BEYOND GROUP LENDING
P.V. Viswanath
Learning Goals
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What are some problems with group lending?
What can a model of individual loans with costly debt
collection tell us?
Can progressive lending be used to resolve some of the
problems with individual lending?
What is the role of hard and soft collateral?
Why do many microlenders require public repayments?
What is the impact of competition? Is it good or bad?
Why do microlenders require very frequent payment
installments?
Problems with Group Lending
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The essence of group lending is that it’s a way to transfer
onto customers the responsibility for jobs usually
undertaken by lenders – screening potential customers,
monitoring their efforts and enforcing contracts.
However, this has its costs.
Need to find other borrowers in order to be eligible for a
loan
 Attending meetings can be costly, both in terms of time and
money, particularly in sparsely populated areas.
 Borrowers have to bear the risk of other borrowers’ default
 Further, in sparsely populated areas and urban areas,
borrowers might not have good information on each other
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Problems with Group Lending: Social Pressures
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Excessive People are committing suicide over the shame of not
being able to pay the debts back. A 30-year-old mother of two
boys poured 2 liters of kerosene on herself and lit a match, after
she and her husband argued bitterly the day before over how
they would repay multiple loans. Shobha Srinivas, was being
pressured to pay interest on her 12,000 rupee ($265) loan.
Lenders also were demanding that she cover for the other women
who had borrowed, since borrowers essentially guarantee each
other’s loans in order to use social pressures to ensure repayment.
She had her husband are both dead after he was unable to put
out the flames and got caught in them himself. More than 70
people committed suicide in this particular Indian state from
March 1 to Nov. 19 to escape payments or end the agonies their
debt had triggered.
Nathalie Martin, http://www.creditslips.org/creditslips/2011/01/indiasmicrofinance-industry-fuels-mass-suicides.html
Problems with Group Lending: Flexibility
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Lack of flexibility – what happens if a borrower through no
fault of her own has liquidity problems?
Grameen USA has not experience this problem, yet, but
Sandy was a test case. Surprisingly, there were no defaults
or delinquencies because of Hurricane Sandy.
This is not only a problem in equity, but also one of
efficiency.
In the corporate world, this is taken care of through
restructuring. The US Bankruptcy code is essentially a
debtor-friendly system, for this very reason.
Grameen II has a basic loan with weekly repayments, but
also a Flexible Loan with easier terms spread over a longer
period; this is a sort of workout procedure.
Problems with Delegation of Control
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There can be collusion between borrowers, undermining the whole rationale
for groups.
From Hussan-Bano Burki, “Unraveling the Delinquency Problem in PunjabPakistan.
Group leaders and activists get an opportunity to turn into commission agents
primarily because the MF staff, lending through solidarity groups, tend to
delegate significant portion of their client selection responsibility to group
leaders or activists. Having a de facto power to accept or reject a potential
borrower in a group, the group leader has the power to provide or refuse
access to financial services to potential clients. This power allows group
leaders to charge commission from borrowers for access into a group.
…
…often, the group leader had accessed more loans from an [MFI] than the
[MFI] had record of by borrowing through a “dummy” or “ghost” borrower. In
some cases the group leader and the “ghost” borrower had subdivided the
loan amount and thus the repayment responsibility as well.
Solutions to group lending problems
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Progressive Lending –promising larger and larger
loans for groups and individuals in good standing.
Repayment Schedules with weekly or monthly
installments (as opposed to daily payments in
earlier group lending contracts).
Public repayments – e.g. the use of shaming (this
has its own problems)
The targeting of women (is this a solution or refusal
to address a problem?)
Weakening or eliminating of joint liability.
Group loans versus individual loans
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Relative to group-lenders, individual loan lenders
are slightly more self-reliant as proxied by the percentage
of their financial costs covered and
 Charge lower interest rates and fees
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Does this mean that individual lending is better?
However, individual lenders
Serve better-off clients, as reflected by average loan size
 Serve a smaller population of women
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So it is still important to look at whether and how
individual lending can be used to solve group lending
problems in target populations.
Progressive Lending
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Microlenders can give incentives to borrowers by
threatening to exclude defaulting borrowers from future
access to loans.
Ever-larger loans to good customers can turn startup
businesses into steady enterprises.
This can only work if the microlender is the sole source
of fund.
In a study by Aleem (1990), moneylenders elicited loan
repayments by
Developing repeated relationships with borrowers
 Making sure that existing borrowers do not contract new
loans.
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The economics of non-financing threats
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Assume that there are two periods of production and that an
investment project requires $1.
At the end of each period, the borrower can generate a
gross return y > $1, calculated before repayment of the
loan with interest, provided that her current project is
financed by the bank.
At the repayment stage, the borrower may decide to
default strategically by not repaying the loan.
In order to deter the borrower from doing this, the bank can
extend a second period loan contingent upon full repayment
of the first-period obligations.
The borrower’s penalty for defaulting after the first period
is that she will not be able to invest in the second period.
The model: details
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Suppose the borrower defaults on the first period loan. The
expected payoff will be y + dvy, where d is the discount factor, and
v is the probability of being refinanced by the bank despite having
defaulted.
The reason v is not automatically zero is that the borrower may be
able to get funding from another bank, which leads to a greater
likelihood of default. This is possible if there are no credit bureaus.
Assume further that the borrower needs the bank to go ahead with
the second project even if she pockets the proceeds of the first
period realization. (This doesn’t make sense because if each project
requires an investment of $1, the proceeds from the first investment
should be sufficient to fund the second project – but we will see later
how progressive lending can resolve this issue.)
If the borrower decides to repay the first period loan, her payoff is
y – R + dy, where R is the gross interest rate. For simplicity, assume
that in the second period, there will be no repayment.
The borrower’s problem
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Of course, in a finite-period game, it makes sense to default in
the second period. However, in reality, the borrower might
become large enough that it would make sense for the
borrower to invoke the legal system. Alternatively, banks
might not provide her with a loan with defaults in her
background. (Of course, this is another way of saying that the
game is really an infinite one.)
Clearly, the borrower will repay in period 1 if y + dvy < y – R
+ dy. This requires that R < dy (1-v). Note, here, that R is
decreasing in v; i.e. the greater the chance that the borrower
will have access to the bank after default, the lower the
interest rate that the lender can charge to forestall default.
Hence in equilibrium, the bank will want to set v=0, i.e. the
incentive compatible condition is R < dy.
Costly Collection and Microlending Failures
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We have interpreted d as the discount factor accounting for
the borrower’s time preference. However, if we simply
interpret dy as the value at time 1 of the expected time 2
payoff from a second project, d could also incorporate the
likelihood of the band having sufficient funds to lend to the
entrepreneur in the second period.
So since R is decreasing in d, we see that the interest rate
that the bank can charge and still have the borrower repay
is even lower if borrowers believe that the bank will not be
able to make future loans. This shows why it is important for
the bank to maintain an impression of stability.
In any case, if R must be less than dy to elicit repayment, the
bank cannot break even! So what can it do?
Progressive Lending
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One answer is progressive lending.
If successive loans are larger, then clearly, interest rates can
be higher because servicing costs are lower for larger loans.
Assume, for now, that the cost of capital per dollar of loan is
constant.
Now, suppose the bank increases the size of its loans by a
factor l . Assume, however, that we have constant returns to
scale.
Now, by not repaying, the borrower suffers a loss of l dy,
which is larger than dy. The restriction, now, is y + dl vy < y
– R + dl y, i.e. R < l dy(1-v) or with v=0, R < l dy. Hence
interest rates can be raised, relative to the constant loan size
case. Let the interest rate, in this case, be R’ > R.
How Progressive Lending Helps
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Earlier, we assumed that the borrower could not invest in period 2 if she
defaulted on the first loan. However, if she defaults, she would have access
to the returns from the first loan! So let us assume that the borrower can
keep part of the principal from the first period even in case of default.
Suppose f percent of the proceeds can be reinvested in the second period.
Assume, once more, that v=0.
In this case, if the loan is repaid, the return for the borrower is y-R’ + l dy.
If she does not repay, then the payoff is y(1- f) + fdy2. When f = 0, the
payoff is simply y because the borrower can invest nothing in the second
period; now if f > 0, the borrower gets to keep y(1- f) from the first
period returns, and invest fy instead of 0. The return, therefore on this
investment in period 2, will be (fy)y or fy2. After discounting this amount,
we get y(1- f) + fdy2. Hence, there will be no default if y-R’ + l dy > y(1f) + fdy2. Simplifying, we get R’ < l dy + (1-dy)fy, which is smaller than
the previous R’, as we would expect, as long as dy >1. That is, having f >
0, is not helpful to the bank.
Note at this point, that R’ is increasing in l . Furthermore, R’ is decreasing in
f, under the same assumption.
The eventual need for collateral
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Let’s look again at the condition as to when the borrower would not
default: y-R’ + l dy > y(1- f) + fdy2. Suppose now, that in case of
default, the borrower would hold back f = R’/y; i.e. the amount fy
that she reinvests is exactly equal to R’, the amount that she would
have had to repay to the bank. In this case, substituting for in the
inequality above, we get y-R’ + ldy > y(1- R’/y) + (R’/y) dy2.
Cancelling, we get the condition l > R’.
That is, if we can assume that the defaulter will act in a reasonable
manner to use the defaulted funds, default can be forestalled by
ensuring that the factor of increase of funds is greater than the
interest rate. This makes sense, because then the borrower gets a
net influx of funds.
The only issue is whether it makes sense for the bank to make such
loans, since there’s going to be default at some point. This makes
sense if at some point, there will be collateral that will make it not
worthwhile for the borrower to default.
Numerical Example
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Consider y = 1.2, l = 2, d = 0.9, then R = 2(0.9)1.2 = 2.16, or an
interest rate of 116%.
So the borrower gets (1.2+2-2.16) 1.04 in period 1 and 2(1.2) or
2.4 in period 2, for a total of 1.04 + 0.9(2.4) = 3.20 in date 1 PV
terms. The bank pays 1 at time t=0, then gets 0.16 (2.16-2.0) at
time t =1; this is not profitable for the bank. Even though the stated
interest rate is so high, it is illusory, since the bank doesn’t get to
collect in period 2 at all!
Furthermore, the assumption that the borrower does not have access
to the second project is unreasonable.
Now let f = 0.8. Then the condition is R’ < l dy + (1-dy)fy, or R ’ <
(2)(1.2)(0.9) + -[1-(0.9)(1.2)](0.8)(1.2) or R ’ < 2.0832.
This is more realistic, but of course the situation has become worse.
Collateral
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Suppose there is some collateral available; then, as long as it
has value to the borrower, it might help in resolving moral
hazard problems.
For example, we saw earlier that the borrower would repay if
R’ < l dy + (1-dy)fy. However, if there existed collateral of
value w to the borrower, then the condition would be R’ < l dy
+ (1-dy)fy + w. This allows R to be larger.
Going back to our previous example, assume that collateral
worth wd = 1 is available to the bank at time 2. That is, wd is
the value at time 1 of the collateral to be collected at time 2.
Thus, if d is 0.9, then wd must be 1.11 for w to equal 1.
Then the condition on R is R’ < l dy + (1-dy)fy + wd, or R ’ <
3.0832. Suppose the interest rate is set at 108%, i.e. R ’ =
2.08
Hard and Soft Collateral
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Now the bank pays out 1 at time t=0. At time 1, it gets back 2.08,
but relends 2 for a net return of 0.08 at time 1. However, at time 2,
it can collect on the collateral which at time 1, by our assumption is
worth 1. Hence the total return to the bank at time 1 is 1.08, for a
net return of 8% per period. In this case, we see that the bank can
operate profitably, assuming the cost of funds is less than 8%. The
borrower has a cashflow of 1.2 at time 1 plus a second loan of 2,
from which she has to repay 2.08, for a net positive cashflow of
1.12 at time 1.
If the bank cannot sell the collateral, but nevertheless, it has value w
to the borrower, then the bank could set an interest rate of 3.08 or
208%. Once more, it would make 8% per period. Even though the
collateral is worthless to the bank (soft collateral), the incentive
compatibility condition still holds and the borrower will repay the
loan at time 1.
Competition
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Normally, competition is good, but in this case,
competition can be bad if it is promoted before certain
institutional safeguards are introduced.
In terms of our model, competition can increase the
value of v. And this can reduce the interest rate that
can be charged (recall in our first model, R < l dy(1-v).
In this case, competition can cause the whole
microlending enterprise to become unprofitable and
unsustainable.
This is what seems to have happened in Russia (1998),
Ecuador (1999-2000), Bolivia (1999-2001) and
Argentina (1999-2002), India (Andhra Pradesh, 2010)
Competition and Efficiency
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Vogelgesang (2003, World Development 31: 2085-2114) looked at
competition and loan repayment performance for Caja Los Andes. He
found that competition is related with multiple loan taking and higher
levels of borrower indebtedness. Although higher levels of borrowing
does lead to higher default, still, the probability of timely repayment is
high in areas where there is high competition and high supply of
microfinance services.
A recent study looked at data from 362 MFIs in 73 countries for the
period 1995-2009. They found that intense competition is, overall,
negatively associated with performance of MFIs.
“As a number of competing MFIs increase in a market, which makes
information sharing between them challenging, borrowers may engage in
multiple borrowing which increases the debt level of clients and the
probability of default. This in turn can make worse off borrowers with a
single lender since this behaviour will create an externality by inciting MFIs
to respond to multiple borrowing by adjusting interest rates upward.”
Esubalew Assefa, Niels Hermes and Aljar Meesters, “Competition and
Performance of Microfinance Institutions,” 2010
Solutions to problems from competition
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Designing ways that makes sure MFIs do not
compromise lower lending standards for increased
market share.
Credit Bureaus: Designing ways that promote
information sharing between MFIs, so that a borrower
that defaults on one MFI loan could not turn to another
MFI in the neighborhood and be granted a loan
Promoting financial literacy among clients may help
them in their borrowing decisions, which in turn may limit
multiple loan-taking.
Frequent Repayment Installments
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Repayments in microfinance usually start immediately after the
loan is disbursed.
Even though there is a mismatch between the repayment
frequency and the borrower’s cashflow, there are some
advantages:
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It provides an early warning system of potential default.
It helps the lender select less risky clients – the only way to make
payments even before the business starts paying off is if the
borrower has access to other sources of capital
Reduces incentives for borrowers to use cashflows for other nonproductive purposes, in the absence of savings facilities
Regular repayments are difficult to impose in areas with highly
seasonal occupations, such as agriculture. Everybody (not just
the borrower) is exposed to this schedule of cashflows; there is
nobody to borrow from, in order to make initial payments.
Making Payments Public
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Social stigma can be used as an inducement to
repay.
Meeting a cluster of borrowers simultaneously can
reduce collection costs.
Group meetings can facilitate financial education
Group meetings can elicit information about errant
borrowers.
On the other hand, this may increase tension among
individual borrowers or create incentives to collude.
Questions
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Is there a difference between Bangladesh and New
York?
Between New York and Omaha?
What are the specific features of Grameen USA
microfinance loans that reduce the problems of
individual lending?