group lendingprimer

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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

January 07 IIMB Microfinance Group 2

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The Principal-Agent Relationship

• PRINCIPAL [Uninformed]

• AGENT [Informed] view of “contracts”

• Moral Hazard: Fire insurance example

• Adverse Selection: Health insurance example


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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


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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]


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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


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ADVERSE SELECTIONIllustration 1.1: Individual Lending-

Sensitivity• Fraction of Safe borrowers in the population

40%

• Probability that a Risky borrower is successful 50%


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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


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ADVERSE SELECTIONIllustration 1.2: Individual Lending-

Sensitivity• Risky Borrower: Gross revenue if

successful 267

• AND Probability of success 75%


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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]


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EX ANTE MORAL HAZARDIllustration 2.1: Individual Lending-

Without CollateralIF

– 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


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Without Collateral -Sensitivity

• Cost to borrower of effort 0.30

• Profit to borrower with effort 2.0

• Probability of positive profit without effort 80%


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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


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With Collateral-Sensitivity

• Borrower's collateral 50%


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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


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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


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EX POST MORAL HAZARDIllustration 3.1: Individual Lending with Possible Collateral-Sensitivity

• Borrower's collateral 140%


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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

group lendingprimer

Economy & Finance