seasons. Many of the poverty-
stricken count everything except basic necessities as excess liquidity in order to save
for emergencies, investment opportunities, social and religious obligations, children's
education, and other purposes. The primary need of low-income savers is to swap
small savings flows for lump sums needed for a variety of purposes (Rutherford,
2000). Entrepreneurs also save in the form of raw materials needed for enterprise,
finished goods, by stockpiling construction materials, other liquid assets, or by saving
in cash, gold and land.
© Adnan Rasheed 35
The Committee on Rural Finance (2003) suggests that savings in Pakistan -
although small because of a low national savings rate compared with countries at a
similar stage of development - are available in the rural areas but are not being tapped
due to the lack of institutional channels such as banks for savings in the rural areas. It
reported that rural areas contribute about 20 per cent of total bank deposits, but these
are largely used for lending in urban areas. As a result, people in rural areas invest
their savings largely in livestock. Livestock can be bought and sold when needed and
is a good livelihood diversification strategy for low-income households. It helps
supplement their income through sale of milk and milk products and their
consumption as a food supplement as well as reduces their dependence on a seasonal
income through the harvest yields of crop products. Livestock keeping also acts as an
insurance against unanticipated events and social ceremonies. The International Food
Programme Research Institute
(IFPRI) Rural Survey of Pakistan (1996/97 to 1998/99) shows a strong and positive
correlation between ownership of buffaloes and household income. Goats and sheep
are another form of saving that is more popular with women. Livestock is also kept
through share leasing, a saving arrangement between landlords and the professional
strata or kammis.
However saving through livestock is vulnerable to a number of uncertainties

and hazards. Another traditional saving arrangement is the reciprocal exchange of
cash, kind and favors called vartan bhanji in the Punjab. This is an account of cash
and kind in a household that has been deposited by another family to help them on
certain occasions and is later withdrawn on similar occasions from the depositor's
household. Another such arrangement in rural Punjab is called wanghar, which means
asking others for help on a voluntary and reciprocal basis. Here, a household helps
another household in need of excess labour: wanghar is normally arranged for
seasonal activities requiring extra hands such as sowing, harvesting, threshing,
building sheds or deras and so on. Hoarding gold and silver is also common in rural
and semi-urban areas. Mothers start saving small amounts of jewellery for the
marriage of their children, especially daughters. Traditionally such jewellery is
supposed to be retained for a lifetime and transferred to the children, to be utilised
only as a last resort through sale or mortgage. Lately migrant workers from the
© Adnan Rasheed 36
Middle East have also been bringing home stamped pieces of gold - to be sold in case
of need - and hence performing a saving function.
2.3Informal Transfers
Informal transfers are an exchange between households of cash, food,

clothing, loans and other informal assistance. Such transfers help smooth the
consumption of receiving households. These also impact publicly funded social
protection programmes through a private compensatory response to public
interventions. Empirical evidence suggests that the bulk of informal transfers flow
from older to younger households, poor and vulnerable households are more likely to
receive private transfers while non-poor households are more likely to give private
transfers and female-headed households appear to be more likely to receive them.
While informal transfers do indeed help the poor in risk management, they are not
adequate substitutes for public action in social protection. Public intervention is also
needed when income shocks are covariant, delivery mechanisms are costly, the
severity of the income shock is extraordinary and when shocks are repeated.
A popular informal system of transferring money around the world is hawala .

It originated in the Middle Ages for financing trade but is currently popular among
migrants from Pakistan and other South Asian countries as a speedy mechanism for
sending remittances back home while bypassing banks. It has some advantages over
formal banking operations since it is marked by low commissions, fast transactions,
little documentation with no identification required and round-the-clock operation.
The system works through individual brokers or operators collecting funds at one end
of the payment chain and others distributing the funds at the opposite end. For
example, an expatriate working in USA, Europe or the Middle East, who wants to
send money back to his family in Pakistan, gives the money to a moneylender or
trader with contacts in both countries. The trader calls a trusted partner in the home
country who delivers the amount to the family, minus a commission. For
identification and the details of the trade, a code is often used. The two traders settle
accounts either through reciprocal remittances, trade invoice manipulations, gold and
precious gem smuggling, the conventional banking system, physical movement of
© Adnan Rasheed 37
currency, or by reverse hawala. Hawala markets are characterised by strong market
segmentation.
Thus it has been observed that ethnic communities generally trust and deal
only with hawaladars who belong to their biraderi or community. While it is illegal
in many countries, even central or commercial banks make use of the system.
Anecdotal evidence suggested that most moneychangers currently operate through
Dubai. Usually, hawaladars operate independently of each other rather than as part of
a larger organization and are generally merchants or small business owners who
operate hawala activities alongside their normal business.
However, what makes the system attractive to expatriates and migrant workers
also makes it equally compelling for drug traffickers and terrorists. A report estimates
that 3,000 international hawaladars operate in Asia with an estimated annual volume
of 200 billion US dollars (Beate Reszat, 2002). The hawala system has gained
prominence following the 9/11 attacks in the US as a major medium for money-
laundering, financial crimes and financing of criminal and terrorist organisations.
Pakistan has taken a number of steps to check this practice, including Prudential
Regulations XI and XII to prevent the criminal use of banking channels for the
purpose of money-laundering and so on; the Control of Narcotics Substances Act
1997 with special attention to unusual transactions, illicit narcotics activities and a
penalty for failure to report; and the National
Accountability Law, section 20, which requires banks to report unusual or large
transactions.
2.3Rural Finance
In rural areas, despite the expansion of institutional and policy directed credit,
informal markets still supply most of the credit needed by the low-income segment of
society. A high concentration of the banking sector in urban areas, especially big
cities, and its primary focus on servicing urban and industrial needs leaves limited
financial channels available to the rural poor and small farmers who then resort to
informal means of savings and credit. Such credit is mostly supplied by aartis or
© Adnan Rasheed 38
commission agents and other middlemen at high interest rates through interlinked
transactions. The acute shortage of capital at affordable rates severely inhibits the
growth of the rural economy. Moreover the lack of appropriate saving and insurance
products in rural areas prevents efficient resource mobilisation and risk management.
Rural finance encompasses credit, savings, insurance and payment services.
Credit is needed for agriculture, rural business and agriculture related

activities including retailing-wholesale activity, rural enterprises, and for marketing
rural produce. Payment services are important in rural areas due to the geographical
dispersion of economic agents and are needed for the transfer of remittances and
payment of funds. The rural credit market includes primary processors such as
ginners, rice shellers, those working in flour mills and so on who are financed
substantially by commercial banks. It also includes agriculture service providers such
as aartis, agriculture input dealers and shopkeepers who are very sparsely serviced by
institutional finance and depend primarily on their own cash capital. The non-poor
and better-off farmers are being serviced by the likes of the Zarai Taraqiati Bank
Limited (ZTBL), commercial banks and co-operative banks. Finally it includes the
poor, landless or small landholding farmers, who do not possess the necessary
collateral to access institutional credit. Their financial needs are mostly serviced by
informal lending at rapacious interest rates and in some areas by a few NGOs or
microfinance institutions providing collateral-free microfinance.
The formal credit market includes taccavi loans, commercial banks (especially
active since 1972 when they were given mandatory agricultural credit targets), co-
operative societies and the ZTBL. However, lending from co-operative societies is no
longer a major phenomenon. The cooperative banking sector was sustained by an
enormous subsidy from the State Bank of Pakistan (SBP) from 1985 to 2001 but the
system became mired in inefficiency, corruption and outright fraud. This was amply
demonstrated in two studies conducted by PERI in 1986 and 1997: for instance, the
1986 study found that out of the sample survey only four per cent were genuine co-
operative societies, 22 per cent totally bogus societies, 39 per cent one-family-owned
societies and 35 per cent one-man societies. The 1997 study showed similar results,
finding only 3.9 per cent genuine societies in the Punjab sample and only one-man
societies in the Azad Jammu and Kashmir (AJK) sample. The PERI 1986 report
© Adnan Rasheed 39
showed 35 per cent proxy and fictitious loans out of the sample loans. Out of the
remaining 'loans actually got' (i.e. 65 per cent), 23 per cent were genuine loans, 22 per
cent with area over reported and 20 per cent with area under reported. Furthermore,
the report found that the main beneficiaries of proxy loans were landlords who got 77
per cent of the loans.
Unfortunately, institutional credit is largely serving the privileged and better-

off farmers. This includes commercial banks that have ventured into the agriculture
credit sector only reluctantly and are primarily dealing with a small number of better-
off farmers, as well as co-operative banks that have played an even smaller role. In
fact, institutional credit represents a classic case of the elitist capture of subsidies
targeting poor farmers. The huge SBP subsidy to the co-operatives resulted in an even
greater monopolisation of agriculture co-operative credit by influential farmers. The
credit market in Pakistan is highly concentrated and seems to exist primarily to
service urban and industrial needs. According to the Committee on Rural Finance
(CRF), about 80 per cent of total advances are concentrated in just seven cities.
A CRF (2003) report found that only 5.6 per cent of total advances - about 21.5
million rupees in 2000 - are made from the rural branches of commercial banks.
Commercial banks provide financial intermediation services only to commodity
processors and agriculture service providers and even this segment is not adequately
serviced. The
CRF (2003) argues that the neglect of the rural finance market by commercial banks
is best shown by their lack of interest in pursuing the agriculture aarti or wholesalers
market. The number of clients of all commercial banks, ZTBL and co-operative banks
came to 720,000 in 1999-2000. But these figures overstate the number of borrowers
since these include loaning for two-crop cycles - rabi and kharif - resulting in double
counting. The Committee on Rural Finance estimated that the number of farmers
availing all types of agricultural credit from all banks in the country can be safely
assumed to be no more than 577,000. This figure shows that only 15 per cent farmers
are availing institutional agricultural 2 credit. This is exactly half of the coverage
shown by the traditional measure of the volume of credit. The CRF estimates,
however, that even this figure is inflated due to the widespread practice of borrowing
from institutional sources in the name of their haris, servants and families by large
and influential farmers.
© Adnan Rasheed 40
Suppliers' credit or credit from marketing agents is a major source of rural

lending. Its importance has increased since the Green Revolution due to rapid
commercialization and intensified trading activity. For instance, much of the marketed
rice is procured by private marketing agents consisting of paddy traders or
commission agents, rice millers, wholesalers and retailers. These agents usually
engage in money lending as a means to acquire and to secure the trader's share in the
output market. The dominance of marketing-agent credit lies in the substantial
advantage that these agents possess in the access to information and in enforcing
repayment. Marketing-agent lenders provide loans to the vast majority of small
farmers, who are rationed by formal financial institutions under the perception that
they are risky, non-creditworthy prospects and, in the process, are able to obtain very
high repayment rates.
2.3Characteristics Of Informal Finance Markets
Information constraints: The fundamental feature creating imperfections in credit

markets is the lack of information regarding the use to which a loan will be put as
well as the repayment decision. This deficiency includes limited knowledge of the
innate characteristics of the borrower that may be relevant in such a decision and
limited knowledge of the defaulter's subsequent needs and activities, which place
limits on his incentive to default. All the important features of credit markets can be
understood as responses to these information problems. Unlike commercial banks,
informal lenders use personal, social and business relationships to pre-select clients.
RoSCAs use group membership as a selection device, while traders and landlords
only lend to their customers and tenants. Moreover, recommendations from previous
clients and personal knowledge are important ingredients in the selection process.
Level and variation of interest rate charged: Informal markets are generally
characterised by high interest rates and a sizeable gap between lending and deposit
rates. Aleem (1990) reports that the average interest rate charged by moneylenders in
Chambar was 78.5 per cent; in that year, the bank rate in Pakistan was 10 per cent and
the opportunity cost of capital to these moneylenders worked out to 32.5 per cent. For
© Adnan Rasheed 41
comparison, the “Summary Report on Informal Credit Markets in India” (Dasgupta,
1989) finds results from a number of case studies in which the average interest rate
charged by professional moneylenders for the rural sector is about 52 per cent. The
IDEAS study in NWFP (1999) found the interest charged by moneylenders ranged
from 40 per cent to 120 per cent per annum depending on the amount of money
borrowed and time period of repayment. The rate of interest for short-term financing
in film industry circles at Lakshmi Chowk, Lahore, reportedly ranges from 100 to 300
per cent. Because lenders in the informal market enjoy a sort of monopoly position,
they are thus able to charge exorbitant rates of interest. In interlinked contracts,
especially those of credit labour, the actual interest charged is considerable because of
the implicit rate of interest involved. There is extreme variability in the interest rate
charged by lenders for similar loan transactions.
Low levels of default: IFMs are generally marked by low levels of default. Giving
default rates for individual lenders, the study by Aleem found the median default rate
to be between 1.5 and two per cent and the maximum 10 per cent. According to the
IDEAS study (1999), however, there is virtually no default in the informal sector. In
transport financing, repayment is only delayed in extremely unavoidable
circumstances such as death of the client, accident of the vehicle purchased on credit
and so on.
While this lowers the profit or interest earned, the amount is eventually
recovered from the client or his family. In case of cash lending, there have been
instances where the borrower could not pay due to bankruptcy and the legal course to
recover from the sale of mortgaged property may take a long time. It is therefore not
possible to recoup the whole principal amount in such cases. The Survey of Informal
Lenders (1996) also estimated the ultimate default rate to be less than six per cent. It
cited repeat transaction - stemming from a desire to maintain the credit line - and
social pressure as the main reasons for high repayment rates.
Some moneylenders were reportedly powerful enough to take land from the
borrowers in lieu of an unpaid loan. RoSCAs or committees require no overhead and
capital accumulation since all participants are residents of the same area or are
colleagues - mostly linked through more than one channel - and default chances are
© Adnan Rasheed 42
checked by social pressure and group sincerity. But considerable anecdotal evidence
suggests that auction RoSCAs with a large number of members went out of fashion
because of several defaults which forced traders to form smaller and simpler
committees that were either random-based or need-based. In urban markets, social
sanction, past history and repeat transaction help keep default rates low. But it was
observed that in markets where new players constitute a large share, collective action
through unions was not very effective and there was anecdotal evidence of organised
'collection brigades' and qabza groups.
Interlinkage: Interlinked transactions are defined as “contracts made between the

same pair of individuals relating exchange in more than one commodity or service,
the contracts being linked in an essential way so that de linking the contracts would be
infeasible or costly for at least one party. So contracts between a pair of individuals in
two or more commodities that are linked by coincidence, i.e. contracts that could as
well have taken place without change at different points in time and not necessarily
between the same individuals, are not inter-linked in this sense.” (Braverman and
Srinivasan, 1980). Intertemporal linking or interlinkage of present and future
transactions is quite prevalent, especially in the labour market.
Interlinked contracts are a response to screening, incentive and enforcement

problems. These problems arise when one party of an economic transaction cannot
observe the characteristics or actions of the other party, cannot rule out default by
compelling repayment once the loan has been made, and when it is costly to
determine the extent of the risk. Such uncertainty may be faced by a landlord
regarding the level of effort that his tenant puts in, or about whether he will obtain
sufficient labour during peak agricultural season. Similar uncertainties may be faced
by commission agents regarding their share of the cultivators' crop. Such situations
provide incentives for these agents to link one transaction with another. Credit
transactions are frequently tied with transactions in land and labour markets. Thus,
traders disburse credit to farmers in exchange for the right to market the growing
crop; shopkeepers increase sales by providing credit for food, farm inputs and
household necessities; large landholders secure access to labour in the peak season in
return for earlier loan advances to labourers. An important feature of such transactions
© Adnan Rasheed 43
is that the lender also deals with the borrower in a non lending capacity and is able to
use this position to screen applicants and enforce contracts.
The extent of interlinkage in Pakistan is borne out by Mansuri's study (1997)

based on data from the Punjab and Sindh which shows that among tenant households,
landlords are the dominant source of credit. But this relationship changes as we move
to owners. For the class of owner-cum-tenants, loan sources are almost equally
balanced between traders and landlords. Finally, those who are owner-cultivators
receive their loan funding largely from traders. “In the Punjab or the Sindh, virtually
all traders provide inputs on credit to cultivators. Traders do not require collateral and
don't charge interest, but most loans are interlinked with the sale of agricultural output
to the trader. In one type of contract, often referred to as kachi bol, the trader specifies
the amount of crop required as loan repayment. Another type of contract, often
referred to as kabala, requires the sale of a specified amount of crop to the trader at a
discount below the announced support price or, in some cases, below the harvest
price. Finally, some loans are given simply against a promise that the farmer will sell
this entire crop to the trader at harvest at the going market price. Because the market
price of agricultural output tends to at its lowest level just after harvest, the
compulsion to sell at harvest introduces an element of implicit interest in an
interlinked contract,” (Ray 1998).
While the interlinking moneylender has an edge over other moneylenders,

there are some advantages for interlinked borrowers as well. For the borrower who is
shut out from institutional sources, interlinked contracts are an attractive option as
these ensure that he not only gets the money without any formalities but also secures a
job for himself throughout the year by offering his labour services to a landlord or
ensures a ready market for his crop, thus relieving him of the worry of storage and of
finding buyers for his output. But such contracts are also highly exploitative and their
exploitative aspects sometimes far exceed the beneficial aspects.
Debt bondage and informal credit: One form of an exploitative inter linkage
between credit and labour markets exists through the system of peshgi, or advance
payment for workers, which often results in debt bondage. This is usually disguised
behind seemingly legitimate and 'voluntary' economic transactions where, in addition
© Adnan Rasheed 44
to the transaction in the labour market, a worker also transacts with the employer on
the credit market and repays his debt by working for the creditor. The employer
creditor enjoys monopolistic power vis-à-vis the worker-borrower, and is able to
impose exploitative terms and conditions in both transactions. The worker is
considered a bonded labourer if the terms faced on either or both markets are
extraordinarily exploitative and allow no exit from either or both sets of contracts.
The peshgi system prevails in many informally organised sectors where a

worker-borrower contracts a cash or kind advance – in case of agricultural tenants the
advance is in the form of a production credit from the employer-creditor. The worker-
borrower then works on a piece-rate or wage-rate basis and a part (in some cases all)
of his earnings go to repay the advance. The worker-borrower cannot change
employers or locations as long as the loan remains unpaid unless the new employer
takes over the loan, thereby becoming the creditor. The role of the peshgi system is
crucial in the understanding of bonded labour in Pakistan.
The system of peshgi is also very common in the carpet industry. Field data
gathered from all the four provinces in the Bonded Labor Research Forum (BLRF)
report, 2004, reveals that all workers have taken loans/advances from their employers.
These loans range from as little as 800 rupees to 75,000 rupees and are paid back in
small installments every week. The workers are bound to work for the employer until
the loan is fully repaid. But because of the peshgi system, amounts sometimes
exceeding more than two years of earnings and with high interest rates, workers are
left with little to sustain their livelihoods. Debt bondage of children against an
advance payment for their labour is also common, especially in Thar, Sindh.
One of the interesting innovations in the informal lending market is a group-

based lending contract where a producer makes an advance payment to a worker on
the guarantee of a group of six workers. If the borrower leaves work without clearing
his debt, the lender-employer recovers his advance from the remaining six workers.
This form of employer-employee credit transaction was reported from some tanneries
in Kasur, Punjab. As a coercive labour arrangement, the peshgi system is embedded in
the wider relations of dependence and power between unequal social groups. But
contrary to the popular view that peshgi legitimises bonded labour, Gazdar and Khan
© Adnan Rasheed 45
(2004) argue that it may be one way in which workers can secure advance payment
for their services that may go unremunerated if their accounts are settled only at the
end of the contract period. “In conditions where the general contractual environment
is insecure, workers who are socially weak compared to their employers are likely to
be fearful of employer default … The peshgi system, according to this view, is not a
credit arrangement designed to ensure labour supply.
Rather, it is an assurance device that allows workers to enter a contract in an

otherwise insecure contractual environment. Those workers who are vulnerable to
employer default are the socially weak, and therefore also vulnerable to other forms of
coercion and abuse. The key to ending bonded labor according to this interpretation
lays not in improving poor people's access to credit, but in improving the overall
contractual environment and reducing social hierarchy.” Serious empirical work is
needed to explore whether the peshgi system, interlinking labour and credit, is a
control device over workers or an assurance device for workers.
Rationing: Informal credit markets are marked by widespread rationing, that is, there
are upper limits on how much a borrower receives from a lender. This implies that, at
the going interest rate, the borrower would like to borrow more but cannot. Rationing
comprises the complete exclusion of some potential borrowers from credit
transactions with some lenders: at the going terms offered, certain borrowers would
like to borrow but the lender does not lend to them. In this sense, rationing is closely
connected to the notion of segmentation. Such markets are also characterised by
layering where the principal moneylender sub-lends to other moneylenders, each of
whom maintain tight circles of trusted clients outside which they are unwilling to
lend.
Segmentation and exclusivity: Segmentation is another feature of informal credit

markets. Many credit relationships are personalised and take time to establish.
Typically, a moneylender serves a fixed clientele, whose members he lends to on a
repeated basis and he is extremely reluctant to lend outside this circle. Often, a
moneylender's clients are from within his own neighbourhood or at least nearby, so
that the moneylender can keep an eye on their activities and whereabouts. Repeat
lending – a phenomenon in which a moneylender lends funds to individuals to whom
© Adnan Rasheed 46
he has lent before or has close interactions with - is very common. Aleem (1993)
found in Chambar that as many as 10 out of 14 moneylenders surveyed lent more than
75 per cent of their funds to old clients. Even among the remaining four lenders, the
lowest percentage of repeat lending was reported to be 52 per cent. They insist that
the borrowers deal with them exclusively, i.e., approach no other lender for
supplementary loans.
These features of informal credit markets imply that such markets cannot be
regarded as competitive simply by counting the number of active lenders and
borrowers because although there may be a backdrop of competition, particular
dealings are often (though not always) bilateral. Informational, geographical and
historical advantages often tend to confer the blessings of a local monopoly on
lenders, which they are not slow to exploit.
2.3Contract Enforcement Mechanisms
Social sanction and market limitations are the most common instruments for
the enforcement of contracts and the recovery of loans.
Recourse to the legal system of the country is uncommon since such financing is by
its very nature conducted without reference to the legal system. However, the
meaning and use of social sanction is specific to the type of lender. Commission
agents and input dealers usually extend credit without any collateral or written
agreement. Recovering loans is generally a smooth process since farmers usually
return the borrowed amount to maintain a good relationship with the dealers in view
of their future needs for credit. Recovery of a full loan is naturally very difficult in
case of crop failure and lenders have to wait till the next crop. Some lenders, however,
do adjust loans by transferring the property of the borrowers in their name. Some
moneylenders extend loans through mediators, local councilors or landlords and
recover their loans by using the influence of these intermediaries. Indeed, a few
moneylenders were found to be powerful enough to force borrowers to hand over
jewellery, livestock and farm machinery in order to adjust the loans. In some cases,
even land was acquired from borrowers by moneylenders in lieu of the loan. Another
© Adnan Rasheed 47
phenomenon in these areas was the emergence of powerful landlords with political
standing either as moneylenders themselves or through their agents.
Moneylenders usually take various precautionary measures before taking on a

new client. These almost invariably include the practice of dealing with the potential
client in other markets (for example, employing him on his farm or purchasing crops
from him) for some period before advancing a loan, if at all. This is done in order to
gather reliable information about the potential client's alertness, honesty and
repayment ability. In addition, moneylenders also extensively scrutinize new clients
by visiting their neighborhood and conducting interviews with his neighbors and
previous business partners to assess his reliability and character. Such interaction
carries a high opportunity cost due to the considerable amount of time involved in
information collection. Aleem (1990) found that if, after the intense screening and
period of waiting, the lender agrees to advance a loan (the rejection rate of new loan
applications was around 50 per cent), he usually begins with a small 'testing loan'.
After all, the most reliable information about a trading partner's characteristics can
come from the experience of actually dealing with him; no number of enquiries can
reveal what actual interaction will tell. Carrying out transactions with the person
concerned is, therefore, the ultimate 'experiment' that will reveal his characteristics.
However, the experiment is risky and hence lenders exercise caution at the beginning.
Only when the testing loan is duly repaid does the lender increase his trust in
the client and increase the loan amount to match the latter's needs. The sharp
segmentation and exclusivity of informal credit markets induce most borrowers to
comply with contractual terms: a defaulting borrower, who is removed from the good
books of his current lender, will find it extremely difficult to find a new source. Thus,
apparent competition between lenders and free access to multiple sources is actually
restricted due to informational limitations and this is what helps discipline most
borrowers. In urban business transactions, the caste system also plays a large role as it
is easy for certain business communities to develop trust and enforce contracts. While
contracts do take some formal shape, ultimately, it is reputation which counts. Certain
markets are just like a perfect information market where every player knows how
good the other player is. In an environment of weak contractual enforcement, those
engaged in business (especially arms-length transactions) have to be very discreet and
© Adnan Rasheed 48
often rely on individual goodwill and on social pressure in the absence of security or
collateral. In cases of default, market associations normally mediate and decide about
receivables and payables. In extreme circumstances, they may even dispose of assets.
Social and political influence does give an edge in business dealings.
The use (or threat of use) of force is also a potent instrument for enforcing
contracts or ensuring payment when all else fails. The mere reputation of willingness
and capacity to use coercive means, if credible, is often enough to ensure that
contracts are respected. There is considerable anecdotal evidence that the
intermediation of state agencies is often also used by influential parties for recovery
of defaults, gaining possession of property, forcing sale on low prices, or for getting
out of a contract. But such intermediation does not always yield the required results.
In many urban areas, there are now organized groups that offer their services for a fee
in order to force recovery. These groups charge anywhere from 10 percent to 50 per
cent of the amount involved for their services. Among the tactics that they use are
threats, abduction, illegal confinement, torture and other forms of coercion.
2.3Implications For Policymakers And The Microfinance Sector
It is not possible to wish away informal finance markets. Policymakers need to

realize that so long as institutional finance has limited access and does not fully meet
the demand of the client, the informal financial sector will continue to flourish.
Attempts to cap interest rates charged in informal finance markets or an outright ban
of certain IFMs are therefore not likely to yield results. This is because these defy
economic logic and the weak institutional arrangement for implementation may, in
fact, raise the transaction costs of doing business in IFMs. A better economic response
to the existence of such markets may be to develop more linkages between the formal
and informal markets, speed up financial liberalization and encourage the deepening
of formal finance markets.
A long-term strategy in deepening the financial market should focus on institutional
reforms which address the information problems in financial markets that are
primarily responsible for market failures.
© Adnan Rasheed 49
Such reforms should also focus on exploring ways to create an enabling
environment for private sector participation in microfinance and on enhancing the
sustainability of the microfinance sector. This may involve providing the right
incentives (avoiding subsidies and bailouts that distort incentives), and creating
institutions that promote transparency through oversight and prudential regulation. A
key policy question regarding the inter linkage of formal and informal finance
markets is to determine whether and to what extent these complement or substitute
each other. If complementary, then policies need to focus on eliminating distortions in
both markets and simultaneously encouraging both to grow. But if the two are strong
substitutes for one another, the question becomes one of evaluating which markets are
better at achieving any given economic objectives and designing policies aimed at
improving their efficacy. For instance, it appears that IFMs tend to have a greater
informational advantage: instead of trying to replace them, one response could be to
encourage them by extending formal finance to economic agents who are likely to use
these funds in informal markets. Another response is to actually design and help
expand microfinance institutions that will take advantage of locallevel information.
There is evidence of some interlinkages between formal and informal credit

institutions in Pakistan. Aleem (1990) argues that lenders sometimes borrow from the
informal market and then lend at an even higher interest rate. According to the Survey
of Informal Lenders (1996), around one-third of the credit extended by informal
lenders is provided by formal sector institutions such as banks. Processing units,
landlords and other influential persons borrow from banks for onward lending through
informal channels. One way of expanding formal credit through informal agents is
through servicing the aartis. Regarding the disconnect between aartis and commercial
banks, the Committee on Rural Finance ascribed it to the lack of interest by
commercial banks in pursuing this line of client. The survey of informal urban
markets conducted for this study, however, suggested that there may be little
competition between suppliers of formal and informal credit since banks cannot
adequately cater to the demand in such markets. This implies that the formal and
informal credit markets are more often complementary rather than substitutes: there
may often be no link between the two at all as borrowers have access to only one or
the other. However this is an issue on which there is need to conduct empirical
research.
© Adnan Rasheed 50
Another policy question that needs to be explored empirically, as this has a

bearing on the case for subsidised credit, relates to the responsiveness of the demand
for credit to changes in the interest rate. “Practitioners in Bangladesh tend to believe
that the elasticity of credit demand with respect to the interest rate is high and
accordingly they keep interest rates relatively low (below 25 percent real).
Practitioners in Latin America tend to believe that the elasticity is low, and they set
interest rates as high as needed (approaching 60 percent real). Both could be correct in
their contexts, but serious empirical work is lacking,” (Morduch 1999).
This question has a bearing on the issue of what interest rates to charge and
whether or not to subsidise credit. If it is true that the credit demand by poor
borrowers is not very sensitive to the interest rate, then pushing for financial
sustainability should not limit the depth of outreach by much and the case for
subsidization weakens considerably. Regarding the impact of expansion of formal
finance on informal finance, there are some theoretical models but few empirical
studies.
A recurrent theme that emerged in this study was the weak contractual
environment pervasive in both urban and rural areas – a particularly binding
constraint to business development. This weak environment creates an atmosphere of
low trust and manifests itself in many ways, especially in hindering business
expansion for SMEs and the informal sector. It is a factor of mostly poor judicial
enforcement rather than inadequate legal rules. Poorly enforceable property rights and
the lack of a fair, efficient and cost-effective judicial system result in an unpredictable
environment hampering business expansion, leading to distortions in the business
structure, sub-optimal decisions arising from a desire to secure contracts (for example,
vertical integration without any competitive advantage, retailers taking up
manufacturing to secure supply lines and so on), and a reluctance to enter into long-
term contractual 3 arrangements.
In terms of urban informal sector financing, access to credit is only one of the
constraints. Other constraints are lack of market access and participation, lack of
technology and skills, high transaction costs and transportation costs, lack of
© Adnan Rasheed 51
bargaining power and representation, an unfavorable legal, policy and regulatory
environment, and biases in existing private sector development strategies. Whereas
some of these constraints can be addressed through financial and business
development services, others can only be addressed through changes in the investment
climate or wider business environment. This suggests that the most important
intervention for business expansion is improving the wider investment climate and
reducing the cost of doing business. For the informal sector and the micro-enterprises,
it is far more important to remove the policy biases and specific constraints against
these sectors and to establish a level playing field than to institute preferential policies
seeking to promote these sectors, which may not be justifiable on grounds of
economic efficiency.
A study of IFMs can help microfinance institutions (MFIs) in understanding

their market, developing their core niche, exploring the options for cross-subsidization
between markets and developing viable and demand-driven products and practices.
This can help the sector outgrow its current small outreach to a more sustainable size.
“For microfinance institutions, the lessons are to build long term, credible
partnerships. The belief that the accumulated benefits associated with continued long-
term transactions are larger than short-term gains associated with delinquent behavior
is what propels self-enforceability of most informal institutions. Formal institutions
also need to successfully demonstrate to clients … that they are not transitory
phenomena and that it is worthwhile for them to invest in a long-term, profitable
relationship.
This demonstration is essential for maintaining high repayment rates. Short-

term and sporadically implemented “credit projects” generally encounter higher rates
of loan delinquency precisely because short-run gains associated with default
outweigh extremely uncertain future gains” (Sharma, 2000). MFIs need to learn to
tailor financial services to specific demand patterns from informal finance markets.
Although microfinance can help the poor smooth consumption and make productive
investments, microfinance cannot be a solution to all their financial intermediation
needs. In the long run, even the sustainability of microfinance requires a shift away
from a supply focus to a demand-driven market system. This is especially important
in the rural areas where financial markets seem to have thinned instead of having
© Adnan Rasheed 52
deepened during the 1990s, as indicated by a decline in the number of banks and a fall
in the share of commercial funding in total agriculture credit. MFIs can expand recent
innovative experiments involving microfinance and land allocation (Gazdar, Khan
and Khan, 2002).
MFIs can also reap the advantages of clustering. Clusters are geographically
concentrated systems of interconnected firms and institutions in a particular field,
which face common opportunities and threats and are linked by commonalities and
complementarities. Many informal firms typically operate in clusters, with the
geographical boundary delineating an 'internal' market for all kinds of activities. Its
advantage results from reductions in transport costs and from a relatively easier access
to credit from informal sources, since information about borrowers is more easily
available within the cluster. Clustering also makes a larger pool of labour, with
expertise available in the activities carried on within the cluster. Successful clusters
upgrade over time by channeling competitive pressures into enhanced productivity.
Moreover, clustering is a mechanism that reduces the transaction costs of doing
business and obtaining access to credit either through financing co-operatives
(associations of cluster firms) or financing individual firms in clusters while using the
cluster associations for generating external economies.
This results in better screening, monitoring of clients and facilitated repayment

mechanisms. There is tremendous potential in Pakistan for MFIs to collaborate with
public or private agencies through targeted, competitive and market driven public
interventions in upgrading existing clusters or kick-starting the growth of new cluster
through a catalytic effect. Some recent initiatives in Pakistan highlight the
possibilities of this approach. A recent initiative of the Punjab Government titled the
“Cluster Development Program for Small and Medium Enterprises” involves
collaboration between the Pakistan Small Industries Corporation (PSIC), United
Nations International Development Organisation (UNIDO) and Small and Medium
Enterprises Development Authority (SMEDA) for the development of seven existing
clusters in the Punjab. Another initiative, one of the best examples of successfully
using the cluster approach to finance micro-enterprises, is the Bank of Khyber's
financing of a big weaving cluster in Matta Mughal Khel, Charsadda. A study of this
endeavor clearly revealed its effectiveness in raising local incomes and upgrading the
© Adnan Rasheed 53
cluster. Clusters make it easy for a MFI to develop a customised financial product that
not only caters to the business needs of the cluster firms, but also utilises the
informational and commitment advantages which make screening and recovery easy.
MFIs can collaborate with either commercial banks or public agencies on cluster
development programmes. Meanwhile, the Pakistan Microfinance Network can
facilitate this process by conducting studies on existing clusters and suggesting
models of such collaborations.
Another option for MFIs is to implant themselves into the entire suppliers'
chain through those who provide embedded services or business development
services. These include informally provided services such as knowledge and advice
available to small businesses through business and social relationships (for example,
family, friends, social networks and associations), design specifications, access to raw
materials, capital and markets, training, storage, and transportation services. One good
example of embedded services leading to enhancement in productivity and to a
mutually beneficial relationship is the Idara Kissan model where the Idara is
providing veterinary and social services to milk producers. There is a potential for
collaboration between institutions providing embedded services as part of their
business strategy or mission and MFIs.
Finally, MFIs have a unique opportunity at present to venture into the area of
SME lending by using the soft information available to them. Bari and Faheem argue
in this study that MFIs can trade on this information by either renting out their ability
to use social collateral or by going into SME lending them. This soft information, due
to MFIs' grass-roots presence, established reputations and extensive knowledge and
relationship with the people and enterprises in an area, enables them to utilize social
collateral as a valid means of control. Moreover, they have staff members that are
trained in developing and using soft information as well as using cash flow-based
lending, and an institutional structure that does not discourage smaller borrowers from
approaching them.
In the first option, MFIs cannot only become information providers to banks
and/or partners of banks which need credible soft information, but also act as levers
by which this information can be used to avoid default and thus generate extra
© Adnan Rasheed 54
resources from existing information and knowledge. Another option is for MFIs to go
directly into SME lending. This option carries higher risks but promises higher returns
as well and could be a strategy for achieving financial sustainability and portfolio
diversification. For this option, MFIs need to have marketable products and services
as well as trained staff to deal with established business enterprises. This strategy
implies a significant change in the organizational structure, client base and priorities
of MFIs. This may not suit MFIs trying to reach the very poor but could work well for
MFIs that fund existing micro and small businesses. Both these options need to be
explored further. The Pakistan Microfinance Network can take the lead and initiate a
dialogue as well as further research on their prospects. MFIs can explore different
models of the contractual nature of their relationship with commercial banks while the
PMN can support pilot testing of innovations. Such experimentation, although
carrying its own risks, can potentially help MFIs to meet the goals of expansion and
sustainability.
2.4 Micro-Finance Institutions (MFIs) and Small and Medium Enterprises

(SMEs)
1. Introduction
There are tremendous opportunities for micro-finance institutions (MFIs) to

explore the credit market for small and medium enterprises (SMEs) , especially the
smaller and micro-enterprises. SME are credit constrained and smaller enterprises are
even more credit constrained than the larger ones. The main reasons for the credit
rationing of SMEs by large lending institutions in the formal sector are largely due to ,
a lack of physical collateral that SMEs can offer as guarantee for loans as well as a
lack of access to credible information about the SME on the part of the potential
lender. These factors are embedded in a legal and judicial structure that does not
protect property rights effectively, which makes enforcement of contracts very costly
as well as unpredictable. Given the above, many banks shy away from lending to
SMEs even when personal guarantees are available. MFIs have some very specific
advantages in this regard. They have more presence in local areas, access to the use of
social collateral, better information on the potential borrowers as well as about their
© Adnan Rasheed 55
reputation in the area, and know potential guarantors better as well. MFIs can thus a)
trade on this information to become information providers to the larger banks, or b)
go into lending to SMEs directly. There are quite a few such examples available from
around the world. Both strategies will allow a diversification of the MFI portfolio and
can give additional sources of revenue to the MFI while exploiting existing
information. The Government of Pakistan (GoP) is currently looking for ways of
increasing financing for SMEs and easing their credit constraints.
Furthermore, various formal sector banks are also trying to establish

themselves in this market. This seems like an opportune moment for some MFIs to
explore the possibility of link-ups and partnerships. In this chapter we establish the
credit constraints of SMEs, the nature of the constraints, and identify where MFIs can
help become part of the solution. Using several surveys available to us we establish in
section 2, that SMEs are indeed credit constrained and the smaller firms are more
constrained than the larger ones. Section 3 will show, using the same surveys, what
the exact nature of these constraints is. Section 4 will provide a conceptual framework
for looking at the problem and identify where MFIs can successfully explore
possibilities. We conclude in section 5.
2. Trends and modes of financing SMEs
We use data from three different surveys to establish some results regarding
financing patterns. This is done not only to cross-verify the results but to show that
though all three surveys are based on small samples, compared to the vast universe
constituting the totality of SMEs in Pakistan, they represent results of which there is
no need to assume is atypical of the larger body. These surveys are:
a) A 60-firm survey that was conducted in 2002 for a study for the Asian
Development Bank (ADB) with the purpose of trying to understand what
factors were constraining the growth of SMEs in Pakistan. These firms were
mostly from Lahore, Karachi and Gujranwala.
b) An 80-firm survey conducted in 2004 for the Securities and Exchange

Commission of Pakistan (SECP) to understand obstacles in the way of the
© Adnan Rasheed 56
incorporation of SMEs. This survey included firms from Quetta and Peshawar
in addition to the cities mentioned above.
c) A 650-firm survey conducted in 2003 by the Small and Medium Enterprise

Center (SMEC) at the Lahore University of Management Sciences (LUMS).
This survey was conducted to establish a baseline for some of the salient
features of SMEs in Pakistan. This sample was from across Pakistan.
Firms need funds for capital expenditure and expansion (medium- and long-
term lending) as well as for working capital (short term) requirements. We analyse the
lending pattern of both types of financing. The available literature also points out that
access to finance is linked to the size of firm, legal structure, age of business, and the
sector that the firm belongs to. We analyse borrowing patterns along all of these
dimensions.
2.1. Credit Rationing
For SMEs most of the resources for financing long-term fixed investments
come from retained earnings, personal sources, and borrowing from family and
friends. Commercial sources, supplier/buyer credit, and even the high interest
informal market seem to form a very small source of such funding. According to Bari
et. al (2003) 55.7 per cent of the funds for fixed investment, for the sample firms,
came from self financed sources; 19.3 per cent from retaining earnings; and 4.6 per
cent from friends and family (Table 1 below). Commercial banks only contributed 6.1
per cent of the financing.
The percentage of self-financing is larger for smaller firms and drops

significantly with size. Retained earnings form a bigger source for larger firms,
though commercial banks also increase their funding percentage for larger firms.
Trade credit and local moneylenders remain a very small part of the financing spread.
This pattern was consistent across the data sets as well. Of the 278 firms that
responded to questions on fixed investment, 60 per cent said they financed their fixed
investments through personal sources and only 15 per cent got financing from
commercial banks, while 15 per cent borrowed from friends and family.
© Adnan Rasheed 57
For working capital the pattern is slightly different: the percentage from
commercial sources is somewhat higher. This is to be expected as working capital
loans are better secured and less risky compared to fixed investment loans. Even then
the percentage is not significantly different and the bulk of the financing comes from
retained earnings and self financing. There is again a clear pattern based on size of
firm. As the firm size goes up a larger percentage of funds is secured from
commercial banks. There is a larger role for trade credit in working capital. Since
these are short-term loans and are needed on more flexible basis, this is again to be
expected. Paying higher interest is justified from the borrowers side on the basis of
the short time period involved while the lender is covered due to the better security
available in case of working capital loans. Again the pattern of financing is consistent
with the one reported by the 650-firm data set. Out of 363 firms, 50 per cent financed
their working capital needs from their own funds and 18 per cent received it from
commercial banks, while 20 per cent raised money from family and friends.
The share of informal markets and trade credit was quite small. Table 1 and
the larger data set show that firms do not use commercial banks very often. But this
argument does not establish the fact that firms are credit constrained or rationed. The
above pattern would be consistent with the possibility that the demand for loans from
SMEs, for both working capital as well as fixed investment, might be low and it is not
the supply side that is creating the constraint. To explore this possibility we can report
financing patterns on the basis of size too. If the problem is with demand there should
not be a very significant pattern based on size. But if there is credit rationing and
larger firms are in a better position to acquire credit and ration out smaller firms, we
would see a clear direct correlation between size of firm and percentage of funds from
sector banks. We have already seen some correlation of size and financing pattern in
Table 1. Table 2 makes the relationship more explicit. Table 2 shows that there is a
clear correlation between size of firms and access to credit. As firms get larger their
access to finance gets better. This shows that smaller firms are indeed credit rationed
and have to rely on retained earnings and personal sources to finance investment and
expansion as well as working capital needs. This could be an important growth
constraint on smaller firms.
© Adnan Rasheed 58
The literature on financing patterns also shows that as firms get older they are
not only able to access credit markets more, but are able to get better terms and
conditions from lenders. But Table 2 does not show the expected pattern. The key
problem here is that age can only matter if there is an accumulation of credit history
and history of a working relationship with a lender. If the small firm stays in the
informal sector, does not have access to credit registries to establish a track record
with, and does not have a long-term relationship with a bank, age will give no
advantage in terms of access to finance. It is only for firms in such relationships, as
found by Siddique and Bari (2004), that access does improve.
2.2 Legal Status/Structure of SMEs
The literature on firm financing also points out a connection between the legal
status of firms and access to finance. Firms that are incorporated under the more
formal laws such as the Companies Ordinance - since they are required to have better
records, get audits done, make more information public and be more transparent -
should have more credible information available to share with banks and so should
find it easier to get access to credit. But we do not find much evidence for this
relationship within our samples. Siddique and Bari (2004) analyse the change in the
pattern of financing due to a change in the legal identity of the firms. They find no
significant relationship between the two. In their sample of 80 firms, only 40 firms
approached banks for loans.
Of those 40 firms that approached banks, more than 50 per cent (25 firms) of
the firms belonged to the sole proprietorship and partnership classes. Only 11 firms
are private limited companies. The firms that never approached banks consisted of 38
sole proprietorships and partnerships and two private limited companies. The new
SME prudential regulations set out by the State Bank of Pakistan (SBP) mandate
lenders to acquire personal guarantees from all SMEs irrespective of their legal status.
This takes away any limited liability advantages that were available from
incorporation anyway. The National Accountability Bureau (NAB) law also does the
same. Thus even if there were any benefits from incorporation, they have been diluted
by recent regulatory changes and it is not surprising that no correlation is found in the
data. Both Bari et. al (2003) and Siddique and Bari (2004) show that even
© Adnan Rasheed 59
manufacturing SMEs find it easier to acquire credit from formal sector lenders than
service, especially retail sector firms. This has to do with the relative ease with which
manufacturing sector firms can post physical collateral compared to retail/trade firms.
From the above analysis we can conclude the following: SMEs are 'credit
constrained' in the sense that at prevailing interest rates they are willing to borrow
and/or borrow more but do not have access to funds and thus get credit rationed.
1. SMEs do not approach formal sector financial institutions very often and the
smaller firms, even within the SME sector, approach them even less.
2. Within SMEs, manufacturing firms find it easier to obtain finance from the
formal sector institutions compared to firms from the service sector.
3. The legal structure (sole proprietor, partnership, limited company) or age of
SME firms seems to have little or no bearing on its ability to obtain finance.
4. For SME firms that have received loans from formal institutions, working
capital loans constitute a higher percentage of loans than long-term fixed
investments.
5. Supplier/buyer or trade credit forms a small part of SME firms' total credit
portfolio.
6. Personal sources, retained earnings from the business, and loans from
family/friends form the bulk of investible resources for
7. SMEs. The first two are the main contributing heads for most firms. Large
firms use formal sector credit providers much more heavily.
8. High interest commercial but informal credit markets form a negligible source
of credit funds for SMEs.
In the next section, we identify some of the constraints that have been
mentioned by SMEs as the major reasons for their inability to get access to finance
from formal sector institutions. An analysis of these constraints will set up our
discussion for the space that MFIs have in addressing some of these issues and getting
a foothold in this market.
3. Constraints to SME finance
© Adnan Rasheed 60
The major constraints faced by SME firms in obtaining finance from formal
sector financial institutions are listed in the table below:
None of the constraints mentioned above were reported as binding for large
firms while they were almost all binding for small and medium firms. There is a clear
trend in the reported severity of the constraint too: small firms found the constraint to
be more binding than even the medium-level firms. Lending to SMEs in an
environment where property rights are weak, contract enforcement unpredictable and
costly, knowledge about firms as well as sectors in which firms work opaque,
incomplete, nontransparent and non-verifiable forces lenders to ration SMEs out, or
require extra collateral and guarantees as well as demand a high level of
documentation. The small asset base of SMEs makes it difficult for them to
collateralise loans and personal guarantees (or rights over personal assets) raise the
risk levels for entrepreneurs. The table below shows that out of 510 loan applications,
300 had to furnish collateral in the form of personal land or money. Smaller firms also
find it costly to institute and provide sufficient documentation. The constraints
become weaker for medium and large firms.
A delay in obtaining loans causes significant problems for SMEs. Commercial

banks have lengthy procedures and significant documentation requirements before
they can release funds. These procedures take longer for firms that are owned by less
educated people (there is strong correlation between the size of the firm and the
educational attainment of the owner) and are smaller or have not had previous
dealings with banks. So delay and previous experience becomes a significant entry
barrier. Formal sector banks also do not have credit officers that can help and advise
entrepreneurs in filling forms and meeting bank requirements. Table 6 below shows
that out of 405 firms, only 17 percent expected their loan applications to be processed
and be able to obtain financing within 15 days of filing their applications. For the rest
the delay expectation ranged between 16 to 1,080 days. Most firms expected a onto
three-month processing time for loan applications. Clearly this is too long a wait for
small firms that are cash-strapped most of the time, and have to deal with emergencies
all the time.
© Adnan Rasheed 61
The remaining factors mentioned do not require any elaboration. The literature
on constraints shows that if these firms are at all entertained by banks, they have to
post collaterals which they do not usually possess, deal with delays in obtaining
finance and have difficulty in meeting the documentation requirements of banks.
Moreover, firms believe that they need to have connections with lending agencies in
order to obtain loans. These factors, coupled with the fact of credit rationing, open up
certain opportunities for MFIs. We discuss these in the following section.
4. Implications for MFIs
Pakistani institutions, whether they are firms or banks, work in an

environment where property rights are not secure, contract enforcement is weak, and
legal recourse in case of a dispute is not only costly and lengthy but uncertain as well.
This makes contracting across time that much harder and requiring extra guarantees.
There is not much of a problem with on the-spot transactions as they do not depend on
the legal and judicial environment much as long as proper inspection costs are
instituted from the start. But when contracting has to be done across time, firms will
either have to build extra leeway or avoid such contracting. While both options are
more costly, given the incomplete contracting environment, they are the only options
open to firms. This is one reason that asset-specific investments are less common in
Pakistan, sub-contracting does not happen across all industries and in proportions that
we see in Taiwan, Korea and other developing countries, and the cost of transactions
tends to be higher. Bari et. al (2003) provides a detailed discussion on the issue. Firms
can develop 'trust' networks based on repeated interactions but these require
significant switching costs to be successful. A lot of the sectors that we are talking
about are fairly competitive and have a large number of potential suppliers and
buyers. Thus repeated interactions do not mean development of trust since there is no
'investment' in the current period game possible that can credibly predict future
behavior.
Credit extension is the quintessential across-time activity. The lender gives

money today and the payback comes after a period. If the contract is not backed by an
efficient property rights and contract enforcement regime the risk of the lender for
willful default increases and so will the cost for the lender. This is the situation that
© Adnan Rasheed 62
Pakistani lenders face. Banks use two ways to cover this risk. First, if they can
collateralize the loan with an asset that can be taken away from the borrower in case
of default and can be disposed of, they are safe. But for this to happen they have to
have collateral that is large enough to cover the loan, the interest they expect from the
loan, and the cost they expect to incur in acquiring and selling the asset in case of
default. The more problematic the legal environment the larger will be the collateral
required. This becomes a stumbling block for most SMEs since they are usually too
small to be able to furnish such collaterals. Furthermore large banks can only use
physical assets as collateral as they do not have the local presence to be able to use
reputation and reciprocity relations as collateral. Only smaller and more local
institutions can do this. We will return to this point when we discuss the opportunities
for MFIs.
The other way banks can cover their risk is by having excellent verifiable
knowledge about the actions of the borrower and the ability to monitor his/her actions.
Knowledge can be based on public sources of information, access to firm accounts
and company internal papers, but its verifiability depends crucially on third-party
validation since banks cannot possibly verify all the information about all of its
clients. These banks rely on third parties such as independent auditors, reports to the
SECP, stock prices, and other such information but smaller firms usually do not have
such information available. Smaller firms are not well documented, are not required
by law to have third-party validation, and are not mandated to provide publicly
available information about their business. Here banks have to rely crucially on the
information provided by the clients themselves and on verifications that the bank can
make itself. Similarly the ability to monitor actions of a small firm is going to be less
than the ability to monitor actions of a large firm. Formal sector banks do not have the
density of credit officers that can give them the ability to follow every client. The cost
to do so would be high.
The upshot of this is that formal sector banks, interested in maximizing profits,
will ration out smaller firms as a part of their profit maximizing strategy as they
would prefer to focus on larger clients and larger loans so that the cost of transactions
can be minimized. The weaker the legal/judicial environment of a country the more
binding would be this pattern. This is exactly why we find commercial banks
© Adnan Rasheed 63
rationing smaller firms more than larger firms in Pakistan. It is true that as
competition for clients gets more strenuous due to more competition between banks,
some banks will be forced to move towards riskier clients but the discrimination
against the smaller player will continue. The reasoning given above is further
strengthened by the way prudential regulations on lending have been shaped. Till
recently banks were not allowed to lend to firms on the basis of cash flows - they had
to have collateral-based lending. Although the SBP has now allowed programme
lending and cash flow-based lending, there is a dearth of staff that knows how to do
cash-flow lending and there have been no training courses arranged as yet introducing
the staff to the tools they need. Formal sector banks are still organized in a way that
favors bigger clients.
Branches are in areas that are closer to larger clients, credit officers are trained
to deal with corporate leaders, and the name of the game is still the size of the
individual loan. There are some banks that are making extra efforts to reach out to
SMEs for example, Habib Bank, NIB and Union Bank, but these efforts are still small
and will do nothing to alleviate the credit constraints of most of the SMEs in the
country. In particular, none of these banks are reaching out to the smaller and micro-
firms as yet. One way of conceptually looking at the issue is through the model given
as Figure 1 at the end of the chapter. Financial institutions, whatever their size or
ownership structure, depend on the lending infrastructure to make decisions about
what sort of information they are going to need to reach a particular client. If the
lending infrastructure (availability of verifiable information, commercial law,
regulatory environment, bankruptcy system, and so on) is weak, as it is in Pakistan,
the bank needs more protection. Lending technologies depend crucially on the
availability of 'hard information' or information that is verifiable and validated by a
third party. This becomes especially important if the infrastructure is weak. But for
any given level of infrastructure, if hard information is not available, the bank has to
rely on soft information such as personal relationship and social collateral. In fact, if
the infrastructure is weaker - even if hard information is available soft information is
quite often required.
If we look at the Pakistani situation we can immediately see how we fit into
this conceptual framework and this helps us explain the current financing patterns as
© Adnan Rasheed 64
well as the opportunities open to MFIs. Pakistan has a weak infrastructure for lending
and its lenders cannot really rely on hard information. Larger banks, however, are also
not very suited to collecting soft information. As a result SMEs get credit rationed and
the smaller firms get more rationed than the larger firms even within the SMEs. It also
explains why more manufacturing sector firms find it easier to get loans, why age and
legal structure has no bearing on SME financing, and why more working capital loans
are available than longer-term fixed investment loans.
In this environment, MFIs have multiple advantages. First, they have a grass-
roots presence, extensive knowledge of the people and enterprises in an area, and
established reputations as long-term players in the market in that area. As a result they
have credible soft information on all players, are in reciprocity relationships with
many of them, can call upon social collateral as a valid means of control, have
personal relationships with many players and know the economy of the area well.
They can therefore call upon the more knowledgeable people of the area to share their
information with the bank, have staff members that are trained in developing and
using soft information, have staff that is also trained in using cash-flow based lending,
and have an institutional structure that does not discourage smaller borrowers from
approaching them. This creates a unique opportunity for MFIs in this area. There are
two ways MFIs can make use of the special position they have.
They can become information providers to and/or partners of banks. Banks

need credible soft information and levers by which this information can be used to
avoid default. MFIs have the information and the levers and could do with the extra
resources that they can generate from existing information and knowledge. The exact
contractual nature of the relationship can only be worked out with experimentation
between banks and MFIs and cannot be predicted a priori. MFIs can also go directly
into lending to the micro and smaller enterprises. In this case the MFI bears the entire
risk too but the returns would be higher as well. Most MFIs do not have staff that is
trained to deal with established business enterprises, they also do not have knowledge
of the kind of products that businesses require as well as the kind of services they
would need. With staff training, however, some MFIs could experiment in the area. If
successful this could potentially be a lucrative field for micro-finance institutions and
could be a way to achieve portfolio diversification as well as financial sustainability.
© Adnan Rasheed 65
Of course, it can mean a significant change in the MFI organizational structure, client
base and priorities, and it is probably not the ideal move for an MFI trying to reach
the very poor. But it could work well for micro-finance institutions that fund existing
micro and small businesses.
History gives us quite a few examples of both kinds of roles being played by
small players which had similar knowledge and skill bases as today's' MFIs. The Oath
Commissioners (Notary Public) in France used to provide soft information to
potential lenders because they had information about all contracts of a party in an area
and so knew their financial situation well. Some of these officials even worked as
small credit bureaus. This continued for quite a few decades till institutions that could
take over the market were developed: the government disallowed Notary Publics from
working as banks, though not as providers of information, after it was realized that
their function as a bank implied a conflict of interest with their function as a Notary
Public. In Germany, credit cooperatives worked on this basis to extend credit to local
businessmen. The advantage of the local co-operative was that it had more credible
and verifiable information on local businessmen, the ability to monitor them and to
use social collateral as a means of avoiding willful default. The same happened in
rural Quebec through credit co-operatives, of which some became larger banks with
time. Committees also (RoSCAs and ASCRAs) work on the same principle. But they
are not formal sector institutions in Pakistan , do not have the ability to pass on this
information to other people credibly and do not have an institutional structure that has
allowed them to be transformed into permanent institutions so far.
MFIs, individually and collectively, can enter into a dialogue right now with
banks and other lending agencies about the kind of institutional partnerships
mentioned above. The opportunity is there. On way of tackling this possibility is for
MFIs to collectively or through the Pakistan Micro-Finance Network initiate a
dialogue as well as further research on this topic. This will give the MFIs new ideas to
work with and also information about how others have, in other times and even in
contemporary setups, used the informational and institutional advantage to create
larger roles for themselves.
5. Conclusion
© Adnan Rasheed 66
The GoP has announced its intention of using SMEs as a vehicle for sustaining
high industrial growth and as a means of spreading the fruits of growth from both the
large-scale to the small-scale industries. For this purpose, the GoP has already created
a company to looking after the technology and human resource needs of SMEs and
one for looking into the infrastructure needs of SMEs. Another company has been
formed to explore the possibility of developing product or industry specific clusters
through industrial estate development. The GoP has also announced that it is finding
ways of improving SME access to finance. For this purpose they have already
announced a Credit Guarantee Scheme and are also going to be announcing some
other initiatives quite soon. SMEs are credit constrained and the smaller the enterprise
the more binding seems to be the constraint. At the same time it appears that given the
infrastructure lenders have to contend with, lenders will have to rely heavily on soft
information to reach SMEs. But the organizational structure of existing formal sector
does not bank, their incentives and the training of the staff either do not encourage
banks from entering into SME lending, nor do they give a comparative advantage to
do so either.
At the same time, an analysis of MFI strengths suggests that micro-finance

institutions might have the information as well as the levers for encouraging
compliance that these lenders will need to enter the market. This gives MFIs a unique
opportunity right now. They can a) trade on the information that they have and rent
out their ability to use social collateral, or b) go into SME lending on their own. This
could be a lucrative market for them but each option bears its own risk as micro-
finance institutions will be going into a territory that few MFIs have tread before.
© Adnan Rasheed 67
CHAPTER 3: RESEARCH METHADOLOGY
3 METHODOLOGY
In this chapter, the outline of the methodology that is used in the research and
the theoretical basis behind the approach and their definitions will be explained.
After mentioning the research purpose, according to research process onion, the first
layer raises the question of the research philosophy. The second layer considers
the subject of the research approach that flows from our research philosophy. Thirdly,
the research strategy will be examined and the fourth layer is about time horizons
which are applied to the research. In the fifth layer data collection method will be
identified, and then the validity and reliability of the research will be explained.
3.1 Research Approach

The research approach is deductive when a theory and the hypothesis (or
hypotheses) are developed and a research strategy is designed to test the hypothesis,
or it is inductive when the data is collected and the theory is developed as a result
of the data analysis. The deductive approach owes more to positivism and inductive
approach more to phenomenology, although it is believed that such labeling is
potentially misleading and of no practical value.
This research is deductive because first the hypotheses are developed and then
the research strategy is designed.
3.2 Research Strategy

Research strategy is a general plan of how to answer the research
questions that have been set. What matters is that the strategy that is appropriate
for the research question(s) and objectives be chosen (Saunders et al.,
2000).Saunders explained that the research strategy is employed as follow:
3.2.1 Experiment
Experiment is classic form of research that owes much to natural sciences and
also social sciences, particularly psychology. It involves the definition of theoretical
hypothesis, selection of samples and allocation of them to different experimental
© Adnan Rasheed 68
conditions, introduction of planned changes, measurement on some variables and
control of other variables.
3.2.2 Survey
Survey method is very popular and common business strategy research.
Surveys allow the collection of a large amount of data from a sizeable population in a
highly economical way. Based mostly on the questionnaires, the data are standardized
and allow easy comparison. It is also easily understood. But much time is spent
in designing and piloting the questionnaire. After that on analyzing the results even
with the aid of an appropriate computer package the disadvantage is that by the survey
method the data collected may not be as wide ranging as those collected by
qualitative research methods.
There can be limited number of questions. Another threat is that the
questionnaires might be answered not completely by the respondents. There are also
other data collection devices that belong to the survey category such as structure
observations and structured interviews where standardized questions are asked
from all interviewees. Questions “what” and “how” tend to be more the concern of
the survey method.
3.2.3 Case Study
Case study is the development of detailed, intensive knowledge about a single
case, or a small number of related cases. This strategy is of particular interest when
the purpose is to gain a rich understanding of the context of the research and the
processes being enacted. Case study can be a very worthwhile way of exploring a
theory. The case study approach has considerable ability to generate answers to the
questions “why” as well as “what” and “how”.
3.2.4 Grounded Theory
Grounded theory is often thought of the best example of the inductive
approach. It is better to think of it as a combination of induction and deduction.
In grounded theory data collection starts without the formation of an initial
theoretical framework. Theory is developed from the data generated by series of
observations. These data lead to the generation of predictions that are then tested in
further observations.
3.2.5 Ethnography
Ethnography is to interpret the social world the research subjects inhabit in
© Adnan Rasheed 69
the way they are interpreted. This is obviously a research process that is very time
consuming and take place over an extended period of time.
3.2.6 Action Research
Action research is the part of the organization within which the research
and the changing process are takes place. So action research differs from other
forms of applied research because of its explicit focus on action, in particular
promoting change within the organization.
In this research, survey method is employed to have an analysis on the model
of customer loyalty in banking industry of Pakistan. In order to find the factors
and also the relationship between these factors, a questionnaire is designed. For doing
so the factors of models which were mentioned in the literature review are used.
Because one of those models is for e-commerce industry, I had to check the
factors to see whether they are appropriate for banking in Pakistan or not. So I had a
discussion with some experts in banking industry to show them the factors which
were going to be used in the new model.
After the discussion all of the considered factors were accepted. after
finalizing the factors the questionnaire of those researches were combined
together, then among those questions some had little changes, some were
eliminated, some were added and the rest were not changed. Then a complete
translated questionnaire was ready.
3.3 Time Horizon
It is believes that most research projects undertaken for academic courses
are necessarily time constrained. When planning for the research there are two options
in the time perspective:
3.3.1 Cross Sectional
Cross –sectional, a study in which a group(s) of individuals are composed into
one large sample and studied at only a single point of time.
3.3.2 Longitudinal
Longitudinal, a study in which an individual or a group of individuals is
observed over a period of time.
In this research cross –sectional study is performed.
© Adnan Rasheed 70
3.4 Data Collection Method
The gathering of data may range from a simple observation at one
location to a grandiose survey of multinational corporations at sites in different parts
of the world. The method of research can determine how the data are collected.
Questionnaires, standardized tests, observational forms, laboratory notes, and
instrument calibration logs are among the devices used to recover raw data (cooper
and Schindler, 2003).
3.4.1 Sampling
If we collect and analyze data from every possible case or group member, this
will be termed a census. However, for many research questions and objectives like
this research it will be impossible to collect or analyze all the data available owing to
the restriction of time, money and often access. Sampling techniques provide a range
of methods that enable us to reduce the amount of data that is needed to be collected
by considering only the data from a sub-group rather than all possible case elements
(Saunders et al., 2000).
As in this study there are many constraints on budget and time for surveying
the entire population and it is impracticable to survey the entire population, sampling
provides a valid alternative to the census (Saunders et al., 2000).
3.4.1.1 Population
A population consists of all elements-individuals, items, or objects-whose
characteristics are being studied. The population that is being studied is also
called the target population (Mann, 1995).The population in this research consists
of the bank customers.
3.4.1.2 Sampling Frame
The sampling frame for any probability sample is a complete list of all cases in
the population from which your sample will be drawn (Saunders et al., 2000). As the
research questions in this study concern bank customers, so the sampling frame is a
complete list of all banking customers in Pakistan.
3.4.1.3 Suitable Sample Size
Determining sample size is a very important issue because samples that
are too large may waste time, resources and money, while samples that are too small
may lead to inaccurate results. According to (Saunders et al., 2000) researchers
normally work to a 95 percent level of certainty. This means that if your sample were
© Adnan Rasheed 71
selected 100 times, at least 95 of these samples would be certain to represent the
characteristics of the population. The margin of errors describes the precision of
the estimation of the population.
For most business and management researches, researchers are content to
estimate the population’s characteristics to within plus or minus 3-5 percent of its true
values. This means that if 45 percent of the sample is in certain category, the
estimation for total population within the same category will be somewhere between
42 and 48 percent.
According to (Cooper and Schindler, 2003) the formula for calculating the
sample size is as below:
(+,-) 0.05 = desired interval range within which the population proportion
is expected (subjective decision)
1.96(σρ) = 95 percent confidence level for estimating the interval within
which the population proportion is expected (subjective decision)
σρ = 0.0255= standard error for the proportion (0.05/1.96)
pq = measure of sample dispersion(used here as an estimate of the
population dispersion).
n=pq /σ2ρ
In this research, after running the 30 questionnaires, a sample size was calculated.
And the result shows 280 questionnaires.
N= 0.24*0.76 /0.0255 2 =280
In order to have an accurate model I ran 400 questionnaires, and I got 392 back. From
this number, 388 were completely useful. So again at the end of he research I
tested the above formula to see whether the sample size was enough or not. The
result shows that by 295 questionnaires would be enough, but as I mentioned above I
had more questionnaires.
n= 0.26*0.74 / 0.02552 = 295
3.4.1.4 Response Rate

While employing all probability samples, it is very important to consider the
response rate. According to (Saunders et al.,2000), response rates in business surveys
are usually as low as 15-20 percent for postal surveys and also response rate of
between 50 to92 percent for questionnaire surveys and of 73 to 99 percent for
© Adnan Rasheed 72
telephone interviews. Therefore I asked the customer in my sample population to fill
the questionnaires.
Those who didn’t want to participate mentioned the lack of time was the
reason. The response rate in this research performing the above method of data
gathering was calculated as 97 percent and this is because the questionnaires were
given one by one and face to face.
According to (Saunders et al., 2000) the actual sample size of this
research is calculated by this formula:
N=n*100/ (response rate)

N=280*100/97 =288
This means by spreading 288 questionnaires, I could have the minimum

sample size which is 280, but as I mentioned previously, I had 400
questionnaires and got 392 filled, among them some were useless, and 388 were
gained completely useful.
3.4.1.5 Sampling Technique
According to (Saunders et al., 2000), sampling techniques can be divided into
two types:
a) Probability or Representing Sampling

The chance or probability of each case being selected from the known
population and this is usually equal for all cases. It is most commonly associated
with survey-based researches where you need to make interfaces from your
sample about a population who answer your research questions or meet your
objectives.
b) Non-Probability or Judgmental Sampling

The probability of each case being selected from the total population is not
known and it is impossible to answer research questions or to address the objectives
that require making statistical inferences about the characteristics of the population.
Then the first 4 banks which have the most market shares in the banking industry of
Pakistan similar to Beerli et al. (2004) were chosen. This choosing was because of
© Adnan Rasheed 73
the time and money limitations .Then for each bank, the same number of branches
was chosen randomly. Then the same number of questionnaires was given to the
respondents at the main door of each branch.
3.4.2 Collecting Primary Data Using Questionnaire

It is noted that the greatest use of questionnaires is made by the survey
strategy. Questionnaires can therefore be used for descriptive research, such as that
undertaken using attitude and opinion questionnaires and questionnaires of
organizational practices will enable you to identify and describe the variability in
different phenomena.
3.4.2.1 Questionnaire Design

Because of the reasons mentioned above I used a self-administered
questionnaire method for collecting the primary data. More importantly replicated a
study that had been done in Taiwan by (Lin and Wang, 2006) and in Spain by
(Beerli, Martin, Quintana, 2004)’s questionnaire. Hence in this research I combine
those two questionnaires and added some more to them.
First the duplicated questions were omitted. Then because of the different
environment between the banking industry of Pakistan and other countries, questions
had to be checked to see whether they needed localization changes or not. Some
of the questions were edited for this reason. And a few questions were added to some
of the factors. After that they were translated accurately to Farsi for being simple
to be understood by the respondent.
(Salant and Dillman, 1994) argue that, to achieve a response rate as high
as possible, you need to explain clearly and concisely why you want the respondent
to complete the survey on the first page. Regarding this issue a covering letter was
provided for the first page.
The questions in the questionnaire tried to find the factors of customer loyalty
in Pakistan. The above opinions were measured by requesting respondents to
indicate, on a five-point Likert-type scales, anchored on “1 = to a very little extent”
through “5 = to a very great extent”, their agreement or disagreement with a
series of statements that characterize the factors for loyalty model of the customers
© Adnan Rasheed 74
in banking industry in Pakistan.
Likert scales were developed in 1932 as the familiar five-point bipolar
response format most people are familiar with today. These scales always ask people
to what extent they agree or disagree with something, approve or disapprove
something and believe something to be true or false. There's really no wrong way to
do a Likert scale, the most important thing is to at least have five response categories
(Likert, 1932).The questionnaire also contained some personal questions to reach
to some contextual sense of the answers collected such as name, age, position, etc.
3.4.2.2 Pilot Testing

According to (Saunders et al., 2000) the purpose of the pilot test is to
refine the questionnaire so that respondents will have no problems in answering
the questions and there will be no problems in recording the data. For small-scale
questionnaires, it is unlikely to have sufficient time or financial resources for
such testing. However, it is still important to have the questionnaire pilot tested.
For most questionnaires the minimum number for a pilot is 10 (Fink, 1995).
Although these questionnaires were used before but because of the little
changes that have been done I needed to have a pilot test. The pilot test was done in
three stages. The first stage was done by some banking experts to see whether the
factors of this model are proper in this environment or not. All of them agreed with
the factors except the factor “trust” which was in the m-commerce model, and the
reason is because of the different nature of these two industries.
For this reason, I ran a short questionnaire to see whether this factor could
have influence on the loyalty or not. The questionnaire with its analysis results are
shown in appendix B. approximately all of the respondents mentioned that they trust
the banks in Pakistan and by having this result and the experts’ comments this factor
wasn’t used.
The next stage was done for becoming sure of the simplicity of the
questionnaire. So 20 questionnaires were given to the customers of the bank to see
whether the questions were understandable or not. In this phase I was beside
each customer during the filling process and I took notes of all of their
comments. After doing the pilot test some little editing was done. The last phase
of the pilot test was done by 30 customers to see whether every thing was ok
© Adnan Rasheed 75
with the questionnaire or not. Fortunately I got the positive answer.
3.4.2.3 Some Approaches to Gain Access

Feasibility is an important determinant of what is chosen for research and how
to undertake the research (Saunders et al., 2000). Access is a problematic area. “The
reality of undertaking a research project may be to consider where you are likely able
to gain access and develop a topic to fit the nature of that access.” Several strategies
can be used to gain access. The strategies that he mentions are:
 Allowing yourself sufficient time

 Using existing contacts and developing new ones
 Providing a clear account of purpose and the type of access required
 Overcoming organizational or individual concerns about the granting of access
 Identifying possible benefits to the organization or individual in granting
you access
 Using a suitable language
 Facilitating ease of reply when requesting the access
 Developing your access on an incremental basis
 Establishing your credibility with intended participation
In this research a lot of time was spent on gaining access.
3.5 The Credibility of the Research Finding

According to (Saunders et al., 2000) reducing the possibility of getting the
wrong answer means that attention has to be paid to two particular points in the
research design:
3.5.1 Reliability
3.5.2 Validity
3.5.1 Reliability
This is about the results of each investigation, which have to be reliable. If
nothing changes in a population between two investigations for the same purpose, it is
reliable. (Robson, 1993) asserts that there may be four threats to reliability:
© Adnan Rasheed 76
3.5.1.1 Subject Error
Subject error has to do with the time the interview is carried out. It is of great
importance to select a neutral time and date.
3.5.1.2 Subject bias
Subject bias is a great problem in organizations where the management is of
an authoritarian character and the interviewee(s) might say what the manager
wants them to say, not what they feel.
3.5.1.3 Observer Error
Observer error can be lessened with a high degree of structure to the
interview schedule.
3.5.1.4 Observer bias
Observer bias is a question about how the interviewer interprets the data
received.
As we dispensed the questionnaires during the exhibitions we really did not

face the subject error. For reducing the subject bias, we tried to make the respondents
certain that their answers would be considered confidential. Since the questionnaire
was designed as a survey format, we did not face the observer error or the observer
bias. A minimum (Cronbach, 1951)’s Alpha value of 0.7 indicates reliability of
the questionnaire.
3.5.2 Validity
Validity is concerned with whether the findings are really about what they
appear to be about (Saunders et al., 2000). There are three tests for validity:
3.5.2.1Construct validity
Construct validity, establishing correct operational measures for the
concepts being studied.
3.5.2.2 Internal validity
Internal validity, (for explanatory and causal studies only, not for
descriptive or exploratory studies) establishing a causal relationship, whereby
certain conditions are shown to lead to other conditions.
3.5.2.3 External validity
External validity, establishing the domain to which a study’s findings can be
generalized.
© Adnan Rasheed 77
If a question can be misunderstood, the information is said to be of low
validity. In order to avoid low validity, we piloted the questionnaire after translating it
into Farsi. In addition, meetings were arranged in a semi-interview environment and
questionnaires were given to the respondents face-to-face, so that if they faced any
difficulties while filling out the questionnaire, the ambiguity could be explained.
By doing so, the validity was increased.
© Adnan Rasheed 78
CHAPTER 4: DATA ANALYSIS
4 Data Analysis & Interpretations

The empirical data collected have a lot of problems in analysis, its viability,
handing, missing scenarios and its outliners are aspects that relates with its
interpretations. My data is mainly constituted on the questionnaires and interview’s
answers. I selected the most valid data through inferential & descriptive statistics
methods.
Data Analysis
Gender
Frequency Percentage (%)
Male 143 71.5
Female 57 28.5
Total 200 100.0
Result shows that out of 200 respondents 143(71.5%) were male while 57(28.5%)
were females.
Profession
Housewives 30 15.0
SMEs 135 67.5
Labour 35 17.5
Total 200 100.0
Above table shows that out of 200 respondents 30(15.0%) were Housewives,
135(67.5%) were SMEs and 35(17.5%) were working in the Labour.
Salary
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Rs.100-500 38 19.0
Rs.501-1000 28 14.0
Rs.1001-5000 59 29.5
Rs.5001-10000 20 10.0
Above Rs.10000 55 27.5
Total 200 100.0
It is depicted from table that 38(19.0%) respondents were earning between Rs. 100-
500, 28(14.0%) between Rs. 501-1000, 59(29.5%) between Rs. 1001-5000, 20(10.0)
between 5001-10000and 55(27.5%) were earning more than Rs. 10000 per month.
Bank Preference
First Microfinance Bank 40 20
Kushali Bank 105 52.5
Kashf Foundation 45 22.5
Others 10 5
Total 200 100.0
Out of 200 respondents preferred by First Microfinance Bank for services, 40 (20%),
preferred by Kushali Bank, 105 (52.55%), preferred by Kashf Foundation 45 (22.5%),
preferred others by 10 (5%) for deposits.
Microfinance & Satisfaction
Yes 135 67.5
No 65 32.5
Total 200 100.0
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Result shows that out of 200 respondents 135(67.5%) were satisfied with the services
provided by Habib Bank Limited and 65(32.5%) did not satisfy.
Necessity of Microfinance
Yes 170 85.0
No 30 15.0
Total 200 100.0
Out of 200 respondents 170(85.0%) said that there should be customer relation officer
in the bank while 30(15.0%) said no.
Behavior of CROs in MFIs & Satisfaction
Yes 155 77.5
No 45 22.5
Total 200 100.0
Above table shows that out of 200 respondents 155(77.5%) were satisfied with the
behavior of Customer Relation Officers and 45(22.5%) were not satisfied.
Microfinance & impact on the business of the bank
Yes 195 97.5
No 5 2.5
Total 200 100.0
Result shows that 195(97.5%) respondents said that behaviour of customer relation
officers impacts on the business of the bank while only 5(2.5%) replied in negative.
Good packages for customers enhances the performance of the Microfinance
© Adnan Rasheed 81
Yes 170 85.0
No 30 15.0
Total 200 100.0
It is depicted from above table that out of 200 respondents 170(85.0%) said that good
salary package enhances the performance of the customer relation officers while
30(15.0%) said no.
Microfinance activities can enhance the economy
Yes 173 86.5
No 27 13.5
Total 200 100.0
Result shows that 173(86.5%) respondents were agreed that customer relation officers
activities can enhance the customer satisfaction and loyalty while 27(13.5%) were not
agreed with it.
Data Analysis & Interpretations
In this chapter the results of the statistical analysis will be presented.
The statistical analysis has been done by SPSS software and for the modeling part,
has been done by LISREL software. Then some suggestions will be given according
to the results.
4.1 General Information

In the questionnaire, we asked for some general information from the
customers. The result shows that the most active customers are the ones between 20
and 35 and are university graduated. Also the results show that most of them
have official occupations. This could be because of their education.
4.2 Analysis of Factors

4.2.1 Quality
As it was mentioned in the second chapter, quality is one of the most
© Adnan Rasheed 82
important factors which have a main role on making a customer loyal or churner. In
the banking industry, the product is equal to the service. It means that a customer
perceives a service which in the customer’s view can be the same as a product of
another industry. In the previous models the authors considered quality as only one
factor. So in this research also at first the quality of the service in banking industry is
considered as just one category.
After the questionnaires were given to the respondents and I got the
filled ones back, by analyzing them in SPSS software I noticed that there could be
two categories for quality. Then by having the correlation between the questions it
seemed that it could be divided in to two separate groups. By focusing on the
common attributes of each group it became clear that we could break up the service
quality in the banking industry into two parts and name them: tangible quality(in
which the perceived quality can be seen) and intangible quality(in which the
perceived quality can’t be seen).
Here are the whole quality questions:
Tangible perceived quality
1. The received interest from the bank is effective to continue my work with this
bank.
2. Advertisement in broadcasts or relatives is effective for me to use the services of
this bank.
3. This bank’s facilities are attractive and modern. (Such as telephone banking,
internet…)
4. This bank’s employees are tidy in appearance
5. Materials associated with the services are visually clean, tidy, intact, and enough.
(Such as pen, chair…)
6. This bank informed me of its side services from the beginning.
7. The opening hours of the bank are convenient to me.
8. My needs and interests are considered in the bank’s services.
9. I use this bank because all of its services are available in the branch.
© Adnan Rasheed 83
Intangible perceived quality
1. This bank insists on providing the services error-free.

2. Employees of this bank solve your problems when they promise to do so
3. This bank provides its services at the time it promises to do so
4. The bank employees are fast enough in providing the services.
5. Employees of this bank are always willing to help you o overcome the problems.
6. Employees of this bank are aware of when exactly services will be performed
7. The behavior of employees of this bank instills confidence in customers
8. Employees of this bank are constantly courteous to you
9. Employees of the bank pay special attention to you.
The Cronbach’s alpha, which was gained from these questions after
running the questionnaires, were 0.92 which was a very high one. This means that the
questions were reliable and also valid. But by having a deeper look at them and
considering the situation in Pakistani environment, and also having the factor
analysis, these questions could be separated into two groups. Questions 1 to 9 are
in tangible group and the others are in intangible group. Again after separation,
Cronbach’s alpha was tested. This time the result of the first category was 0.84 and
the result of the second was 0.90. They show that the division is done correctly.
4.2.2 Satisfaction
Satisfaction in banking industry means that the product or service which is
offered to the customer makes him/her satisfied and meets his/her expectations. This
means that the customers feel good to have the service from that bank another time. In
the competitive environment which the competitors are trying to have the other’s
customers, this antecedent can be vital. By this, the company can gain more profit.
The direct monetary profit and the indirect one which can be for example advertising
by word-of-mouth process or etc can be the means of profit gaining.
This factor in this research is measured by four questions that are brought in
table 7, and the test for reliability of these questions was done. The result of
Cronbach’s alpha is 0.78 which is a good one and shows that the questions were
© Adnan Rasheed 84
chosen properly and they are reliable.
1. This bank doesn’t meet my needs.
2. The bank I work with is far from my expectations of an ideal bank.
3. According to my experiences, I’m satisfied with this bank.
4. In comparison to other banks, I consider this bank and its services successful.
The factor analysis for this part was done and the result shows that
these 4 questions are correlated for banking industry in Pakistan. It means that all of
these questions are trying to show one thing, which is satisfaction in the banking
industry. The table below shows the mean and the variance of the questions
which are answered by the customer.
It seems that most of the customers answer higher than average. The
respondents felt particularly strong about the 3rd question because it has the highest
mean in the survey and less highly rated question is the second one, with the average
mean of 2.98. In the table the average of the mean and variances are shown.
4.2.3 Switching Cost

As it was mentioned in chapter 2, switching cost means the price
(internal or external) which a customer should pay for moving from one company
or brand and choosing another. According to what has been said in the previous
researches, there are some barriers for the customer in defection time, so they
don’t feel that it is simple to move.
This factor in this research is measured by three questions, which are mentioned in the
table.
1. To change to another bank involves investing time in searching for
information about other banks
2. To change to another bank involves much effort in deciding which other bank
to use
3. To change to another bank involves a risk in choosing another bank which
might turn out not to satisfy me
© Adnan Rasheed 85
These questions were analyzed by SPSS software and Cronbach's alpha 0.71
was gained, which is a completely reliable result. Then again factor analysis was done
for these questions and the result shows that the questions are trying to identify the
switching cost factor. As the following table is showing, the mean and std.
Deviation are showing that the questions were understandable for the customers, and
all of the respondents had approximately a common understanding.
By paying attention to these points, managers can understand that finding
information about the services of the new banks is the most time and energy
consuming activity for customers and they don’t feel easy to do this. So by
simplifying these activities they can gain more customers. Also the average of the
variance and the mean scale in table is showing that the questions have a common
concept in the customers’ point of view.
4.2.4 Choosing
This factor is trying to find the importance of customer choosing power. When
a customer decides to choose a company for getting some sort of services, for
example a bank to have the financial services, if the selection of that target
company is done by considering some factors, then being loyal to that company in
the future is more possible and probable.
At the beginning, four questions were designed to estimate the factor, but by
having the factor analysis for the results of the pilot test, the forth question was
eliminated. After elimination the analysis was done again and the gained Cronbach’s
alpha for this factor for the remained 3 questions is 0.71. Also factor analysis has
been done for the questions and the result shows that they are trying to represent one
factor.
The result of mean and Std. Deviation of the questions are as below.
1. Before choosing a bank I consider its advantages and disadvantages.
2. The decision which I make for choosing a bank for the first time is very
important
3. Before choosing a bank, I compare it with other banks.
As it is shown in the results of the table 14, the highest mean and the lowest
std. Deviation are for the first question, and this shows it is important for a
© Adnan Rasheed 86
customer to consider the advantages of the service provider. And also the average of
the means and the variance of the questions of the choosing factor are as below. All
of the components of both tables prove that these questions are completely
understandable and bring a common idea to the respondents.
4.2.5 Habit
As it was mentioned and explained in chapter 2, habit is an important factor
which 40-60% of the customers purchase the services because of habitual behavior. In
banking industry, habit can be made because of different things which are asked
among the below questions.
1. I use this bank because my family also uses it.
2. I use this bank because I am admitted as a member of this bank by my office
or family
3. I use this bank because it is near my office or home.
4. I use this bank because it has many branches.
5. I use this bank because this is the first bank which I used its services.
6. I’m used to using of the services of this bank.
After doing the analysis on the result of the pilot test, the questions were reduced
from 8 to 6 main ones, and the other two questions were not representing the habit
factor. In this part the Cronbach’s alpha which was gained from the respondents’
answers is 0.73 and it shows the reliability of the questions. Also by having the
factor analysis on the answers, the results prove that the questions are attempting to
find this factor. The table shows the results of mean and Std. Deviation of the
questions which are related to the concept of habit. Also the average of the mean and
variance in the next table proves that the questions are designed correctly and have the
same meaning for the customers. Among the above questions, the third question
has the highest meaningful result and the first one has the lowest score. Also the
sixth question has the lowest std. deviation and the second has the highest. Also as a
result, the distance between the branch and the office or home is the most important
for the customer, so it can be an important point to be considered by the
managers.
© Adnan Rasheed 87
4.2.6 Loyalty
All of the factors which are mentioned above are designed to identify the
customer’s loyalty in banking industry in order to create a model in the Pakistani
industry. To do so, in addition to the elements which were designed and discussed
above, some questions are trying to show the loyalty factor directly. Table is showing
them.
1. I would always recommend my bank to the others.
2. It would be difficult to change my beliefs about this bank.
3. I would always use this bank’s services.
4. I am a loyal customer to this bank.
5. I do not like to change to another bank because this bank sees my needs.
6. Even if close friends recommended another bank, my preference for this
bank would not change.
7. My intention to use the services of this bank would not be changed.
The results show that highest mean value for the loyalty questions is for the
first one; this can help the managers to understand that a loyal person would
automatically advertise the services, and it could be an indirect profit program for the
banks. Also the results show that the questions have the same meaning for the
respondents.
4.3 Factors Relationship And Suggestions

After defining the questions and the factors in the software, the
relationships between them have been extracted out and explained as below: The
analysis shows that satisfaction has a link with loyalty. This link is very strong, and it
shows that if the bank managers want to make the customers loyal, they should have
some special strategies to satisfy the customer. When a customer is satisfied with
the received services or the products of a bank, he/she doesn’t want to take the
risk of changing or moving to other competitors.
For this reason, managers should always consider the needs of the customers.
© Adnan Rasheed 88
It can be the current needs or the ones which could be desired in the future. This
means that the managers should have a team which can estimate the future
requirements by having the fast movement in the world and technology, specially in
the developing countries like Pakistan, this movement could be a little faster, so the
research team of the banks should consider the environment and by having the focus
on the culture requirements estimate the future needs of the customer. Also the
managers should consider the competitive environment, and should think out of
the box to offer the best and to satisfy the customers.
The next link which is going to be explained is habit. Habit also has a
relationship with loyalty. The t-value of the analysis for this relationship is more than
2, and this shows that this relation ship exists. When a customer stays with a
bank to have some sort of services, it can have two reasons. First this customer
is really satisfied with the current services and the next reason could be the
habitual behavior. It means that some sort of reasons is related to the factor
Habit. Some of the most important habitual reasons are measured in this
research like the family influence, or the distance which can make a customer
find the habit of using a special bank services. In finding the loyal customer, this
category also can be considered. But it is not as serious as the satisfied customers.
Because if the cause of the habitual behavior, like the distance or other
reasons, change the customer would stop the habit.
The customer managers should find this category and to minimize the risk
of defecting of these customers, they can find a way to change this group of
customers to satisfied ones. By doing this, the number of loyal customers is not
changed at the moment but the number of satisfied ones and also the number of
future loyal customers is changed. The next link which is valid, and its t-value is
greater than 2 is the link between switching cost and loyalty. By analyzing the
answers of the three questions of this part, the relationship between the loyalty of the
customer and the switching cost can be explained as below:
When a customer is not sure about the new bank which might be chosen, it
makes him/her not move simply and suddenly. He or she thinks that should spend
more time in order to be able to make a good decision. This process makes the
customer stay more with the current bank, because he/she considers the risk of not
being satisfied with the new bank and tries to think more about switching. By doing
© Adnan Rasheed 89
so, staying with the bank for a longer time is more possible than choosing a new one
carelessly.
The next factor that has a valid relationship with loyalty is choosing. In this
factor when a customer tries to find a new bank for having financial transactions, he
or she tries to compare the different banks with each other. And at last the best
one will be found (almost it is in his/her point of view), so because of the effort that
the customer puts for selecting the bank, he/she would be more satisfied with the
services of the new bank. In long time, this can make a long-term relationship, and
the customer who tries to compare the banks and select the proper one would be more
satisfied and loyal. By this explanation, the link between choosing and satisfaction
becomes clear. So the managers of the banks can give this permission to the
banking industry’s customers to have some sort of clear information about the
services and also about the bank itself.
Choosing can have a big role in making a new customer a loyal one. The next
factors which are going to be discussed are the quality factors. As I mentioned in
the previous parts, in the main model, the researchers analyze the quality as one
factor. But by having a deeper look at this element, I found that it could be separated
into two factors, and I decided to measure them separately and find each one’s
relation with loyalty. The first category is about tangible qualities. This means
the feasible perceived quality in the branches or wherever the customer has the
services, fore example, the beauty or the neatness of the materials, has influence on
the loyalty of the customer. It is important for the customer to have the financial
services in a tidy way. Also the other element that affects this factor is the
advertisements and the interest for the customers’ investments. Intangible factor is
about the infeasible quality .It also can be named as behavioral quality, like the
respectfulness of the bank’s staffs. This factor has also an important relationship
with the loyalty of the customer. Both of these factors got the valid t-value in the
analysis, but in comparison the tangible quality has a greater coefficient with loyalty.
This shows that the viable perceived quality has a greater role in making a customer
loyal or defector.
The bank managers should focus their strategies on offering the financial
services with considering these two factors. The mentioned elements can make the
current customer a loyal one. Also these two factors have influence on the
satisfaction of the customer. It means that by providing a better service, banks can
© Adnan Rasheed 90
make their customers more satisfied. At the next step, they can make them loyal. As
the analysis shows, these two factors have influence on loyalty and satisfaction.
Quality factors have also influence on switching cost. It means that when a
customer receives a good quality (tangible or intangible),his/her expectations of
the banking services increase, so at the switching time, he wants to get more in the
other new banks, and this makes the movement not simple.
Quality factors have relationship with choosing. When a bank is offering the
financial services in a qualified way, and the customer perceived quality (tangible
or intangible) is high, at choosing time, he/she wants to compare the new bank’s
services with perceived one. This can also influence the new customers’ choosing
decisions. This is because of the effectiveness of word of mouth; new customers
will come toward to have their financial services in the mentioned bank. Also
managers can advertise on the customer perceived quality by having some
researches on it and representing the results to the public. Also quality factors have
relationship with habit. This is because when a customer gets a good service quality,
this remains in his mind and when needed he is likely to go the same place again.
Chapter 5: Conclusion
Low-income families strive to maintain the fragile balance between limited

income and on-going financial needs. Given the precariousness of their financial
situation, events that require additional expenses can deal a heavy blow to the poor.
To better understand their financial implications on low-income households, this
study began with a look at these stress-producing events, which can be categorized as
either risks or economic stressors. Risks are unpredictable events that result in an
economic loss. Economic stressors are predictable events – usually associated with
milestones in one’s life, like marriage – that put pressure on cash flow when
expenditures exceed income. This study included both types of events, thereby
allowing for a more comprehensive understanding of the dynamics of household
economics, the coping options available to the poor, and the motivations for the
choices of risk-managing strategies.
© Adnan Rasheed 91
Coping mechanisms fall into two categories. The first consists of strategies
that people do ahead of time in order to reduce their vulnerability to shocks and
economic stress, such as risk avoidance, risk reduction and efforts to protect against
risk. The second consists of loss management strategies that take place after a shock
has occurred. The research examined both types of mechanisms and their
effectiveness.
5.1 Risks
According to respondents, the risks that place the greatest amount of economic
pressure on households are:
 Death of a family member

 Prolonged illness
 Business loss or failure
5.1.1 Death of A Family Member
Respondents viewed death in the family as the most stressful risk. In addition
to the emotional stress of losing a loved one, the bereaved family is expected to cover
all funeral expenses and prepare a sumptuous reception for the mourners. In many
locations, the mourning period can last up to 40 days after the actual death bringing
the total cost of the funeral and related expenses to anywhere from Rs. 8,000 to Rs.
25,000 (US$133 to US$416).
Precautionary coping strategies are not common in these cases. Some

respondents said they had not saved for this event, but a few were able to take
advantage of life insurance policies. Other strategies included:
 The use of savings – particularly in the case of an expected death, the family
© Adnan Rasheed 92
will save by limiting household expenditures and taking on additional work.
 Informal borrowing – predominantly from friends, since borrowing from
relatives for a funeral is not considered socially acceptable.
 Insurance – a limited number of clients have access to either MFI-provided
insurance or formal insurance.
 Sale of assets (e.g. jewelry or electronics) in situations of extreme hardship –
this happens rarely.
During general discussions of risks and economic stressors, respondents did

not differentiate between natural and accidental death, but they did distinguish
between the death of a relative and that of a household’s breadwinner. The latter is
clearly more devastating financially, as they described it as an “economic crisis” or
“disaster.” Respondents provided more details regarding its long-term financial
impact on households during discussions of insurance products. As an unpredictable
risk, the economic hardships caused by a death in the family could be alleviated
through the introduction of a life/accident insurance product or funeral insurance.
5.1.2 Prolonged Illness
All participants perceived health issues as a major risk, although they

distinguished minor health problems, which they considered easier to deal with, from
major illnesses that often require hospitalization and make tremendous claims on
household finances. Chronic diseases like hepatitis, diabetes, tuberculosis, and
chronic kidney problems – all of which are very prevalent in Pakistan – can place a
significant financial burden on many households. Accidents, usually traffic- or
workplace-related, can be equally onerous.
Health services are usually available locally, even in rural areas, although the
quality of these services is very low because many of the village “doctors” do not
have specialized education and are not regulated by the government. For serious
© Adnan Rasheed 93
problems, people prefer to go to the nearest city, where they can choose between
private health service providers, which are expensive, and government hospitals,
which are cheaper but offer inferior quality services.
Costs of health services range from Rs. 30-50 (US$0.50-0.83), for a visit to a
local village doctor plus some simple medications, to Rs. 100-500 (US$1.67-8.33) for
a visit to a private doctor in the city. In cases that require hospitalization, respondents
said they use government hospitals that do not charge for the bed. Nevertheless, many
end up paying Rs.1,500 to Rs. 3,000 (US$25 to US$50) per day for hospitalizations
due to medicine and other expenses like transportation. What’s more, families are
often expected to host and entertain remote family members who come to visit the
sick person, which can add substantially to the already-heavy financial burden.
Most respondents said they do not use precautionary strategies for dealing
with health-related expenses, at least in comparison to other risks and economic
stressors. They do save in anticipation of maternity expenses (see Birth of Children),
which suggests that people save for predictable events only. Low-income clients may
also have too many other pressing needs that they cannot save for health-related
expenses, preferring instead to “pay as you go” when health emergencies strike.
Respondents described a wide range of coping mechanisms, most of which are loss-
managing strategies:
 Home savings – Almost every family has at least Rs. 500 (US$8.33) at home
for emergencies in a “mattress account.”
 Loans from friends and family – These are widely used and commonly
available. Respondents said it is easy to borrow Rs. 1,000-3,000 (US$17-50)
to pay for treatment. These loans are interest-free and have no set terms for
repayment.
 Additional work to earn more income
 Decrease in household consumption
 Major help from extended family – In several cases, rich relatives will cover
the cost of treatment without the expectation of having to be repaid. Loans
from MFIs – This is a diversion from the stated use of productive loans.
© Adnan Rasheed 94
 Liquidation of assets – predominantly jewelry and livestock; land plots in
extreme cases
 Borrowing from moneylenders – accessible to the urban population
 Postponement or early termination of treatment, or no treatment at all
Respondents said that, in most cases, they are able to deal with minor health
issues. Problems involving chronic illness or requiring hospitalization, however, can
debilitate a poor family. Quality savings services could help to minimize such a risk.
Another possible solution is specialized health insurance.
5.1.3 Business Failure/Loss Of A Job
Risks associated with a loss of a job or business failure are generally tied to
the general economic situation in the country, and microfinance services are of
limited help. The nature of the risk associated with losing business assets due to
unexpected breakdowns, theft, or natural disasters is different, however, and could be
insurable.
Clients mentioned that the loss of equipment, goods, or premises can cost from
Rs. 50,000 to Rs. 300,000 (US$833 - US$5,000) in lost assets, which include goods
like livestock, a stream of income, and – in some cases – the entire business itself. At
the household level, the loss results in lower consumption and difficulty in repaying
loans. At the enterprise level, the entrepreneur may go out of business, although
respondents reported that a complete loss of business assets is much less likely to
occur compared to other economic stressors or risks.
The precautionary coping mechanisms for dealing with a loss of business assets are:
 Use of home savings

 Use of committee savings
 Informal insurance – a group of shopkeepers pay in small amounts monthly
and use the money in case of an emergency
 Investment in household assets
© Adnan Rasheed 95
After the fact, clients rely on other strategies to recover from the loss:
 Moneylenders – available to the urban population

 Borrowing from friends and family or from an MFI
 Reducing household consumption
An effective response to this type of risk could be a conventional asset

insurance product. However, since the respondents perceived these risks as lower
priority, such products could be looked into and developed at a later stage.
5.2 Key Economic Stressors
Respondent cited the following as the top economic stressors, in terms of the
amount of economic stress that each puts on a family:
 Construction of a house
 Marriage of a son/daughter
 Education of a child
 Birth of a child
5.2.1 Construction of a House
Construction of a house was the most frequently cited source of financial

pressure for a household, with costs ranging from Rs. 60,000 to Rs. 300,000
(US$1,000 to US$5,000). Even in multi-generational homes, an addition to a house –
which the marriage of a son usually requires – can cost about Rs. 50,000 (US$833).
Despite the high cost of construction, many respondents said it was their dream to
build their own home, so much so that they are willing to forego other needs including
health-related expenses – in order to achieve it.
A few respondents viewed investment in housing as a source of additional
© Adnan Rasheed 96
income through renting the unit. A typical room brings in between Rs. 1,000 and Rs.
2,000 (US$17 and $US33) per month, with rents increasing due to an influx of post-
earthquake population.
Respondents said that they typically use savings and loans from friends and
family to construct a house. Savings take two forms: cash (in home and in
“committee”5) and construction materials. Because savings and informal borrowing
are rarely adequate to cover the cost, respondents said they will try to obtain
“productive” or “micro enterprise” loans, without ever reporting the actual use of the
loan to the MFI. Clients also reported working overtime, receiving salary advances,
and reducing household consumption as means of coping with this expense. In
addition, they mentioned that borrowing heavily from family and friends can cause
mental anxiety and increase social pressure. Since housing construction is not an
unpredictable risk, microfinance is not a suitable solution, but a long-term or contract
savings product, as well as a specialized housing loan, could be helpful.
5.2.2 Marriage of a Son/Daughter
Marriages within the family pose a significant financial stress on households,

second only to construction of a house. Traditionally, parents are responsible for
covering the costs of their children’s weddings, which include the reception, dowry
for the daughter, and expensive presents for the bride’s family from the groom’s
family. These traditions differ slightly depending on the community and/or ethnicity
of the family, but total wedding costs generally fall within the range of Rs. 80,000
(US$1,333) to several hundred thousand. Because weddings are anticipated events,
they allow for the use of a mix of precautionary and loss management strategies.
Typical coping mechanisms before the event include:
 Starting in-kind savings soon after a child’s birth – They include jewelry and
expensive household items like furniture, refrigerators,
 Saving cash closer to the time of the event through committees
 Borrowing from friends and family
 Borrowing from MFIs – by diverting “productive” loans
© Adnan Rasheed 97
 Borrowing from Village Organizations
 Borrowing in-kind from shopkeepers – for example, food or jewelry
 Borrowing from money lenders – accessible to the urban population
 Selling household assets – including land
The social pressure to marry off children – especially daughters – can be great,
and respondents said they use all available options in order to live up to their
obligations. Coping mechanisms range from relatively low-stress strategies (e.g.
long-term savings, committee savings, and savings in-kind) to rather high-stress
strategies (e.g. sale of assets) that can affect the long-term productive capacity of the
household. Some of the traditionally common coping mechanisms, such as in-kind
savings, have become less popular as social pressures dictate that gifts purchased for
the newly-weds be up-to-date with current styles and fashions, thereby increasing the
popularity of cash savings and borrowing. Price inflation and the consequent increase
in the cost of goods and services add to the financial pressure on families. and
bedding After the marriage, households must figure out ways of dealing with their
debts. Some respondents said that they reduced their consumption and other
household expenditures in order to repay these debts. Others reported being in
continuous debt as a result of a marriage. Given that most families have several
children, the long-term burden of recurring wedding costs is significant.
Respondents viewed the marriage of a son or daughter as one of the most

challenging economic stresses. As opposed to the one-time construction of a house,
weddings are especially burdensome because large families must pay for the
marriages of several children. Access to specialized savings or loan products could
provide some relief, although many low-income people have difficulty saving. these
cases, a specific endowment accident and/or life insurance could be more appropriate
since these products would force the client to save on a schedule (see page 18 for
details).
5.2.3 Education of Children
© Adnan Rasheed 98
In general, clients perceived education as an extremely important prerequisite

to a better life for their children, and many attached the highest priority to educational
expenses. Even those from very poor families said they will set aside money for
education. So important is education that a large number of respondents decided to
send their children to private schools – even though private schools are more
expensive than government schools – because they provide a better education
(monthly tuition at government schools is roughly Rs. 20 to Rs. 35 or US$0.33 to
US$0.58; private schools charge Rs. 100 to Rs.400 or US$1.67-6.67). The additional
cost of materials, books, uniforms, and transportation (predominantly for daughters)
can total Rs. 500 to Rs. 600 (US$8.33 to US$10.00) per month. Families generally
prefer to send their sons to schools, especially for further education.
Households pay for on-going educational expenses through current income

sources, savings and loans. Seldom is this enough, however, and many children
cannot pursue further education as this requires higher expenditure, in terms of both
tuition and related expenses. The enrollment fee for college may not be high, but
because colleges are usually located in cities, many families cannot afford the higher
level of expenditures from supporting a child to live in a distant city.
In order to pay for education, respondents named the following strategies:
 Additional work – increasing regular income

 Cutting down on other household expenses – even food consumption
 Negotiating postponement of school fee payment
 Informal borrowing – from friends and relatives
 Not sending daughters to school
 Pulling children out of school – in cases of extreme hardship
© Adnan Rasheed 99
Most families are able to send their children to primary and high schools,
although many go into debt in order to meet these recurrent expenses. Savings
products could be an appropriate financial solution, but a specialized insurance
product – e.g. life/accident endowment insurance – may be necessary to meet the
financial needs of those who pursue higher education beyond secondary school.
5.2.4 Birth of A Child
Female respondents differentiated risks associated with childbirth from

general health-related risks. They mentioned that families have to come up with
additional funds to pay for medical checkups and delivery assistance. These medical
services are provided locally; mostly by midwives (expectant mothers seek assistance
from hospitals only when there are complications). Because local midwives are
generally of very low quality, they often diagnose complications too late, resulting in
high mortality rates among mothers and newborns.
Precautionary measures for dealing with pregnancies include:

 Use of home savings or “mattress” accounts
 Once pregnant, specific savings for childbirth – including cash, food, and
clothing.
When there are very few resources available, an expectant mother may take
more drastic measures, like:
Not seeking needed medical assistance. While there is a need for a

comprehensive health insurance that covers childbirth, such a policy could prove
difficult to provide from the supply side because adequate premiums are likely to be
prohibitively expensive for most clients.
The purpose of this study was to identify the most economically stressful risks
facing low-income micro entrepreneurs in Pakistan, the strategies that they use to deal
with these risks, the gaps in these coping mechanisms, and the needs for better risk-
© Adnan Rasheed 100

managing financial strategies. The microfinance clients at KBL and FMBL face many
economically stressful and risky events. The life-cycle events that cause the most
financial stress include constructing a house and the marriage of children. The most
stressful unpredictable risks are death of a family member – especially that of a
breadwinner – and prolonged illness.
Clients avail themselves of many different types of coping strategies. They

have a habit of saving, but they are often unable to save very much at home, and the
amounts that they save at their MFIs are inaccessible in times of crisis. They also
participate in informal savings clubs – committees – which they use to save usefully
large lump sums for specific purposes. These sums are usually available on a
schedule but not on short notice. Clients also benefit from strong social networks,
including family and friends that will help them by providing loans when needed.
Clients of FMBL have access to emergency loans through their MFI, although the
research suggested that they tend to misuse these loans, making them less effective in
case of a real emergency.
Despite the range of both formal and informal financial services that is
available to low-income clients, they remain vulnerable to economic shocks. Clients
have limited means to cope with expenditures larger than the normal day-to-day
expenses or with large financial losses, particularly those with lasting consequences.
Many clients end up in long-term debt after experiencing an economic shock. In such
situations, families experience a decline in their standard of living and fall deeper into
poverty.
5.3 Risk-Managing Financial Services
The impetus behind the development of microfinance products is the desire to

protect low- income people from economic shocks. Yet there are risk-managing
financial services aside from microfinance that can reduce the vulnerability of low-
income people. They include savings and emergency loan products. Each product has
a particular role to play. Emergency loans are intended to protect people from the

need to sell off assets or take on extremely high-priced debt. Savings products are for
people who have the ability to plan ahead and can afford to put some money aside.
Insurance is to protect people against insurable risk (or risks that can be
observed and are idiosyncratic – i.e. they only affect one person or one family at a
time).
 It is generally agreed that insurance is not an effective response for situations

in which:
 Losses are certain to occur
 Losses are small because the associated administrative and transaction costs
would make the product too expensive in relation to the loss.
 The risk is covariant and affects many people in the risk pool at the same time
– for example, an earthquake or other natural disaster.
 The insured person has control over the insured risk.
Generally, saving and loans are more appropriate for covering economically
stressful life-cycle events, while insurance is best for risks that are unpredictable and
result in significant losses.
5.4 Client Education and Marketing
The discussions with the clients suggested the need for better client education
on insurance and how it works. The desire of clients to receive a refund if they don’t
incur the condition that the insurance covers shows a lack of understanding of the
principles upon which insurance is based, and will be a challenge to the successful
implementation of an insurance product. For this reason, endowment products are
more popular with clients (in fact, endowment insurance products operate much as a
forced savings product). Financial education is key to the long-run success of
insurance, as clients will not continue with a product if they are disappointed with the
outcome or feel that they have been cheated of their money. Education should cover
the nuts and bolts of the insurance product itself (coverage, premium amount, how to

pay the premium, how to make a claim, where to make a claim, etc.) as well as the
way in which insurance works (i.e., it pools risks by collecting payments from many
people in order to make larger payments to individuals who suffer a loss). Financial
education efforts will take some time but they are key to ensuring that clients are
informed consumers of micro insurance products.
Discussions with the respondents suggest that, in marketing insurance, MFIs

could focus on selling ‘peace of mind.’ Many respondents mentioned mental anxiety
or emotional stress when talking about how they coped with large economic risks.
Relying on social networks such as baradri, though helpful, also causes people stress
because they end up worrying about having to ask for help and then having to repay
their peers.
Unfortunately, perceptions of insurance among low-income populations are

not always positive. The research found several respondents who had had bad
experiences with insurance. While their experiences may have been the result of a
poor understanding of the insurance policy, respondents also mentioned problems
with fraud committed by insurance agents or a lack of good faith on the part of
insurance companies. Education and marketing efforts will need to address this poor
perception.
5.5 Further Research
This demand study is one small part of a larger microfinance product

development process underway at PMN. Since some of the FMBL clients reported
that they would not have bought the life insurance policy had it not been mandatory,
PMN and the MFIs should go slowly in introducing new microfinance products. The
recommended process which was outlined in the introduction is a systematic method

for developing viable products. Its remaining elements include:
A supply-side study to assess existing and planned microfinance products.

This helps to (1) refine what should be offered, (2) identify potential insurers and
other partners that MFIs could work with, and (3) uncover information about the
processes, marketing, and efficiencies of various options.
Partner selection Design of product prototype(s) based on the demand and supply
studies Short, quantitative study to determine the demand for the prototype
Preparation and then implementation of the proposed product, including training,
systems preparation, and documentation of procedures.
Pilot Test Review And Evaluation Product Rollout
The supply study should allow PMN and the MFIs to obtain a better sense of
the available partners and viable products (from the insurers point of view). We
recommend that PMN undertake a quantitative demand research, which would
involve developing a questionnaire and surveying a significantly large sample of
microfinance clients. It could hire a local firm to conduct the survey. The
quantitative research would complement the qualitative research by showing the
number of people that face specific risks, the costs of those risks, and the frequency
with which those risks occur. Individual MFIs should conduct market segmentation to
identify sub-groups within the irrespective clienteles before they design product
prototypes. This research had hoped to uncover differences in demand between urban
and rural residents, and between men and women. The research did not find many
definitive differences along these dimensions, but it did demonstrate that there are
significant differences in the income levels of clients within a single MFI that can
result in different types of demand for and use of risk coping mechanisms. The
quantitative survey could investigate market segmentation in greater detail. The
market for microfinance is not limited to microfinance borrowers. The ability to offer
microfinance products presents MFIs with an opportunity to tap into a larger market
of low- income people. Therefore, any future research should include an investigation
into the potential of this currently unserved market. Since MFIs provide insurance
companies with access to a large, untapped market, they should participate more
actively in further studies and the microfinance product development process,

possibly even sharing costs with the insurers. The development of successful
microfinance products will require working closely with the insurance company
partners.

7-Compariso KBL &amp FMBL

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Challenges in Microfiance Banking Sector of Pakistan

Comparative Analysis of Khushali Bank & First Microfinance Bank

Microfinance is an emerging financial service. It fills an important gap for

1. The demand study – the subject of this thesis, undertaken by Microfinance

PMN is interested in promoting Microfinance services among its member

My thesis is organized as follows. First, I present a brief overview of

1.1 RESEARCH OBJECTIVES

This factor of money brings a new dimension in the socio-economic structure

Commercial Banks were focusing on a very limited part of the community

1.3 STATEMENT OF THE PROBLEM

The maintenance of consumer trust in the microfinance banking industry is of

The focus on this research is to identify the common relationship marketing

1.4 RESEARCH QUESTION

1. What functions, products or services offered by Micro finance institutions in

The main objectives of research include the following;

H0 = First Microfinance Bank & Khushhali Bank activities do not

Reliance upon secondary source of information as the data had to be gathered

REVIEW OF RELEVAT LITERATURE

Microfinance began as a series of experiments in how to use finance to

As we observe the recent waves of innovation in microfinance, particularly in

The potential of microfinance to serve as a platform for launching

During the course of the research, I interviewed many microfinance

If we are going to reach the Millennium Development Goal of halving poverty

2.1 Microfinance in World’s Eye

The phrase “Customer is King” may be an oversimplified cliché in business,

Because poverty encompasses more than just finance, microfinance—a

2.1.1 Overview of Microfinance

Because the term microfinance is used in many different contexts, it can

From its tremendous success as a poverty alleviation tool, microfinance as an

2.1.2 Inhibitors to Success

At its core, microfinance is not terribly different from mainstream consumer

The loss of income due to sickness and incapacitation of a borrower or a

Because these three factors, among others, are key impediments to a

2.2 Microfinance & Pakistan

The sustained commitment exhibited by the government to ensure a conducive

In Pakistan, Micro Finance is not a new concept. However, after Micro

2.3 Informal Finance Markets

Informal finance markets (IFMs) have a long history pre-dating formal

Suppliers' credit is a common feature: in old markets with established players,

2.3Implications For Policymakers And The Microfinance Sector

It is not possible to wish away informal finance markets. Policymakers need to

One response to recognition of the informational advantages of informal

In terms of urban informal sector financing, access to credit is only one of

The Pakistan Microfinance Network (PMN) can facilitate this process by

Some transactions in IFMs - especially in urban areas - are linked to the

2.3Size Of The Informal Finance Sector

2.3Implications Of IFMS For Poverty

The lack of well-functioning financial markets has disproportionately adverse

Indeed, this high rate of indebtedness is a major hurdle in poverty alleviation

The indebtedness to informal lenders in the rural areas is not a new

The moneylender ensured repayment primarily through social sanction and

2.3Providers Of Informal Finance

In a rotating saving and credit association (RoSCA) or committee, as it is

Generally, it usually involves a group of people coming together and

Moreover, ostracisation in its various forms acts as a sufficient deterrent. If a

Owing to mass urbanization - especially the proliferation of peri-urban areas

A common feature of all urban markets is suppliers' credit, with as much as 90

The role of market associations, according to most respondents, was very

Although such social interaction helps gather information needed for

In markets with a large number of new players, however, business is largely

Meanwhile, the textile business is facilitated by the presence of brokers and

In case of default, the issue is adjudicated by a panchayat. In Karachi, for

However saving through livestock is vulnerable to a number of uncertainties