A common picture of finance for the very poor involves moneylenders charging extortionate interest rates, perhaps with "white knight" microfinance organisations riding to the rescue. The reality is rather different. Poor people spend a significant amount of time managing money and use a wide range of financial instruments for a variety of ends. While their choices may not be optimal, apparently inefficient financial decisions often make sense on closer inspection.

Portfolios of the Poor is based on the analysis of financial diaries, tracking every financial transaction of individual households, taken from studies between 1999 and 2005 in rural and urban areas of Bangladesh, India, and South Africa. The authors are honest about the number of diaries — some 250 in total — being too small to support statistical analysis, but they are a broad enough sample to give a feel for what is going on and some guidance for policy-makers or financial operators. A strength of the approach is that it is "bottom up", starting with how people actually live, and not narrowly focused on the evaluation of interventions. (The opening chapter covers the background to the studies; it is supplemented by an appendix with more methodological details.)

No one actually receives $2 a day. Even those among the South African diarists with government grants had those paid monthly, "regular" employment is similarly lumpy and not always that regular, and casual employment and agricultural harvests are highly variable. So a central role for finance is in smoothing out income fluctuations to ensure that there is enough money to provide food and other basic requirements on a daily basis. To this end households use savings and borrowings simultaneously, mixing informal, interest free loans from friends and family, wage advances and rent arrears, semi-formal (microfinance) loans, and in occasional cases formal (bank) services. Here the cash flow analysis captures what matters, not the balance-sheet.

Finance is important for dealing with risks. Health problems are the most common source of unpredictable large demands, but funerals in South Africa are extremely expensive; these are funded using a combination of contributions from relatives, formal funeral plans and informal burial societies, which almost always needs to be supplemented with loans. General purpose loans are more flexible than insurance tied to particular risks, but there's clearly an unmet demand for insurance. The most obvious problem here is in trust, with concerns about the possible failure of insurers and moral hazard on the part of the insured exacerbated by the social divide between them.

Large sums are also needed for special occasions such as weddings and for opportunities such as purchasing land, starting a business or furthering education. This involves both borrowing, usually from multiple sources, and the use of savings "accumulators". Among the most sophisticated tools here are auction Rotating Savings and Credit Associations, where participants bid for use of the accumulated money, allowing savers and borrowers to negotiate an effective interest rate without middlemen or sophisticated accounting; these "could be considered the world's most efficient intermediation system".

With financial instruments for the wealthy the price of money — an interest rate or a rate of return — is central. The headline interest rates on some loans for the poor can look completely insane, but annualised interest rates don't make sense for loans of short duration, where charges are better seen as fees. And in practice interest is often not compounded or is waived after some period, or forbearance of other kinds is exercised. Apparently negative interest rates on savings can also be deceptive. One example highlighted is a "collector" who takes 20c a day from women for 220 days and then gives them back $40 at the end. This cycle has repeated so many times that it is no longer clear whether this is a loan or a savings plan. The convenience, flexibility and reliability of financial instruments are often more important concerns than their interest rates.

A later study, using the same diary methodology, was carried out on "Grameen II" households in Bangladesh, attempting to evaluate changes Grameen Bank made in 2001 to its microfinance products. This involved more flexible loans which could be "topped up" before completion of their term, a passbook savings account designed to make management of cash flows easier, and a long-term savings product that allowed access.

This leads into some suggestions for ways in which microfinance could be improved. There's demand for a cash-flow management facility that combines the ability to make small savings of any size at any time with loans of modest value that can be accessed quickly. There may be ways to replicate the best features of informal savings clubs but to improve on their reliability. And there's a space for the provision of general-purpose loans, not restricted to microenterprise as many microfinance loans have been. Products need to be reliable, convenient, flexible and have structure — regularities that promote self-discipline.

This analysis is heavily illustrated with examples from individual households. In addition, a second appendix presents summaries of fifteen of the portfolios, with a page describing each household facing another giving its financial net worth breakdown at the beginning and end of the study year, along with its turnover in each kind of financial instrument. This detail helps to give a feel for the way financial concerns are interlocked with the broader course of people's lives, rather than being abstract problems.

Though slightly more sophisticated terms like "debt-to-equity" occasionally occur in Portfolios of the Poor, no real knowledge of finance is assumed, just the ability to read a basic balance sheet or cash-flow breakdown. It might have been worthwhile including a brief explanation of this, however, since there are plenty of well-off people in developed countries whose understanding of finance may not go even that far. (A similarly detailed study of the finances of poor households in say the United Kingdom would make an interesting comparison.)

The authors of Portfolios of the Poor don't pretend that microfinance is a magic cure for poverty and don't claim that any particular financial instrument or service is going to have revolutionary effects. They do make a convincing case both for the importance of finance in the lives of the extremely poor and for there being room to improve the provision of financial services to them.

March 2012