Group Lending and Enforcement October 2007 () Group lending October 2007 1 / 26
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 () Group lending October 2007 2 / 26
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" () Group lending October 2007 3 / 26
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": � ¯ y with prob. p Gross return = 0 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) () Group lending October 2007 4 / 26
If both types of borrower are in the market, what is the break-even repayment, ˆ R b ? y > 2 ˆ , ! assume that ¯ y is large enough that ¯ R b Then the probability of repayment by a risky pair is 1 � ( 1 � p ) 2 g = 2 p � p 2 > p = since default occurs only if both members fail ) break even repayment: k ˆ R b = q + ( 1 � q ) g This must be less than the minimum repayment without group lending k R b = q + ( 1 � q ) p () Group lending October 2007 5 / 26
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 () Group lending October 2007 6 / 26
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 other () Group lending October 2007 7 / 26
Example: 2 member group Projects require $1 investment Non-shirker generates output y for sure Shirker generates � y with prob. p output = 0 with prob. 1 � p Cost of providing e¤ort = c Gross interest rate = R Cost of funds to to lender = r () Group lending October 2007 8 / 26
Individual contract Borrower’s IC constraint in individual contract: ( y � R ) � c � p ( y � R ) ) lender‘s maximum achievable lending rate c R � R � = y � 1 � p if R � < r , this loan will not be made, even if y � R > c () Group lending October 2007 9 / 26
Group contract Assumption: group members act to maximize expected group income , ! any member that deviates can be "punished" y < 2 r : if only one is successful, this is insu¢cient to cover sum of borrowing costs Borrowers’ IC constraint in group contract: p 2 ( 2 y � 2 R ) ( 2 y � 2 R ) � 2 c � p 2 ( y � R ) ( y � R ) � c � ) lender‘s maximum achievable lending rate c R �� = y � 1 � p 2 > R � If R �� > r > R � , a shift to group lending contract allows this investment to go ahead () Group lending October 2007 10 / 26
Implications Group lending relaxes IC constraint ) more projects will be funded Idea can be extended to situations where internal group sanctions are costly () Group lending October 2007 11 / 26
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 () Group lending October 2007 12 / 26
Individual Contract (benchmark) Borrower’s incentive constraint: 1 δ 1 � δ [ F ( L ) � R ] � F ( L ) + 1 � δ v (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 () Group lending October 2007 13 / 26
Group borrowing contract Repayment only if 1 δ 1 � δ [ F ( L ) � R ] � F ( L ) � q [ R + d ] + 1 � δ v (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 () Group lending October 2007 14 / 26
R ZP IC 1 IC 0 k/q L Figure: Enforcement Constraints under group lending () Group lending October 2007 15 / 26
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 ? () Group lending October 2007 16 / 26
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 () Group lending October 2007 17 / 26
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 () Group lending October 2007 18 / 26
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 others Transfers risk from bank to borrowers Beyond a certain lending scale, individual contracts may be preferred Collusion amongst borrowers () Group lending October 2007 19 / 26
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 () Group lending October 2007 20 / 26
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 () Group lending October 2007 21 / 26
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 + δ AL � AL + δ vAL ) lender’s maximum repayment: R � = δ A ( 1 � v ) () Group lending October 2007 22 / 26
Suppose loan grow by a factor λ > 1 between periods IC constraint AL � RL + δλ AL � AL + δ vAL ) maximum repayment R �� = δ A ( λ � v ) > R � If R � < r < R �� , loans will be made that previously weren’t () Group lending October 2007 23 / 26
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 () Group lending October 2007 24 / 26
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 of 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 () Group lending October 2007 25 / 26
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