Microcredit: Is it limited to village economies? edit

Nov. 6, 2006

This year's Nobel Peace Prize was awarded to a former Professor of Economics, Muhammad Yunus, the inventor of group-lending microcredit in 1976. When the then Professor of Economics at Chittagong University, in Bangladesh, bet on the poor as being bankable individuals by creating the Grameen Bank, in the nearby village of Jobra, he extended tiny loans to poor individuals without collateral out of his own pocket. His motivation was to help such villagers to finance their investment projects, and, eventually, pull them out of poverty. His idea was a successful one, as Grameen replications mushroomed worldwide in the developing world and Eastern Europe, now reaching nearly seven million individuals living under the poverty line. What is exactly Yunus' innovative idea all about, and what made it replicable beyond Bangladeshi villages?

-->Soon after extending loans to poor individuals, Yunus realized that by requesting potential borrowers to get together into groups, the Grameen bank could gain economies of scale. Moreover, he also realized that by requesting potential group members to co-sign for each other's loans, the bank could also benefit in that the costs of screening and monitoring loans, and the costs of enforcing debt repayments could be substantially reduced, which will in turn enable the bank to charge relatively low interest rates. The reason is simple: under the threat of not being refinanced by the bank, unless all members of the group have repaid their loans, participant borrowers have an incentive to screen and monitor their partners, and inflict «social sanctions» upon those group members who do not put effort «adequate» levels of effort in their business and/or willingly default. Because relative to the bank, screening, monitoring, and sanctioning defaulters, is costless for villagers in close-knit societies, delegating such activities to groups of villagers entails what economists call «efficiency gains», which in this case boils down to generating more investment at lower costs from the talented poor.

The question, of course, is that one may argue that such costs and consequent interest rates may be exceedingly high in cities and sparsely populated regions where individuals have little information about each other, and may be reluctant to get together into groups, which in turn limits the scope for replicating Yunus's group-lending methodology beyond villages and close-knit societies. But this is clearly not the case, as Grameen replications abound in large cities, in sparsely populated Latin America, in Africa, and in many other regions. What made the Grameen model replicable in such diverse parts of the world? By digging deeper into the modus operandi of the Grameen Bank, one can shed light on a number of innovations which go beyond the group-lending methodology. These innovations were introduced by field practitioners, and the reminder of this essay will argue that such innovations have made the Grameen model replicable beyond close-knit villages, where participant borrowers have a wealth of information about their potential partners and can inflict penalties for default upon each other.

I shall focus on three innovations introduced by Grameen bank practitioners led by Yunus, and on a fourth one, introduced by practitioners in Indonesia. First, Grameen Bank practitioners introduced a «progressive lending» technique, which consists of lending larger amounts in subsequent loan cycles to those clients that kept a good repayment record. In so doing, the penalty from not being refinanced by the bank increases, and so does the incentive to repay provided, of course, that the bank keeps on increasing loan amounts for a sufficiently long period of time. So, when group-lending is not possible, Grameen-style banks can successfully introduce the progressive lending technique, as it is indeed the case in bilateral contracting between microlenders and individuals by many institutions in numerous countries around the world.

Second, Grameen Bank practitioners introduced a «public repayments» technique, which consists of requesting participant borrowers to make their repayment at a public meeting in a well-defined geographical area. This technique enables microlenders to use the avoidance of social stigma as an inducement for individual borrowers to repay their loans. Again, this strategy is used not just in Bangladesh, but also in numerous countries, most notably in Latin America.

Third, while Grameen Bank practitioners started lending to male and female borrowers, they soon found out that women were better clients, among other reasons, because relative to men, women have very limited sources of lending for financing their investments. The targeting of women became widespread. As recent figures from the Microfinance Bulletin show, as many as eighty percent of microlenders' clients are women. From a development economist's standpoint, lending to women has additional social benefits in that it helps to reduce gender inequalities on the one hand, and benefits a large population of poor households, where women are the main brokers of health and education, on the other.

These lending strategies have in turn helped microlenders in Latin America, Eastern Europe, and parts of Asia, to extend bilateral contracts to poor individuals without collateral, thereby promoting talented borrowers to take advantage of investment opportunities, which boost investment, growth and economic development.

As far as collateral is concerned, numerous microlenders, most notably the exceedingly successful Bank Rakyat in Indonesia (BRI), extend loans against rather peculiar types of collateral, such as land without certificate of title. This is largely due to the fact that like the BRI, for many microlenders throughout the developing world and Eastern Europe, collateral has a «notional» value in that it reflects borrowers' intent to repay.

Financial collateral, notably in the form of savings, is also accepted by numerous microlenders, which in turn has forced a large number of development economist to review the common perceptions on the poor as individuals that are incapable of saving, when in fact they can, albeit in a rather special way. In particular, the poor wish to save tiny amounts on a regular basis, sometimes daily or weekly. Because a growing number of banks for the poor view those savings as being more valuable for the poor than for the banks themselves, such savings both help to sustain high repayment rates while delivering a service to the growing demand for small savings in poor economies. To most observers, the focus on savings and, more recently, on insurance, reflects the growing demand by the poor of other financial services, which go beyond credit. Because those demands are increasingly being met, banking for the poor is no longer called microcredit. It is called microfinance instead.

But the idea of offering credit and collecting savings brings us closer to the way commercial banks operate, except for the fact that those savings by the poor are largely viewed as collateral, and are generally not intermediated by microfinance institutions, which still need outside sources of lending in order to meet the demand for credit by the talented poor. Interestingly, those outside sources of credit are not necessarily from donors, but from commercial banks, as microfinance is showing that it is both serving the poor, and that it can be profitable!

One should note, however, that savings and credit institutions for disadvantaged individuals are not alien to industrialized countries. In particular, Raiffeisen's cooperatives, initiated in 19th century Germany are well-known in Western Europe and North America, which host a large number of poor people too. Thus, why not revive and/or modernize such institutions for boosting the microfinance industry in the developed world? This may seem like a risky bet for commercial bankers in industrialized countries, but as Yunus's one, this bet may be a bet worth taking.