Group Lending Microfinance In the last class we argued poor borrowers can access loans in groups In the case of ROSCAs individuals access credit from other group members In the case of Credit Cooperatives, individuals can access credit from group members and from “outside” sources But mobilizing savings under both scenarios has limitations How about extending credit from outside sources (i.e., donors, commercial banks) to groups of individuals without collateral? ← today’s class 1) Incentives to put effort and monitor under group-lending microfinance 2) The role of social sanctions

1)Incentives to put effort and monitor Some history first: The group – lending microfinance technology often attributed to Muhammad Yunus (Nobel Peace Prize 2007) Yunus launched a microlending project ( the Grameen Bank) in Bangladesh in 1976 The technology has evolved considerably over the past years Meanwhile, a large number of articles have been written to shed light on Yunus’ financial innovation Such articles borrow from the literature on asymmetric information → capital market imperfections (previous classes)

Main intuition: In group-lending microfinance participant borrowers organize themselves into groups Each participant borrower responsible for the debt of others. If the entire group's debt is not repaid, all group participants are excluded from future refinancing: “joint responsibility default clause” The “joint responsibility default clause" induces peer monitoring because a borrower that defaults creates a negative externality on others, namely, others have to pay for his/her share of the debt, or, else other borrowers cannot access future loans from the MFI Incidence of default is reduced because participants make sure that their peers put adequate effort Relative to the donors or commercial banks, monitoring is less costly for the borrowers (i.e., can monitor each other more easily because of geographical proximity) Delegating monitoring activity increases repayment rates and makes credit from commercial sources or donors feasible→ efficiency gains

Intuition: In the absence of costly effort, repayment occurs only when both borrowers are lucky. Each borrower's surplus is therefore higher, which in turn increases the scope for a competitive bank to charge higher repayment rates in order to break even: lending becomes possible→ efficiency gains Now, let us see what happens when there is peer monitoring Ex-post moral hazard models may deliver an scenario which is closer to what happens in reality Suppose that in the absence of ex post peer monitoring the “other borrower" will strategically default with probability 1 Group lending with joint responsibility induces peer monitoring: each borrower will monitor her peer and pay a monitoring cost k Monitoring enables each borrower to discover true return realizations with probability q And assume that if a borrowers is found out to have defaulted strategically, she will have to incur “social sanctions” d