microfinance and ROSCAs P.V. Viswanath

ROSCAs Rotating Savings and Credit Associations (ROSCAs) are in the middle of a spectrum Informal loans from family/relatives on one end and (relatively formal) moneylenders on the other. Explains how group lending in microfinance works: How groups can help to reduce costs Mobilize funds Improve monitoring Deploy informal community-based enforcement mechanisms.

Basic Structure A group of individuals agree to regularly contribute money to a common “pot” that is allocated to one member of the group each period. For example, 20 people may agree to contribute $15 each for 20 months, generating a monthly pot of $300. At monthly intervals, the group meets to collect dues and allocate the proceeds, with past recipients excluded from getting the pot again until every member has had a turn with the $300 pot. Pot recipients can be chosen through a lottery or participants may be allowed to bid to get the pot, with profits shared by the entire group.

Basic Structure ROSCAs are, thus, also in the middle of another spectrum Borrowing (lumpsum inflow first –used for spending – and then periodic outflows afterward) Saving and spending (periodic outflows first and then lumpsum inflow afterward – for spending). They take bits of surplus funds that come into households and translate those bits into a large chunk that can be used to fund a major purchase.

Advantages Clear beginning and end of the enterprise Accounting is straightforward (one only has to keep track of who has received the pot already and who is in line to do so) Storage of funds is not required since the money that is collected each period goes directly to that period’s recipient. Neighborhood institutions – everybody knows everybody else.

Examples ROSCAs have been around for a long-time and the proof that they are very useful and solve financial problems for social groups is in their ubiquity. Tontines in rural Cameroon Hui in Taipei Tanda in Mexico Polla in Chile Chit funds in India Arisans in Indonesia Loteri samities in Bangladesh Kye in Korea Susu in Ghana Esusu in Nigeria Upatu or mchezo in Tanzania Chilemba or hiperegani in Malawi Merry-go-rounds in Africa

How a ROSCA works – without Suppose participants wish to buy a machine for $300 – assume the money is needed in a lumpsum; hence individuals need to wait until the entire sum is available before buying the machine. Assume monthly income is $50/month without the machine, but $70/month with the machine. $35/month are required for subsistence needs; $15/month can be saved to buy the machine. Without a ROSCA, the participant needs 20 months before buying the machine and doubling her income.

How a ROSCA works – with Suppose there is a ROSCA with 20 members and a monthly contribution of $15. Suppose the order of pot recipients is determined through a lottery. The probability of getting the pot in any given week is 1/20; the expected number of weeks to wait is 10. On average, then the participants can increase their consumption by $20 ten weeks earlier than without a ROSCA. The worst case is the person who gets it last; this person does not wait any longer to get the pot, than if she did not participate in a ROSCA. Hence this ROSCA benefits every participant.

ROSCA motives The example earlier clarifies the “early pot” motive to participate in a ROSCA. There is also the “household conflict” motive; participants, often women, seek to get money out of the household and away from their husbands. Then there is the “commitment to savings” motive – ROSCAs present a clear, public, disciplined way to accumulate funds.

What are funds used for? Assumption 1. All individuals wish to buy an indivisible durable good. If this were not so, then individuals can buy the good in installments, as they save their money. A study in Taiwan (Besley and Levenson, 1996) showed that ROSCA participants are more likely to buy durables like microwave overns, air conditioners etc than others. A study in Nairobi (Anderson and Baland, 2002) showed that ROSCA participation is correlated with lumpy purchases (school fees, clothing, rent, medical costs etc.) However, other studies (Gugerty, 2007) show that ROSCA expenditures are often divisible – school fees can be paid in instalments, food can be purchased in small quantities etc).

When do they want the funds? Assumption 2. They are impatient to do so – they wish to buy sooner rather than later. Gugerty (2007) shows that sometimes it’s not the speed of access to the pot, but rather getting the pot when there is a large expense, e.g. having funds available during the harvest season to pay for harvesting expenses and to be able to afford to hold the grain until later when grain prices are higher. This suggests that, more than the early pot motive, ROSCAs are useful because they provide an effective way to save.

Effectiveness of ROSCAs: Incentives Assumption 3. ROSCA participation is enforceable – those who win the pot will continue to contribute to the pot until everybody has had a chance to get the pot and purchase the durable good. Q: In a random ROSCA, why should the last person in line stay in the ROSCA? She has no benefit and loses the flexibility of determining her own savings calendar. Ans: Participants might not have alternative effective ways to save.

Effectiveness of ROSCAs: Incentives Why should early pot recipients stay in the ROSCA and continue to contribute? These are just like borrowers and the ROSCA has all the enforcement problems with these people as all lenders do with borrowers in more familiar arrangements. One answer is to refuse absconders access to future pots, i.e. it’s a multiperiod game. However, if the order of pot assignment never changes, then the participants are no worse off than going off on their own – they will have to wait 20 months before the getting the next pot.

Effectiveness of ROSCAs: Incentives Suppose the order is determined afresh at the end of every cycle. This improves incentives for the participants who get the pot after half the life of the ROSCA. However, this makes the situation even worse for the first half of the recipients. For example, the 9th recipient would have to contribute for another 20 months and would get the pot again in the 29th month if the order remained constant, for a total of 20 more months before getting access to the pot again. If the order were refreshed, she would have to wait 11 months for the current cycle to end and then, on average, wait another 10 months for a total of 21 months, on average. Similar arguments could be made for all the earlier recipients. For the 11th person to get the pot in the first cycle, the average wait drops from 20 to 19; similar arguments can be made for all the later recipients.

Alternative assignment mechanisms Random assignment of the order of getting the pot is considered fair even though the incentives to cheat for early recipients are greater. Alternatively, a fixed order could be used with more creditworthy people going first. Social sanctions could be used to ensure continued payment into the pool – e.g. access to trade credit, material inputs etc., or ostracism and exclusion from social/religious events in the village.

Bidding ROSCAs The pot assignment in a fixed order or a random ROSCA is unrelated to the need of the recipient for the pot. One way around this is to allow participants to bid for the pot. However, risky participants will be willing to bid more, since they will actually pay less often. Studies find that default rates in bidding ROSCAs are higher. One way around this is to limit the size of the bids and to institute some kind of credit screening.

ROSCAs to ASCAs We have seen that one motive for ROSCA participation is to have an effective way to save. ROSCAs only allow for raising resources from the borrowers, themselves and assume that savers are also borrowers. Credit Cooperatives provide a way of including savers who don’t necessary want to borrow to join the group. Credit cooperatives are formal versions of ASCAs (Accumulating Savings and Credit Associations). The main advantage is that savers are no longer required to borrow and the size of loans can vary with need, but the disadvantage is that funds must now be stored, and bookkeeping and management become more complex.

Village Banks One of the important characteristics of ROSCAs and ASCAs is that the group is small, and the members of the group know each other. This facilitates screening, monitoring and enforcement. Village Banks share this aspect. John Hatch in 1983 hit upon the idea of making block loans, using USAID funds, to cooperatives of about fifty villagers, instead of five or seven. The group, not an outside banker, would allocate the credit to members and keep the books. All could borrow immediately. The banks would take savings, as well, working in an informal setting using members to keep an eye on the use of funds. This technique has been used by the US nonprofit Foundation for International Community Assistance (FINCA) and the Mexican lender Comportamos.

Self-Help Groups (SHGs) These were created in India in the mid-1980s by the Mysore Resettlement and Development Agency (MYRADA). These groups were homogenous, being united by caste, cred, ender, profession, economic status, or kinship. Again, the aspect of inexpensive self-monitoring can be seen. SHGs encourage members to save into a group fund, rather than obtain capital from outside. Groups collectively decide on any lending to members. These groups also serve as conduits for other services, such as training in irrigation and agricultural practices. Under the auspices of the National Bank for Agriculture and Rural Development (NABARD), a semi-governmental apex bank, SHGs have also borrowed from banks, after accumulating their own capital base and establishing a track record of regular repayments.

Credit Cooperatives One of the problems with ROSCAs and many of their informal and semi-formal cousins is that loans are of short maturity and repayments are frequent and often start soon after the loan is made. Such a credit schedule is convenient for shopkeepers and other small businesses, whose inventory turns over rapidly. However, for some borrowers, such a schedule is impractical. For example, farmers usually have no cash inflows until the harvest, which may only be once or twice a year. They also need to make capital investments, which may not be recouped for several years. A similar situation obtains for shepherds.

Credit Cooperatives Friedrich Raffeisen, in Germany, in 1864, started credit cooperatives. Some key aspects were: Members should belong to the same local parish. Members would have unlimited liability to support borrowing from outsiders. Defaulting members would lose their current assets, as well as suffer social costs. Low-income individuals could not be discriminated against and should be given equal rights as members of the cooperative. The cooperative also facilitated the purchase of inputs of production for its members. Members were to deposit savings as they repaid their loans, so that the cooperatives could eventually free themselves from outside credit. The terms of loans, which were often made for farm investments, could extend to two years or even more.

How Credit Cooperatives work Consider a cooperative with two members. One of the two has an investment opportunity and needs financing. The project is risky and yields y with probability p and zero with probability 1-p. The investment requirement of F can be financed partly by borrowing from an outside lender and partly from an inside lender. First assume that both members have zero wealth. The loan contract specifies an amount b (= F in this case) lent and a gross interest rate R, with R.b < y, which is paid if the project succeeds, and not otherwise. Suppose now the insider lends F-b and the outsider, b. The insider acts as guarantor, possibly offering collateral that would secures the outsider’s loan. In this model, the inside lender has an incentive to monitor the (inside) borrower.

How Credit Cooperatives work Since the borrower’s effort increases the probability of success, for convenience, let p denote both the borrower’s effort and the probability of success. Let m denote the intensity of monitoring. The cost to the borrower of exerting effort is given by 0.5(1/m)p2. The marginal cost of effort is increasing, as indicated by p2, but is decreasing in m. This latter point can be understood by thinking of effort as the opposite of shirking – the higher the level of monitoring, the costlier is shirking, for the borrower. The timing is as follows: first the borrower contracts with inside and outside lenders; then the inside lender choose how much to monitor; then the borrower decides how much effort to invest; finally project revenues are realized.

How Credit Cooperatives work The borrower chooses effort, p, to maximize p(y-Rb) - 0.5(1/m)p2. The optimal level of p is seen to be m(y-Rb), for a given level of monitoring of m. Substituting this into the maximand, we see that the gross return to the borrower, is (m/2)(y-Rb)2. Since the benefits of monitoring would go primarily to the outside lender, why would the insider monitor, and how much? Suppose the inside lender has wealth w, that she uses as collateral for the outside loan. If the project fails, the insider loses her collateral. Hence she would have an interest in monitoring the borrower. Clearly the provision of collateral would reduce the interest rate, R, that the outside lender charges. Hence the greater the amount of monitoring, the greater the surplus available to be shared by the insider lender and the inside borrower.

How Credit Cooperatives work Since the insider would be able to monitor the borrower cheaper than the outsider, this setup benefits all parties – the outside lender and the two insiders. How much monitoring will occur depends upon the contract set up between the inside borrower and the inside lender. It is, however, entirely possible that insiders will monitor too much and punish borrowers too often relative to the social optimum. In fact, in other social group borrowing contexts, such as the Grameen bank group lending model, it has been suggested that monitoring and punishment is excessive. This might have led Grameen Bank to move away from its group lending format.