The Economics of Group Lending

1. The Economics of Group Lending This is completely based on The Economics of Microfinance (2005) Beatriz Armendáriz de Aghion & Jonathan Morduch The MIT Press, Cambridge, Massachusetts

2. The Principal-Agent Relationship • PRINCIPAL [Uninformed] • AGENT [Informed] view of “contracts” • Moral Hazard: Fire insurance example • Adverse Selection: Health insurance example IIMB Microfinance Group

3. Understanding Credit Using the Principal-Agent Relationship • The Principal is • The MFI • The Agent is • The Borrower • The MFI can choose individual or group lending technologies IIMB Microfinance Group

4. Basic Assumptions: “No-fat” model • Assume MFI is in a competitive market: Would like to charge an interest rate that covers cost of funds, operating expenses and possible default • Borrower either Safe Type [invests in Month 0 in specific project and earns income with certainty in Month 1] OR • Risky Type [invests in Month 0 in specific project and either earns a higher income than Safe in Month 1 or earns zero income • Unless otherwise explicitly assumed, borrowers have no collateral–loan repayment [principal+interest] has to be made out of income from the specific project] IIMB Microfinance Group

5. ADVERSE SELECTIONIllustration 1.1: Individual Lending IF • An MFI faces a potential client group that includes both Safe and Risky borrowers • Cannot distinguish between them • And wishes to sanction individual loans THEN • The MFI will have to increase its interest rate to take care of possible defaults by Risky borrowers. The interest rate will depend on: • The fraction of Safe borrowers • The probability that Risky borrower is successful IIMB Microfinance Group

6. ADVERSE SELECTIONIllustration 1.1: Individual Lending-Sensitivity • Fraction of Safe borrowers in the population 40% • Probability that a Risky borrower is successful 50% IIMB Microfinance Group

7. ADVERSE SELECTIONIllustration 1.2: Individual Lending IF • An MFI faces a potential client group that includes both Safe and Risky borrowers • Cannot distinguish between them • And wishes to sanction individual loans THEN • The interest rate the MFI has to charge may become so high that Safe borrowers no longer wish to borrow, and the MFI is left with only Risky borrowers IIMB Microfinance Group

8. ADVERSE SELECTIONIllustration 1.2: Individual Lending-Sensitivity • Risky Borrower: Gross revenue if successful 267 • AND Probability of success 75% IIMB Microfinance Group

9. ADVERSE SELECTIONIllustration 1.3: Group Lending IF • An MFI allows potential borrowers to form groups with joint liability • The bank offers all groups the same interest rate • AND potential borrowers know each other’s type [Safe OR Risky] THEN • Borrowers sort themselves into groups: The Safe partner with other Safe and the Risky with other Risky • Also although the bank charges all groups the same interest rate, the Risky end up paying more than the Safe [a well-deserved fate] IIMB Microfinance Group

10. EX ANTE MORAL HAZARDIllustration 2.1: Individual Lending-Without Collateral IF • An MFI has lent money to an individual without collateral • The borrower can choose • To expend effort and earn an income with certainty • Or “slack” and either earn a positive income or earn zero THEN • Beyond a certain interest rate the borrower will choose NOT to expend effort but to slack • If this interest rate is less than the rate that covers the MFI’s cost, the MFI may find it optimal NOT to lend IIMB Microfinance Group

11. EX ANTE MORAL HAZARDIllustration 2.1: Individual Lending-Without Collateral -Sensitivity • Cost to borrower of effort 0.30 • Profit to borrower with effort 2.0 • Probability of positive profit without effort 80% IIMB Microfinance Group

12. EX ANTE MORAL HAZARDIllustration 2.2: Individual Lending-With Collateral IF • An MFI has lent money to an individual with collateral • The borrower can choose • To expend effort and earn an income with certainty • Or “slack” and either earn a positive income or earn zero THEN • Even if the MFI charges a higher interest rate than in Illustration 2.1, the borrower may choose to expend effort IIMB Microfinance Group

13. EX ANTE MORAL HAZARDIllustration 2.2: Individual Lending-With Collateral-Sensitivity • Borrower's collateral 50% IIMB Microfinance Group

14. EX ANTE MORAL HAZARDIllustration 2.3: Group Lending IF • An MFI has lent money to individuals who are members of a group with joint liability • Each borrower can choose • To expend effort and earn a certain income • Or “slack” and either earn a positive income or earn zero THEN • Even if the MFI charges a higher interest rate than in Illustration 2.2, the borrowers may choose to expend effort • More importantly, the borrowers may not “slack” at all IIMB Microfinance Group

15. EX POST MORAL HAZARDIllustration 3.1: Individual Lending with Possible Collateral IF • An MFI has lent money to an individual with possible collateral [less than the total repayment of principal+interest] • The borrower invests in a successful project that earns income with certainty • The borrower can choose either to repay or default • The collateral is seized if the default is detected by the MFI THEN • Then the borrower will default if the interest rate is set too high • The MFI may decide not to lend IIMB Microfinance Group

16. EX POST MORAL HAZARDIllustration 3.1: Individual Lending with Possible Collateral-Sensitivity • Borrower's collateral 140% IIMB Microfinance Group

17. EX POST MORAL HAZARDIllustration 3.2: Group Lending IF • An MFI has lent money to individuals who are members of a group with joint liability • A group member can monitor peer at a cost, possibly observe the actual income of peer and apply “sanctions” if borrower tries to default THEN • The threat of sanctions may reduce default depending on • The monitoring cost • The probability of observing actual income of peer • The value of social sanctions imposed on defaulter IIMB Microfinance Group