The Hindu Business Line : Micro-credit: Looking beyond group lending

Considering the increased competition in micro-credit and the pressure to reduce interest rates, it is time for micro-finance practitioners to consider moving beyond group lending.

In India, the preferred form of micro-finance loan is group lending . According to a study by Sa-dhan (Industry Association of Community Development Finance Institutions in India), only 7 per cent of micro-finance loans in India is to individuals.

Many of the large micro-finance institutions provide individual loans to clients who have a track record and have improved their economic status; the provision of individual loans to first-time borrowers is not common.

Lender's concern

Why is the group lending the preferred model? The primary reason is that those taking micro-credit loans are unable to offer collateral and, hence, the group mechanism is viewed as a substitute for the collateral.

The main concern of any lender when lending without collateral is that of repayment. The commonly stated advantages of group lending are that the problems of adverse selection (selecting risky borrowers), moral hazard (inability to monitor) and enforcement (in case of default) are addressed by the group mechanism.

The issue of adverse selection is addressed by the fact that groups are formed by self-selection. The information asymmetry that banks face with regard to micro-finance borrowers is addressed, as the screening is not done by the banks, but by those who know more about the individual — the group members.

The problem of moral hazard is addressed by the fact that individuals who are part of the same group monitor each other on a continuous basis, not formally but by various informal means. Enforcement is again ensured by the joint liability nature of the loan, which results in social pressure on the defaulting borrower (sometimes referred to as social collateral).

Group loan models

The groups themselves vary in the level of formalisation of the joint liability concept. In some cases, while the joint liability of the loans is documented, in others it is more implicit. In India, there are primarily two group loan models — the Grameen Bank type and the Self Help Group model. The former originated in Bangladesh, while the latter, a model that originated in India, is an independent unit of 10-20 members.

Regardless of the form the group may take, the operational costs for lenders can be expected to be lower in the case of individual loans since group loans have certain peculiar costs associated with them such as on group formation and training.

Further, to cater to the credit requirements in sparsely-populated areas, where it may not be viable or possible to form groups and have regular group meetings, it may be important for lenders to look at individual lending.

Minimising credit risk

How can lenders give collateral-free loans in the absence of group lending? One approach is to take non-traditional collateral. For example, the lender may accept the borrower's degree certificate, driver's licence, marriage certificate and such other documents as collateral.

The logic being that what matters most is the value the borrower attaches to losing the item than what the lender expects to recover from selling them.

Bank Rakyat Indonesia, a leading name in micro-finance, uses this technique effectively.

Another way of reducing credit risk in the absence of collateral is to insist that borrowers demonstrate habitual savings for a certain period before a loan is sanctioned. The SHG-Bank Linkage model, India's homegrown micro-finance model, uses this technique in conjunction with group lending.

Other means to incentivise repayment is to give dynamic incentives in the form of progressive lending (loan sizes get bigger with each repeat loan) and disincentives in the form of credit denial in case of default.

However, the latter would be difficult to enforce in an environment where there is competition among lenders. Some lenders have repayments in groups so that non-payment becomes public knowledge even when there may not be joint liability. In fact, the Grameen Bank, the pioneer in micro finance, has introduced some changes in its lending mechanism, one of which is the removal of joint liability of the group for the loan taken by one member, though the regimen of group meetings continues.

Considering the increased competition in the field of micro-credit in India and the pressure to reduce interest rates, it is time for Indian micro-finance practitioners to seriously consider moving beyond group lending.

(The author is a Faculty Member at the Institute for Financial Management and Research, Chennai.)

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