Academic journal article Economic Inquiry

Group Size and Social Ties in Microfinance Institutions

Academic journal article Economic Inquiry

Group Size and Social Ties in Microfinance Institutions

Article excerpt

I. INTRODUCTION

In recent years microfinance institutions (MFIs) have become one of the most important instruments in development policy. The idea of microfinance arose in the mid-1970s when Mohammad Yunus started a pilot scheme lending small amounts of money to villagers in Bangladesh who, due to a lack of collateral, had no access to conventional loans. Encouraged by high repayment rates, he founded the Grameen Bank to run such schemes on a larger scale. Today the Grameen Bank lends to more than 2 million people. Since Grameen's early successes, the concept of microcredits has spread throughout the world, and a plethora of organizations providing small loans to the poor have come into being. (1) MFIs are most widespread in less developed countries, although they are by no means confined to them. Microlending programs have also been introduced in transition economies like Bosnia and Russia and even in Western economies like Canada and the United States. (2) There are more than 5 million households served by microcredit schemes in the world today.

Prior to the microfinance revolution, poor people's opportunities to take up loans had been severely limited for several reasons. First, poor households cannot offer collateral to back up their loans, because they own too few substantial possessions. Second, the potential addressees of small loans in less developed countries often live in remote rural villages beyond the reach of the traditional banking system. Third, although loans needed for individual projects are small, their myriad nature makes monitoring and enforcement costs prohibitively high. Poor villagers' only access to credit had been through non-commercial development programs that provided subsidized credit. However, because these schemes faced the same monitoring difficulties as traditional banks, they often suffered from poor repayment rates and high costs and were typically doomed to failure for that reason.

MFIs use innovative means to overcome these problems. Though the individual schemes differ vastly in their concrete implementations, most of them share some main characteristics, the most prominent of which is that of group lending. (3) In a typical microfinance scheme, borrowers with individual risky projects form groups that apply for loans together. The whole group is liable if one or more group members default. Thus, joint liability provides an insurance against individual risks. Even if an individual project fails and some of the borrowers are unable to repay, the group as a whole might still be able to do so. In this sense, joint liability serves as a substitute for collateral. Unless the individual risks are perfectly correlated, the overall risk of involuntary nonrepayment can be substantially lower than with individual borrowing.

Compared with traditional credit programs in less developed countries, microcredit schemes have proved to be a great success. Repayment rates leaped to levels previously unseen in less developed regions. Grameen reports repayment rates of more than 90%; other programs replicated such figures. However, the story is not without blemish: Although many were successful, numerous MFI programs have failed to live up to their promise (see, e.g., Conlin 1999). Furthermore, the ultimate goal of establishing sustainable credit schemes for the poor has not been reached, and most programs still rely on subsidies and donations.

To improve the performance of microlending, it is vital to improve the design of these schemes. Among practitioners as well as academic scholars, there is a heated debate on the appropriate design of their key features. Lending to groups involves a fundamental dilemma: It may insure the credit against involuntary defaults, but individual borrowers' reliance on fellow borrowers to repay the loan gives the former an incentive to free ride. Indeed, if the success of an individual project is not sufficiently verifiable by other group members, the dominant strategy for each individual is to shirk and hold others liable for own default. …

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