In the past decade, microfinance programs have demonstrated that it is possible to lend to low-income households while maintaining high repayment rates--even without requiring collateral. The programs promise a revolution in approaches to alleviating poverty and spreading financial services, and millions of poor households are served globally. A growing body of economic theory demonstrates how new contractual forms offer a key to microfinance success--particularly the use of group-lending contracts with joint liability. For the most part, however, high repayment rates have not translated into profits, and studies of impacts on poverty yield a mixed picture. In describing emerging tensions, the paper highlights the diversity of innovative mechanisms beyond group-lending contracts, the measurement of financial sustainability, the estimation of economic and social impacts, the costs and benefits of subsidization, and the potential to reduce poverty through savings programs rather than just credit. The promise of microfinance has pushed far ahead of the evidence, and an agenda is put forward for addressing critical empirical gaps and sharpening the terms of policy discussion.

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The microfinance promise

Microfinance contracts have proven able to secure high rates of loan repayment in the face of limited liability and information asymmetries, but high repayment rates have not translated easily into profits for most microbanks. Profitability, though, is at the heart of the promise that microfinance can deliver poverty reduction while not relying on ongoing subsidy. The authors examine why this promise remains unmet for most institutions. Using a data set with unusually high quality financial information on 124 institutions in 49 countries, they explore the patterns of profitability, loan repayment, and cost reduction. The authors find that institutional design and orientation matter substantially. Lenders that do not use group-based methods to overcome incentive problems experience weaker portfolio quality and lower profit rates when interest rates are raised substantially. For these individual-based lenders, one key to achieving profitability is investing more heavily in staff costs-a finding consistent with the economics of information but contrary to the conventional wisdom that profitability is largely a function of minimizing cost.

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Financial performance and outreach: a global analysis of leading microbanks*

https://personal.lse.ac.uk/GHATAK/jde2.pdf

The economics of lending with joint liability: theory and practice

https://personal.lse.ac.uk/GHATAK/jde1.pdf

Group lending, local information and peer selection

Although the word finance is in the term microfinance, and the core elements of microfinance are those of the finance discipline, microfinance has yet to break into the mainstream or entrepreneurial finance literature. The purpose of this article is to introduce the finance academic community to the discipline of microfinance and microfinance institutions (MFIs). We provide a comprehensive review of over 350 articles and address the issues of MFI sustainability, products and services, management practices, clientele targeting, regulation and policy, and impact assessment.

/pdf/microfinance-a-comprehensive-review-of-the-existing-dj7o02qtm8.pdf

Microfinance: A Comprehensive Review of the Existing Literature

http://beatriz-armendariz.com/pdf/design.pdf

On the Design of a Credit Agreement with Peer Monitoring

Microlending is growing in Eastern Europe, Russia and China as a flexible means of widening access to financial services, both to help alleviate poverty and to encourage private-sector activity. We describe mechanisms that allow these programmes to successfully penetrate new segments of credit markets. These features include direct monitoring, regular repayment schedules, and the use of non-refinancing threats. These mechanisms allow the programmes to generate high repayment rates from low-income borrowers without requiring collateral and without using group lending contracts that feature joint liability.

Microfinance beyond group lending

This paper develops an adverse selection model where peer group systems are shown to trigger lower interest rates and remove credit rationing in the case where borrowers are uninformed about their potential partners and ex post state verification (or auditing) by banks is costly. Peer group formation reduces interest rates due to a 'collateral effect', namely, cross subsidisation amongst borrowers acts as collateral behind a loan. By uncovering such a collateral effect, this paper shows that peer group systems can be viewed as an effective risk pooling mechanism, and thus enhance efficiency, notjust in the full information set up. A well-known family of adverse selection models in the Stiglitz and Weiss (1981) tradition demonstrates that when banks are imperfectly informed about the riskiness of borrowers' projects and therefore cannot discriminate against risky borrowers, interest rates become inefficiently high, and worthy borrowers are driven out of the credit market. The extent of this problem is substantially magnified when borrowers do not have adequate collateral to secure a loan. Typically, adverse selection combined with lack of collateral leads to prohibitively high interest rates. Poorly endowed individuals (e.g. students, immigrants, the unemployed, and a vast majority of poor individuals in developing countries) often face such high rates, and therefore cannot take advantage of profitable investment opportunities. A peer group formation system represents a possible solution to the above problem. Under this system a bank lends to borrowers without collateral on condition that the borrowers organise themselves into groups, and that participant borrowers within each group accept to take 'joint responsibility' for a loan. Thus, in addition to repaying their own share of the loan, each group member must accept to repay the obligations of their defaulting peers, otherwise the entire group is denied access to future refinancing. Systems of this kind have been very successful in practice: they have generated lower interest rates for the rural poor in, for example, Bangladesh, the Philippines, Bolivia, and the State of Arkansas in the United States. Moreover, group lending has also been successfully implemented in large urban areas such in the cities of Dhaka and Chicago.1

Peer group formation in an adverse selection model

Economies are built upon people buying and selling, lending and borrowing. The beauty of the market is that, when it works well, sellers are matched to buyers and lenders are matched to worthy borrowers. But when the market does not work well, goods go unsold and promising investment projects go unfunded. We understand why markets fail - the economics of information provides rigorous underpinnings for why credit markets, in particular, are so problematic.1 The challenge has been to move from diagnosis to prescription. The challenge is particularly great in poorer regions, where individuals may have workable ideas and relevant experience but lack collateral. Even a £100 loan can make a difference to a small-scale shopkeeper or craftsperson in countries like Nepal or Uganda, but formal sector banks have steered clear, focusing instead on larger loans to better-established, wealthier clients.

Beatriz Armendáriz de Aghion

Papers

On the Design of a Credit Agreement with Peer Monitoring

Microfinance beyond group lending

Peer group formation in an adverse selection model

Microfinance: Where do we Stand?