The Roots Of Microfinance

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The Roots Of Microfinance

• Last class
• We provided a justification for subsidies based
  on capital market imperfections, exacerbated by
  the fact that the poor lack collateral
• And as we shall see later in the course,
  microfinance can mitigate problems associated
  with capital market imperfections
• But in order to understand group lending
  microfinance (Yunus major innovation) we need to
  analyze some of its predecessors first? todays
  class
• 1) ROSCAs
• 2) Credit Cooperatives

2
1) ROSCAs

• Have existed for many years in many countries
• Also known as tontines, tandas, pollas, susu,
  merry go rounds..
• Modus operandi
• - group of individuals self-select themselves
  and agree to contribute pre-determined amounts of
  money to a common pot
• on a regular basis
• - the sum of the contributions in the pot is
  then allocated to one individual at each meeting
• -3 ways of allocating the pot random, bidding,
  pre-determined

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Salient features

• Motivation buy an indivisible product earlier
• Participants self select themselves ? adverse
  selection problems mitigated
• Social sanctions imposed upon participants that
  cheat
• Also a way of saving, particularly for women
  (gender issues, will turn to later in the course)
• Main drawbacks
• Lack of flexibility
• Do not mobilize funds from outside the community

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2) Credit Cooperatives

• Date back to Germany in the 1850s
• Group of individuals that share a common bond
• Gather funds (their own savings), and also borrow
  a limited amount from outside sources
• Lend those funds (their own and from outside
  sources) to themselves
• All participants are shareholders
• Key decisions taken democratically on a
  one-share-one-vote basis

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Credit Cooperatives and Peer Monitoring (based on
Banerjee-Besley-Guinnane (1994))

• Assume
• 2 members
• One of them has an investment opportunity and
  needs to borrow
• The project is risky
• With probability p ?y , and with (1-p) ? 0
• Carrying out the project requires F which will be
  borrowed partly from his peer, and partly from
  an outside lender

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• Suppose first that the two members have zero
  wealth
• Then, the loan contract between one of the
  members of the cooperative and the outside lender
  is a standard debt contract
• An amount, b, lent at an interest rate R
• And Rb lt y when the project succeeds, and when
  it fails, the borrower is protected by limited
  liability and repayment is 0
• Now, lets see how a credit cooperative can
  improve matters
• Suppose the other member (insider) has funds F
  b to lend to his peer
• Suppose that insider acts as a guarantor and has
  wealth w (collateral)
• Suppose social sanctions can be imposed if
  borrower shirks

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• Assume that cost of effort is

• Assume the following timing of events
• Borrower contracts loans with insider and
  outsider, assuming perfect competition
• Insider decides m
• Borrower decides p
• Project returns are realized
• So, for a given m, the borrower chooses p to
  maximize

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• And, the optimal level of effort, p, is
• m(y Rb)
• Now suppose that the insider promises w to the
  outsider if R not repaid
• And assume w large enough so outsider always
  repaid in full
• So, p rises to
• m(y rb) where r is the return on safe
  investments
• Drawbacks
• Common bond limits size and scope
• Collateral is often needed

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• So, clear similarities and also differences
  between credit cooperatives and microfinance
• As in the case of the insider, peer members in
  microfinance act as guarantors and monitors
• But motivation for monitoring is not collateral,
  though, it is future access to loans
• ? Next class A-M (2005), Chapter 4 Group
  Lending Microfinance