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On Monday, November 27th, 2017, Babar Ali Fellow, Saad Azmat will give a talk about his work about financial inclusion in Pakistan.

The seminar will focus on how different modes of financial inclusion have helped or hindered poverty alleviation in Pakistan. Azmat will examine factors such as psychology of the households and the institutional environment of the country, which may impact the effectiveness of policies geared towards poverty alleviation.

Saad Azmat spoke to LMSAI about the inspiration for his research and his hopes for how his work might impact Pakistan.


Where are you coming from before this?

I’m coming from Lahore University of Management Science.  I’m an Associate Professor of Finance there. And before embarking on my sabbatical, I was also the Associate Dean of Research.


Can you describe your current line of research in a few sentences?

My research focuses predominantly on financial inclusion. The underlying focus is the debt contract and if there are alternatives to the debt contract that we can use.  In the aftermath of the financial crisis, the focus on the debt contract has increased significantly in the literature, where researchers are trying to understand if there are any other viable alternatives. One particular alternative is risk sharing, where two people rather than one party, bears the risk.


Can you describe the risk-sharing contract, for someone who may not know a lot about finance, how it works?

To be honest, we are trying to understand risk-sharing ourselves.  The contract is very simple, it is the implementation of the contract which is problematic. The contract is easiest to understand in terms of a new firm or venture that is starting. The debt contract would require this new venture to pay a periodic return to the bank for the loan. A new business in its earlier years is not making a lot of profits, there is a possibility that their profits could be really high and low.  A risk sharing contract, on the contrary, promises the lender a portion of return of the business. If the business is doing well, the lender would get a bigger amount and if the business is not doing very well, the lender would also bear a loss. In a nutshell, it has more in common with an equity contract than a debt contract.


Can you tell me about when you first became interested in the risk-sharing contract?

My mother had a domestic helper who has been with us for as long as I can remember, she is an old lady.  I remember engaging her in a conversation, when she was cooking food. I started asking her questions about her life, how things have been, in her village life etc.

In those days, I was doing some research on capital structure and how firms borrow and so I asked her out of curiosity, how do you borrow in your village? She said that there is this very ‘nice guy’ in her village and they go and ask him for money. You have to understand there are no formalized banks in their village to borrow from and microfinance is still very new and hasn’t really permeated through the villages. I asked her if she could tell me about a recent time when she had to borrow?  She said, there are two events when the need to borrow is the greatest, one is during a wedding and the other is during a funeral; moments of extreme happiness or extreme sadness. She said during her daughter’s wedding, the need to borrow was the most, it’s a cultural thing, where dowry still exists.

She mentioned the instance when her cousin had to borrow, and again I’m talking about more than 10 years ago. Her cousin had borrowed about one hundred thousand rupees. I asked at what rate, she said at a rate of fifty percent a month. This was a time when the rate in the US was touching 0% a year. And there is this lady, who needs money and is borrowing at a rate of 50% a month. So I asked her,  isn’t the rate too high and she said it was much better than what other money lenders were charging in the market. I asked, how much does this guy make and she said he makes about fifteen thousand rupees a month. So you do the math,  fifty thousand rupees a month is the money that he has to return. I asked her, why she borrowed in the first place and she responded, as opposed to what, not getting my daughter married? That was her response.

It was very difficult to understand her decision, but one thing was very clear, that the debt contract may not serve their needs of the very poor.  you know the person who was offering the contract was doing everything right. I did the pricing myself and anyone who would want to make some money from lending to the poor would charge a very high rate.  So you know, you want to bring the poor into the financial sector, but at the same time you would also want to help them out.


Ideally, what do you hope will be the impact of this work?

People are trying to understand risk sharing for bigger businesses and they feel that if risk sharing can be implemented, it may have repercussion for financial stability and may be evading a possible financial crisis. It is a very tall claim to make, but that’s what has got many researchers interested. During a crisis you want people to take risks and that’s the time when people are most frightened, they are reluctant to take risks because they don’t want to bear losses. In a risk sharing contract, for the venture or borrower, the downside is curbed; it encourages people to take risks during the time when the economy needs it the most.

Secondly, it would allow the small and medium enterprises to be financially included. The banks are risk averse, if you look at India, Pakistan, Bangladesh and other South Asian economies you will find that banks are not interested to lend to small and medium enterprises, they’re more interested to lend to bigger companies or the government and partially because they feel that the smaller enterprises are risky.  Risk sharing contracts can help small and medium enterprises get funding from the banks.  They are risky, but since the banks are partners in a way, if some of these bigger ventures end up doing well then the banks will benefit from that and they would get a higher chunk of their profits.


How do you hope to implement your research when you return?

Some of the projects are going to take at least 3 -5 years to implement, I have already started a few of them.  We have started running lab experiments and we are trying to test them in a lab setting to identify the challenges associated with that. But the bigger project that myself and Asim Khwaja are interested in is testing this product in a field setting. Now the next step would take place six months to a year down the line, once some of the challenges that we’ve seen in the lab setting are neutralized. We would encourage banks to test this product in a smaller setting and to see the challenges.   If we can show that this product can work in a smaller setting, and we if we can identify and iron out some of the problems with this product, then we can encourage this product to be implemented in a large setting. As an academic, my focus would be to work with these banks and to identify the upside and downside of this product.

The other way to go about it would be to apply to potential donors and get some funding. Two years ago, we got some funding from the State Bank. The idea hopefully is to go back to our donors so we can implement this product on the village level.  So imagine you give a risk sharing product to a hundred villages and to another hundred villages you give a debt product, in 3- 4 years you will understand how the risk sharing product impacts their lives and their economies. This has not been done yet, at least not in a published study that I know of.


How might these risk sharing contracts be perceived and received in a predominantly Muslim country like Pakistan compared to your work in North America and Australia?

Earlier, I talked about the idea of financial inclusion. One of the challenges of financial inclusion has been that people have concerns regarding the debt contract. Some of these concerns are religious concerns, primarily the prohibition of “riba” meaning interest.  Basically, the foundation of the debt contract is interest, which is a predetermined return. If you look historically, not just in the Islamic faith but in other faiths, usury is prohibited. In a predominantly Muslim country, a risk sharing project where returns are not fixed or they are not predetermined to be technically correct, a risk sharing contract would neutralize concerns emanating from faith and more people would be able to utilize that financial product.

Let me give you another example, Islamic finance has become very popular in many of the Muslim countries. In Malaysia, it’s about twenty five percent.  I have worked with Islamic banks, they are also looking for alternative products. Currently, some of Islamic banks are using products that have much in common with conventional products with debt like features. This creates an ambiguity in the minds of the customer. A risk sharing product is a completely distinct product so the ambiguity in the mind of the customer would be clear if the product gets implemented.



The conversation has been edited for length and clarity.