Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Group Lending and Financial Intermediation: An Example

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Group Lending and Financial Intermediation: An Example

Article excerpt

Imagine a small group of people, each of whom borrows money from a financial intermediary. The intermediary does not require collateral because the borrowers are relatively poor and do not own much property. Instead, the intermediary requires group members to be jointly liable for each other's loans. That is, if a member defaults on a loan, the rest of the group is liable for the remainder of the loan. If the group does not honor this joint obligation, then the entire group is cut off from future access to credit.

The lending arrangement I just described is not fictitious. Two million villagers, most of whom are female and poor, borrowed in this way from the Grameen Bank in Bangladesh. In Bolivia, 75,000 urban entrepreneurs, roughly one-third of the banking system clientele, borrowed money via group loans from BancoSol. Even in nineteenth-century Ireland, many rural residents took out loans similar to group loans.

Motivated in part by group lenders in less-developed countries, organizations in the United States have developed similar programs. The 1996 Directory of U.S. Microenterprise Programs lists 51 organizations that issue group loans. The programs operate in both rural and urban areas. Often they are run by nonprofit organizations.

The underlying idea of group lending is to delegate monitoring and enforcement activities to borrowers themselves. Borrowers who know a lot about each other, such as those who live in close proximity or socialize in the same circles, are the most promising candidates for group lending. For example, the rural villages that Grameen lends in would seem ideally suited for group lending, because they are relatively self-contained communities, and people live close to each other and interact regularly. In such an environment, residents should be better than outsiders at assessing and monitoring the creditworthiness of fellow residents. They should also be better able to apply social pressure on potential defaulters.

The first goal of this paper is to analyze group lending, particularly as a potential method for lending to the poor in the United States. Studying alternatives to traditional lending is important because there is economic evidence that the poor in the United States have an unmet demand for finance. Zeldes (1989) finds that the poor are borrowing-constrained; that is, they would like to borrow more money at existing rates than they can. Evans and Jovanovic (1989), even after accounting for possible correlation between entrepreneurial ability and wealth, find that the lack of wealth affected the poor's ability to engage in self-employment activities. Bond and Townsend (1996), reporting on the results of a survey of financial activity in a low-income, primarily Mexican neighborhood in Chicago, find that bank loans are not an important source of finance for business start-ups. In their sample, only 11.5 percent of business owners financed their start-up with a bank loan. Furthermore, 50 percent of the respondents financed their start-up entirely out of their own funds.

Two services provided by financial intermediaries are delegated monitoring and asset transformation. Banks provide both of these services and, maybe surprisingly, groups do too. Group members monitor each other and through joint liability, transform the state-contingent returns of its members' loans into a security with a different state-contingent payoff. Consequently, groups can be interpreted as financial intermediaries, albeit small ones.

Interpreting groups as financial intermediaries is an important part of my second goal: to place group lending in the context of the rest of the financial intermediation sector. In this paper, groups have a comparative advantage at some types of financial intermediation. Understanding comparative advantage and specialization in financial intermediation to the poor is important because it can help answer questions such as: Which financial intermediary is best at what activity? …

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