Credit where Needed — Lending to the Poor

To argue that banking cannot be done with the poor because they do not have collateral is the same as arguing that men cannot fly because they do not have wings. — Muhammad Yunus

How does one get rich? If economic theory is to be believed, the standard way is to save money, and reinvest it in profitable avenues. Over time, the stock of wealth increases. If people don’t have enough savings, but have guaranteed earnings, they can take loans to achieve the same result. But what can poor people do, who neither have access to conventional banks or assets, nor guaranteed earnings, how do they escape the trap of poverty? Here’s where microfinance steps in. Interestingly, they are attempting to use a form of peer pressure to overcome the aforementioned issues.

Microfinance differs from conventional banking as it doesn’t generally require collateral. They also tend to serve the untapped segment of the market, places where access to banks are not available. Previously, these segments were served by moneylenders, who tended to charge exorbitant rates of interest in the absence of competition. Microfinance lending changed all that, by lending at normal rates with flexible repayment dates, keeping in mind the erratic, seasonal nature of income in these areas. However, like any other institution, they also needed to break even at the minimum to sustain themselves. Certain innovations were clearly required to achieve this.

Joint Liability Lending was pioneered by the Grameen Bank of Bangladesh. The concept is extremely simple — loans are given to groups of people, not individuals. They are all jointly responsible for the repayment of the loan. While it seems simple in principle, it is an idea that has generated a lot of attention on whether it is effective.

Why it’s such a radical Idea

The lack of collateral makes loans extremely risky — if the customer defaults, there is no way for the lender to get his money back. This is why traditional banks have historically stepped away from this market. Microfinance institutions have found an innovative way to sidestep this — using ‘social capital’. Villages tend to have extremely strong social networks based on trust and reputation. However, if one member of the group defaults on payment, the entire group is considered as defaulters. Grameen Bank and other advocates of the Joint Liability scheme claim that repayment rates are significantly higher. Before verifying this, we move to an important reason advocates of group lending believe Joint liability works — Selection bias.

Selection Bias

Place yourself in this situation — if you have to do a project in a course and the marks you obtain would be the average of your group, who would you team up with? You’d team up with the people who tend to score highest, maximising your own score. In theory, groups should be formed in a similar way, where there is self-selection of group members. If there is someone who is financially unstable, he or she is less likely to be selected in the group by peers, leading to a form of self-selection. This ensures that groups form in such a way as to minimise the risk of default, requiring less resources from the microfinance institution to check credit-worthiness. The low overhead cost of verification also allows them to charge low rates of interest.

Why is this likely to work in rural contexts? This is where social collateral comes into play. In rural settings, villagers tend to be informed about the happenings of their neighbour’s households. This includes their knowledge about the sources of income and financial status. In places like these, it is easier for one to form groups so as to minimize default. Similarly, the importance of social stature is very important here, and hence the stigma of default also plays a major role in minimizing defaulters.

What could weaken the idea of selection? We have established that the selection of group members is not random; it is based on knowledge of other’s financial status. However, in places where caste is such a crucial element of life, is there significant inter-mixing of castes within a group? If there is, it probably hints at lowering default risk as the main aim of forming groups. (Alternatively, it could also simply be because villages have mixed communities). But if there isn’t inter-mixing, caste would seem to be playing a strong role in selection, similar to how one would choose friends in their group to do projects, even if it lowers their score.

I worked on a microfinance dataset of micro loans in Tamil Nadu, and the results of over 1000 groups of 5 people established that caste is a major determinant of group members.

Clearly, members of the same caste tend to group together, weakening the hypothesis that self-selection will ensure that groups will form so as to minimise default risk. Similar results are seen with religion. Clearly, this must be taken into consideration by microfinance institutions while designing loan packages. An interesting sub-topic not explored here would be whether some castes are ‘safer’ borrowers than others, which could indirectly establish financial status of different castes.

So does it really work?

Grameen Bank has long established that Group Lending is an inspired idea, giving proof that social collateral is an effective deterrent. The data on Tamil Nadu villages shows similar results.

The company issued both single loans (denoted by 0, blue bar) and Joint Liability Loans (denoted by 1, green bar) over a period of time to different customers. The black line demarcates the average number of ‘late’ payees across both categories. Clearly, single loanees tend to be late significantly more often than group payees. These results show a strong correlation between peer pressure and repayment activity.

Where this leads us

The results are extremely significant in the context of poverty traps and capacity building. Several theories on why poverty exists, point to the fact that there are ‘traps’ — lack of income without avenues to save it leads to a lack of capacity building in terms of nutrition, which causes low productivity. This low productivity again leads to low levels of income. Clearly, access to formal credit could help them break out of this loop, by allowing them to invest in long-term activities like building infrastructure or planting productive agriculture. While there are doubts on the efficiency of microfinance in achieving this goal, it has definitely been useful.

If microfinance can spread into the hinterland, we have a very good chance to eliminating poverty quicker, while building up productive capacity along the way. Joint Liability Lending seems like the model that is most successful today in these areas, despite the inherent challenges it faces. Time will tell whether this peer pressure will lead to a brighter future.

Reference:

‘Group Lending, repayment incentives and social collateral’. Timothy Besley, Stephen Coate. Journal of Development Economics.

Cover Image Source: Grass, by Elizabeth Lies.

Originally published at www.freelunch.co.in.