untaggedHow do micro-credit institutions like Grameen Bank get their loan takers to pay back? Are they threatening to take away something from these poor people, or are they using some other incentives?
Several mechanisms are used to improve repayment rates. The key article in this area is by Morduch (1999).
The group lending incentive is the most studied mechanism for improving repayment in environments in which collateral cannot be collected (and in which proper credit markets are absent). Quoting Morduch (p. 1570):
Group-lending contracts effectively make a borrower’s neighbors co-signers to loans, mitigating problems created by informational asymmetries between lender and borrower. Neighbors now have incentives to monitor each other and to exclude risky borrowers from participation, promoting repayments even in the absence of collateral requirements.
One implementation is to lend to “two members of the five-person group… [i]f they repay on time, the next two get loans, and finally the fifth gets a loan. The process continues in turn as long as performance is satisfactory, but in principle when a member defaults, all five are barred from borrowing in the future.” Aghion and Morduch (2000, p. 3). Thus, each member of the group has incentive to encourage other members to repay.
The group lending mechanism has been extensively studied. A key article on how the peer lending mechanism works is by Ghatak (1999). In micro-finance environments, there is often a problem of information asymmetry: the lender can’t simply pull a credit report. Group lending causes borrowers to select team members according to local information on their ability to repay. That is, low risk borrowers will choose a team that is also low-risk (and exclude high-risk borrowers). At the risk of oversimplifying, the idea is that a high-risk group member, knowing that his collaborators are less likely to repay, will be unwilling to accept relatively large loans. Thus, groups self-select appropriate loan packages.
In environments where collateral is available (e.g. in transitioning economies), more traditional contractual methods are employed. That is, borrowers put up assets to secure the loan. In other areas, a committee is established to guarantee loans at the village level, and to provide a character reference for the potential borrower.
A final feature of many of these loans is an often weekly repayment schedule, beginning immediately after loan initiation. It was once explained to me that this is helpful for people who aren’t used to formal financial arrangements–to get them into the habit of repaying immediately.
Jason’s answer below is great. Let me give you the basic intuition behind two main theories of why group lending works.
The first explanation, which is an adverse selection story attributable to Ghatak (1999) and Van Tassel (1999), suggests that group lending works because borrowers have more information about each other than the lender does. When the lender asks borrowers to form groups, they sort themselves into groups of “good” borrowers and “bad” borrowers (roughly speaking, “good” borrowers want to form groups with other borrowers like themselves, leaving the “bad” borrowers to form groups on their own). As a result, within one or two loan cycles the wheat is separated from the chaff and repayment rates soar, simply because only the best credit risks remain in the borrower pool.
The second explanation, which is a more common moral hazard story, argues that monitoring borrowers is hard, both during the project and afterwards, when the bank needs to figure out whether the project was successful. When there is group liability, borrowers monitor each other, ensuring that repayment rates are high. The important insight here is that microcredit institutions are tapping into the so-called social capital of the borrowers: even though the banks cannot punish the borrowers who don’t have any collateral, other group members impose social sanctions to ensure repayment.
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