Group Lending and Enforcement October 2007 () Group lending - - PowerPoint PPT Presentation

Group Lending and Enforcement

October 2007

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Group Lending in Theory

Grameen I ("classic")

2:2:1 staggering at 4-6 week intervals 1 loan cycle = a year joint liability: formal sanctions in case of default initial small loan, growing with each loan cycle as credit history builds , ! eventually large enough for house repairs, or sending child to university

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Mitigating Adverse Selection

Can group lending make it possible to "implicitly" charge safe borrowers lower interest rates and keep them in the market? Joint liability ) incentive for "assortative matching"

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Example: 2 member group

One-period project requiring $1 investment Bank’s cost of $1 loan = k Fraction q of borrowers are "safe": gross return = y The remaining 1 q are "risky": Gross return = ¯ y with prob. p with prob. 1 p Indentical expected return: p ¯ y = y Borrowers know each others types, but lender doesn’t Assortative matching ) a fraction q of groups are (safe, safe)

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If both types of borrower are in the market, what is the break-even repayment, ˆ Rb? , ! assume that ¯ y is large enough that ¯ y > 2 ˆ Rb Then the probability of repayment by a risky pair is g = 1 (1 p)2 = 2p p2 > p since default occurs only if both members fail ) break even repayment: ˆ Rb = k q + (1 q)g This must be less than the minimum repayment without group lending Rb = k q + (1 q)p

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Implications

In this case risky borrowers can repay more often , ! risk is transferred from bank to risky borrowers , ! allows bank to lower interest rate and still break-even , ! safe types may be lured back into the market

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Ex ante Moral Hazard and Joint Responsibility

Based on Stiglitz (1990)

Can group lending induce borrowers to provide required e¤ort? Joint liability ) incentive for members to impose sanctions on each

• ther

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Example: 2 member group

Projects require $1 investment Non-shirker generates output y for sure Shirker generates

• utput =

y with prob. p with prob. 1 p Cost of providing e¤ort = c Gross interest rate = R Cost of funds to to lender = r

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Individual contract

Borrower’s IC constraint in individual contract: (y R) c p(y R) ) lender‘s maximum achievable lending rate R R = y c 1 p if R < r, this loan will not be made, even if y R > c

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Group contract

Assumption: group members act to maximize expected group income , ! any member that deviates can be "punished" y < 2r : if only one is successful, this is insu¢cient to cover sum of borrowing costs Borrowers’ IC constraint in group contract: (2y 2R) 2c

• p2(2y 2R)

(y R) c

• p2(y R)

) lender‘s maximum achievable lending rate R = y c 1 p2 > R If R > r > R, a shift to group lending contract allows this investment to go ahead

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Implications

Group lending relaxes IC constraint ) more projects will be funded Idea can be extended to situations where internal group sanctions are costly

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Enforcement and Peer Monitoring

Ex post moral hazard

Recall our simple dynamic lending–borrowing game with no saving , ! discount factor δ , ! borrower’s output is F(L) where F 0(L) > 0 and F 00(L) < 0 , ! i = net opportunity cost of funds to lender Now allow possibility of peer monitoring in group lending ) each borrower must pay o¤ debt of the other, if she reneges , ! cost of monitoring = k , ! probability of observing peer’s output = q , ! social sanction that can be applied to reneging borrower = d

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Individual Contract (benchmark)

Borrower’s incentive constraint: 1 1 δ [F(L) R] F(L) + δ 1 δv (IC) , ! lender’s maximum feasible repayment: R R = δ [F(L) v] Suppose v is so high that R < (1 + i)L, for all values of L ) complete credit rationing

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Group borrowing contract

Repayment only if 1 1 δ [F(L) R] F(L) q [R + d] + δ 1 δv (IC) , ! lender’s maximum feasible repayment: R R = δ [F(L) v] + (1 δ)qd 1 (1 δ)q , ! shifts IC constraint up Peer will monitor as long as expected gain exceed the cost qR k , ! introduces another constraint

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R L ZP IC0 IC1 k/q

Figure: Enforcement Constraints under group lending

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Implications

Joint liability can make lending sustainable by inducing peer monitoring and overcoming the enforcement problem Relies heavily on use of "social sanctions" , ! is this realistic ? , ! is this a good thing ?

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Group Lending in Practice

BRAC in Bangladesh (Montgomery, 1996) (1) group lending works against most vulnerable individuals (2) village-level group plays key role in repayment, not 5-member group , ! new borrowers may e¤ectively cover defaults of old Guatemala (Wydick, 1999) , ! social ties have little impact on repayment rates Thailand (Ahlin and Townsend, 2003) , ! in poorer regions (northeast) repayment rise with village level social sanctions , ! in wealthier regions (central) default rates increase with extent of joint liability , ! repayment rates decline with improvements in alternative borrowing sources

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FINCA in Peru (Karlan, 2003), Costa Rica (Wenner, 1995) , ! "social cohesion" matters for repayment rates , ! default rates higher in wealthier towns Calmeadow in Toronto and Halifax (Gomez and Santor, 2003) , ! default less likely if members trust and/or know each other Philippines (Gine and Karlan, 2006) , ! compare individual to group lending in controlled experiment , ! no impact on repayment rates

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Problems with Traditional Group Lending

Mixed results across countries re‡ects di¤erences in trade-o¤ between bene…ts and costs Groups may be di¢cult/costly for borrowers to set up Attending group meetings can be costly in some cases; bene…cial in

• thers

Transfers risk from bank to borrowers Beyond a certain lending scale, individual contracts may be preferred Collusion amongst borrowers

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Social sanctions for default often seem too harsh and/or not credible , ! what if the defaulter has trouble through no fault of her own? , ! punishment imposes a "deadweight loss" , ! Rai and Sjostrom (2004) propose "cross-reporting" , ! e¤ectively what often happens in practice Grameen II proposal , ! "basic loan" (variable duration, seasonal varyiation in installments) , ! then "‡exible loan" (easier terms, but small) if borrower gets in trouble , ! expulsion only if customer fails to repay this

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Beyond Group Lending

Emerging view: joint liability is often not the main key to success Shift toward individual lending for the "not so poor" Emphasis on dynamic incentives to induce repayment , ! e.g. proressive lending , ! a key element of Grameen bank lending

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Progressive Lending (two period example)

Invest L to get output y = AL > L Let δ = discount factor Let v = probability of being re…nanced despite default gross borrowing rate = R IC constraint for …xed L AL RL + δAL AL + δvAL ) lender’s maximum repayment: R = δA(1 v)

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Suppose loan grow by a factor λ > 1 between periods IC constraint AL RL + δλAL AL + δvAL ) maximum repayment R = δA(λ v) > R If R < r < R, loans will be made that previously weren’t

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Implications

Progressive lending can help to relax borrowing constraint But, in a multi-period context, borrower may choose to default one loan size becomes large enough

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Why Frequent Repayment Installments?

Creates an early warning system , ! but why require repayment before investment pays o¤? , ! and why impose this cost on the borrower? Provides lender with information about ability to repay independently

• f investment return

Valuable for households that have di¢culty holding on to savings , ! suggests that a key role of micro…nance is to substitute for lack of savings institutions Fequency should depend on context

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Complementary Incentive Mechanisms

Flexible approaches to collateral (i.e. not only land) , ! incentives to repay depend on threat of loss, not resale value to the lender Financial collateral , ! works like a credit cooperative: micro lender also holds savings Public repayment , ! uses threat of social stigma to induce repayment , ! reduces opportunities for fraud Targetting of women , ! empirical evidence suggests women are more reliable (not clear why) Cross reporting within groups , ! information from another group member as to why a loan is not being repaid

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