Microfinance: directed lending that works

I cheer the upsurge of microfinance in the last decade. Mohammed Yunus of Grameen Bank in Bangladesh first demonstrated the value or organizing poor women into self-help groups (SHGs), with the group guaranteeing repayment by any member. These microfinance groups proved capable of borrowing and repaying small loans with no subsidy: they could tolerate interest rates of 20 per cent plus needed to compensate for the high transactions costs of small loans.

Grameen inspired dozens of microfinance institutions in India. State governments and commercial banks have now got into the act in a big way, utilizing refinance from NABARD. Indian SHGs probably exceed one million in number today.

Do-gooders will cheer, but hard-nosed economists may demur. Is not NABRD-financed microcredit a form of directed credit, one of the discredited pillars of the neta-babu raj? Is microfinance an inefficient system sustained by hidden subsidies, such as donations to NGOs and cheap finance from NABARD and the World Bank?

This is a serious question deserving a serious reply. Recent research (Aghion and Murdoch, 2003) lists strong theoretical grounds why microfinance is economically efficient.

Grameen Bank originally organised borrowers into groups of five. One banker would simultaneously meet eight groups of five each, reducing transactions costs. The original Grameen model did not ask group members to guarantee repayment by individual borrowers. Rather, it disqualified all members from credit if one member defaulted. This provision proved a strong incentive for the group to press individual borrowers against default. The model worked even without group guarantees that other NGOs and banks have insisted on.

Some researchers (Ghatak 2000, Aghion and Collier 2000) argue that SHGs overcome several problems faced by traditional banks. First, pooling itself reduces lending risks. If a normally safe but unlucky borrower cannot repay, fellow-members will typically bear the burden. This may impose a high cost on the rescuers, but reduces costs for the lender, and hence for SHGs overall.

Second, bankers have little knowledge of which borrowers in a village are safe and which risky, and so charge the same high rate to all borrowers . But villagers know who is risky and who is safe. The safe borrowers will band together to form SHGs that keep out risky ones. Risky borrowers will be forced to form their own associations, which will default oftener and so pay higher default fees and other penalties. So, although the safe and risky groups initially face the same borrowing terms, in practice the safe groups will pay lower effective interest rates. Some of the risk of lending to lending to risky borrowers is transferred to the borrowers themselves, improving economic efficiency.

Third, safe borrowers that repay are then entitled to borrow again on a larger scale, while defaulters are cut off. This increases the proportion of credit flowing to safe borrowers, without any extra supervisory costs, in a virtuous cycle.

Fourth, a typical “adverse selection” problem in all lending is that the very availability of easy credit can tempt borrowers to undertake high-risk ventures that they would normally avoid. Borrowers in villages have little collateral that can be seized. Banks have in practice found it impossible to seize land offered as collateral—villagers resist by force, with tacit police approval. So borrowers may be tempted to borrow for very risky ventures. Stiglitz (1990) shows that SHGs put pressure on individuals to avoid risky ventures, since the whole group suffers if the venture fails.

Fifth, the group approach also reduces moral hazard (the tendency of borrowers to become imprudent in managing investments when they feel they need not repay). Group members will, at their own cost, monitor the project for which they have given group guarantees, and press the borrower to handle his assets diligently and prudently. These efficiency gains allow the lender to reduce interest rates further.

A final benefit is the reduction of moral hazard after the event. Even if a micro-loan is successfully used, the borrower has an incentive to default willfully. But other members will monitor ability to pay, and press for timely repayment. Defaulter will suffer social sanctions, which in a village setting constitute substantial penalties.

In sum, there are good theoretical reasons to believe that group lending is far more efficient than conventional bank lending to individuals. Group lending overcomes problems arising from the asymmetry of information between borrowers and lenders. It also creates mechanisms that transfer the cost of monitoring and suasion from the lender to the group.

But perhaps the greatest efficiency gain comes from gender focus. Overwhelmingly, microfinance goes to associations of women. Historically, banks have targeted men, who typically own land and handle monetary transactions. But Grameen (and its Indian imitators) have focused on women, and reaped huge direct and indirect gains.

Women are more conservative and prudent in spending habits than men, and less inclined to go for risky ventures. A Bangladesh study (Khandker, 1995) showed that 15% of male borrowers missed at least one payment, but less than one per cent of women. Why? Because women have fewer economic and social options than men. Microcredit provides a hugely valuable escape from the normally financial and social tyranny that women are subject to, and this greatly improves their incentive to repay.

Besides, much research shows that women are more likely to spend money on family health and education, garnering long-term efficiency gains.

In sum, free market ideologues need to temper their rhetoric on directed lending. A lot of directed lending is indeed wastefully and hugely inefficient. But microfinance is a form of directed lending that greatly improves efficiency. It overcomes a host of market inefficiencies (mostly moral hazard and adverse selection) and social inefficiencies (discrimination against women) that plague conventional lending. This is hard-nosed economics, not the bleeding-heart variety.

This is what Finance Minister Chidambaram needs to focus on, rather than simply forcing banks to lend more for agriculture. The bankruptcy of rural cooperative banks is testimony to the hazard of giving large loans to male farmers.

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