Khwaja discusses issues, inequalities in entrepreneurial lending

Asim Ijaz Khwaja, the Sumitomo-Foundation for Advanced Studies on International Development professor of international finance and development at the Harvard Kennedy School, presented the Department of Economics’ 2015 Birger Lecture yesterday evening. His lecture was titled “Let’s Stop Giving Money to Only Those with Money: Using Psychometrics to Unleash Global Finance.”

Associate Professor of Economics Margaret McMillan introduced Khwaja, recognizing his contributions to the fields of development economics and political economy.

“His work combines extensive fieldwork with rigorous theory and the latest in econometric methodology,” she said.

Khwaja began the lecture by involving the audience in a simulation in what he called “The Game of Loans,” a game of making lending decisions. He played two videos of prospective entrepreneurs in South Africa who explained their respective business strategies and goals. Khwaja then asked audience members to vote for which entrepreneur they would give a loan to and why.

Khwaja then expanded the discussion of the basis on which lending decisions are made to actual real-life lenders, including banks, venture capitalist firms and microfinance institutions (MFIs).

“What are the tools they use?” he asked. “How do they go about solving this problem?”

Within the formal financial sector, the majority of loans received by entrepreneurs still come from banks, according to Khwaja. Entrepreneurs may also receive loans in the informal sector through family and friends, money lenders, trade credit and credit cards, he added.

“What’s the challenge?” he asked. “What are they trying to solve?”

Khwaja explained that the primary problem in financial intermediation is a matching problem between loans and ideas, adding that in theory this should be a simple problem.

“There are people with money … and there are people with ideas, and all you have to do is match the money to the ideas,” he said, noting that the origin of the problem lies in the fact that the distribution of money does not always equal the distribution of ideas.

The consequences of this reality in which money is unevenly distributed include the emergence of family-owned conglomerates and foreign-owned firms within a country, which may lead to unproductive firms, idle capital, high inequality and missed opportunities with profitable ideas that never get funding, according to Khwaja.

He said that because of this uneven distribution, there is no process of creative destruction taking place.

“This is a problem we have to solve,” Khwaja said.

Within the issue of matching, Khwaja identified two main problems: screening and monitoring. For screening, investors must be able to identify entrepreneurs who are honest and have high capabilities.

“If you get people who are trustworthy, they are more likely to pay you back,” he said.

For monitoring, investors must be able to ensure good investment and repayment behavior, according to Khwaja.

“Is the person behaving well and making the right investment decisions that are going to be profit-making for the company … and are they going to take actions that would improve repayment?” he asked.

On account of the difficulties in matching, Khwaja estimated that millions of jobs and $3.6 trillion of GDP have been lost.

Khwaja then discussed the mechanisms banks, venture capital firms and MFIs are already employing for screening and monitoring potential lending recipients.

Banks, for instance, use collateral and credit ratings to screen and monitor, Khwaja explained. If an individual with a good idea has access to neither, however, it is very difficult to secure financing, Khwaja said, underscoring the insularity of such a financial system.

“There are substantial entry barriers on dimensions which are not directly about ability,” he said, adding that the system thus excludes people with good ideas.

For venture capital firms, Khwaja pointed towards possible biases in screening processes as well as possibly incompatible objectives and relationships, since many venture capital firms seek only short-term investment projects.

“You have really these rapid ins and outs,” he said. “It’s the nature of your business.”

Regarding MFIs, joint liability systems can improve monitoring and screening, but there is often a focus on repayment instead of returns, and there may be excess social pressure on borrowers.

Khwaja then called on the audience to reflect on how to solve these problems.

“What I want us to think about is what do we do?” he asked.

To develop solutions, it is important to go back to the design basics in order to come up with more effective screening and monitoring solutions to leverage the information and data revolution, according to Khwaja. He noted that the innovations in technology have significantly reduced the costs to access potential borrowers, which therefore plays a role in the monitoring process.

In order to examine empirically whether this may work, Khwaja began discussing the results of the Entrepreneurial Finance Lab (EFL), a financial technology company that he co-founded.

The EFL uses a test for potential borrowers that measures their skills and fluid intelligence. They also test borrowers’ ethics, honesty, attitudes and beliefs, according to Khwaja. After the client takes the test, the lender uploads the test and receives a score for the client. Repayment data for the client is then uploaded monthly, and default rates have in fact been decreasing, he added.

Thus far, 200,000 individuals have taken the EFL tests and received loans totaling $300 million in 27 countries, according to Khwaja.

Khwaja concluded by touching on other new forms of lending, including peer-to-peer.

“This is a space where I think huge innovation is going to happen,” he said. “If we keep doing this, the lenders of 10 years, 15 years, 20 years from now will look very different.”