ROSCAs and Credit Cooperatives September 2007 () ROSCAs September - PowerPoint PPT Presentation

ROSCAs and Credit Cooperatives September 2007 () ROSCAs September 2007 1 / 24

There is a wide spectrum of indigenous …nancial institutions , ! family and friends , ! ROSCAs , ! credit cooperatives , ! moneylenders Understanding ROSCAs and credit cooperatives helps to undertand costs and bene…ts of group lending , ! also emphasizes link to savings constraints (not just credit problems) () ROSCAs September 2007 2 / 24

Rotating Savings and Credit Associations (ROSCAs) Also known as tontines (Africa), hui (Taipei), tanda (Mexico) Very common throughout the world and very important , ! 40% of micro…nance borrowers in Indonesia , ! funds involved equal 10% of GDP in Ethiopia (1977) , ! 1/2 of rural residents in Cameroon, Cote d’Ivoire, Congo, Liberia, Togo and Nigeria , ! 1/5 of Taiwanese population (1977-95) Several alternative structures: , ! pre-determined order ROSCA , ! random ROSCA , ! bidding ROSCA () ROSCAs September 2007 3 / 24

Characteristics "Local" institution (neighboourhood, workplace) Varying membership: e.g. 5 to 100 in Bangladesh (Rutherford 1997) Varying pot size (e.g. $25 to $400 in Rutherford’s survey) Indivisible goods (e.g. school fees, rent, medical costs, equipment) () ROSCAs September 2007 4 / 24

A Simple Model of a Random ROSCA Number of individuals = n Preferences at each date � v ( c ) without indivisible good U = v ( c ) + θ with indivisible good where � c if c � c v ( c ) = � ∞ if c < c y = monthly income B = cost of indivisible good T = planning horizon t = acquisition date (endogenous) () ROSCAs September 2007 5 / 24

Problem faced by individual outside ROSCA Constrained maximization problem: max tc + ( T � t ) ( y + θ ) c , t subject to c � c t ( y � c ) � B Constrained maximum is where c = c and B t � = y � c Utility of agent is � � B B U A = c + ( T � y � c ) ( y + θ ) y � c () ROSCAs September 2007 6 / 24

c Savings Constraint c t () ROSCAs September 2007 7 / 24

Increasing c Utility Savings Constraint c t () ROSCAs September 2007 8 / 24

c Savings Constraint c Constrained Maximum t t* () ROSCAs September 2007 9 / 24

Problem faced by ROSCA participant Let n = number of periods that cycle lasts If agent ends up being the i th receiver of the pot, her utility is = ic + ( n � i )( c + θ ) + ( T � n )( y + θ ) u i = nc + θ ( n � i ) + ( T � n )( y + θ ) Her (ex ante) expected utility of joining the ROSCA is then n 1 ∑ = U R u i n i = 1 � � n � n + 1 = nc + θ + ( T � n )( y + θ ) 2 () ROSCAs September 2007 10 / 24

Optimal design of ROSCA so that c = c and B n � = y � c and so � � � � n � � n � + 1 B B U R = c + ( T � y � c ) ( y + θ ) + θ y � c 2 � � n � � n � + 1 = U A + θ 2 Example illustrates the "early pot motive": , ! even though saving pattern is unchanged, ROSCA participation gives each member the chance of receiving pot early () ROSCAs September 2007 11 / 24

Enforcement What stops a member who has received the pot early from reneging? , ! Kenya: place "least trustworthy" at end of cycle ) requires ex ante screening , ! ban past absconders , ! social sanctions Lack of alternative ways of saving keeps ROSCAs intact , ! most common response when asked why join , ! key feature of ROSCAs: do not require a place to store money e.g. Anderson and Baland (2003) () ROSCAs September 2007 12 / 24

Limits of ROSCAs In‡exible pot size , ! adding members ) hard to manage Do not introduce new funds into system from outside , ! "bidding ROSCAs": pot goes to member that bids the most , ! but problematic "bidding wars" during downturns () ROSCAs September 2007 13 / 24

Credit Cooperatives Modi…cation of ROSCA that allows some participants to mainly save and others to mainly borrow Old idea going back to 1850s rural Germany (Friedrich Rai¤eissen) , ! by 1910, there were 15,000 institution serving 2.5 million people (9% of German banking market) Spread to Madras and Bengal (India) in the 1890s. By 1946 membership exceeded 9 million () ROSCAs September 2007 14 / 24

Key features Credit cooperatives di¤er from ROSCAs in several ways: , ! members do not have to wait their turn to borrow , ! participants (savers and borrowers) are all shareholders , ! key decisions (interest rates, loan size) determined democratically In the Rai¤eisen model (Prinz, 2000): , ! members were from same local parish , ! unlimited liability: defaulters lose all current assets , ! low income borrowers could not be discriminated against , ! cooperative performed other functions (e.g. purchasing of inputs) , ! extended short and long term loans () ROSCAs September 2007 15 / 24

Credit Cooperatives as a Vehicle for Saving Saver-borrowers each with initial wealth w Two ways of saving: (1) inside the cooperative yields gross interest θ (2) another commercial bank in the city yields θ � δ Each member has access to a project with unit cost and � y with probability e output = 0 with probability 1 � e where ε < e < 1 and cost of e¤ort = Ce , ! assume that θε < θ � δ In case of failure borrowers loses wealth invested in cooperative, plus a non-monetary sanction Gross interest rate on loans = r Timing: (1) borrowers decide how much to invest, and (2) given investment, how much e¤ort to provide () ROSCAs September 2007 16 / 24

Optimal choices Given w i borrower chooses e¤ort e to maximize payo¤ U B = e ( y + θ w i � r ) + ( 1 � e )( � H ) � Ce = e ( y + θ w i � r + H � C ) � H , ! it follows that � 1 if y + θ w i � r + H � C e ( w i ) = ε if y + θ w i � r + H < C , ! probability of default is reduced if w i and/or H are high enough , ! critical wealth level: i = C + r � y � H w c θ () ROSCAs September 2007 17 / 24

Savings in cooperative, w i , chosen to maximize e ( w i ) ( y + θ w i � r ) � ( 1 � e ( w i )) H � Ce ( w i ) + ( θ � δ ) ( w � w i ) or e ( w i ) ( y + θ w i � r + H � C ) � H + ( θ � δ ) ( w � w i ) , ! it follows that the optimal level of saving in the cooperative is � w if w � w c w � i = if w < w c 0 since θε < θ � δ () ROSCAs September 2007 18 / 24

Implications Investing in the cooperative acts as a "commitment device" for the borrower , ! induces the borrower to minimize default probability and take advantage of higher (risk-adjusted) return on savings high social sanctions , H , and su¢ciently high relative return δ allow cooperative to mobilize savings higher return may also increase overall savings, w () ROSCAs September 2007 19 / 24

Credit Cooperatives as a form of Peer Monitoring Based on Banerjee, Besley and Guinnane (1994) Individual has an investment opportunity with cost F and � y with probability e output = 0 with probability 1 � e Competitive outside lender ) gross lending rate , R , must satisfy eR = r where r is opportunity cost of funds Bene…t from "shirking" depends on monitoring m : � � Bene…t from shirking = B ( e , m ) = 1 a � 1 2 e 2 m , ! assume outsider lender can only monitor at minimal level m () ROSCAs September 2007 20 / 24

Borrower chooses e to maximize � � U B = e ( y � RF ) + 1 a � 1 2 e 2 m , ! yields (constrained) optimal e¤ort e = m ( y � RF ) () ROSCAs September 2007 21 / 24

Simple (2 member) Credit Cooperative Now suppose borrower forms a cooperative with another individual This "insider" plays three roles: , ! partial lender, provides F � b , ! guarantor: promises w � rb to outside lender in case of default ) lender faces no risk and can o¤er rate r , ! monitor: can optimally adjust monitoring, m , subject to cost C ( m ) Why would the insider do this? , ! must receive a big enough share of pro…ts, α () ROSCAs September 2007 22 / 24

Optimal choice of e¤ort by borrower is now e � ( m ) = m ( 1 � α )( y � rb ) (IC) If cost of monitoring is C ( m ) = c 2 m 2 , ! insiders payo¤ is e � ( m ) α ( y � rb ) � ( 1 � e � ( m )) w � C ( m ) � r ( F � b ) U I = m ( 1 � α )( y � rb ) [ α ( y � rb ) + w ] � c 2 m 2 � w � r ( F � b ) = ) optimal monitoring level m � ( α , w ) = 1 c ( 1 � α )( y � rb ) [ α ( y � rb ) + w ] () ROSCAs September 2007 23 / 24

Implications In a credit cooperative, each non-borrowing member acts as a lender, guarantor and monitor , ! as guarantor, she reduces interest rate paid by borrower ) increased incentive to provide e¤ort , ! as monitor, the fact that insider has stake in project ) increased incentive to monitor ) induces more e¤ort Because of improved incentives, a well-designed credit cooperative can increase overall output , ! must choose the share, α , appropriately () ROSCAs September 2007 24 / 24