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The Economics of Group Lending This is completely based on  The Economics of Microfinance (2005) Beatriz Armend á riz de A...
The Principal-Agent Relationship <ul><li>PRINCIPAL [Uninformed] </li></ul><ul><li>AGENT [Informed] view of “contracts” </l...
Understanding Credit Using the Principal-Agent Relationship <ul><li>The Principal is </li></ul><ul><li>The MFI </li></ul><...
Basic Assumptions: “No-fat” model <ul><li>Assume MFI is in a competitive market: Would like to charge an interest rate tha...
ADVERSE SELECTION Illustration 1.1: Individual Lending <ul><li>IF </li></ul><ul><ul><li>An MFI faces a potential client gr...
ADVERSE SELECTION Illustration 1.1: Individual Lending-Sensitivity <ul><li>Fraction of Safe borrowers in the population 40...
ADVERSE SELECTION Illustration 1.2: Individual Lending <ul><li>IF </li></ul><ul><ul><li>An MFI faces a potential client gr...
ADVERSE SELECTION Illustration 1.2: Individual Lending-Sensitivity <ul><li>Risky Borrower: Gross revenue if successful 267...
ADVERSE SELECTION Illustration 1.3: Group Lending <ul><li>IF </li></ul><ul><ul><li>An MFI allows potential borrowers to fo...
EX ANTE MORAL HAZARD Illustration 2.1: Individual Lending-Without Collateral <ul><li>IF </li></ul><ul><ul><li>An MFI has l...
EX ANTE MORAL HAZARD Illustration 2.1: Individual Lending-Without Collateral -Sensitivity <ul><li>Cost to borrower of effo...
EX ANTE MORAL HAZARD Illustration 2.2: Individual Lending-With Collateral <ul><li>IF </li></ul><ul><ul><li>An MFI has lent...
EX ANTE MORAL HAZARD Illustration 2.2: Individual Lending-With Collateral-Sensitivity <ul><li>Borrower's collateral 50% </...
EX ANTE MORAL HAZARD Illustration 2.3: Group Lending <ul><li>IF </li></ul><ul><ul><li>An MFI has lent money to individuals...
EX POST MORAL HAZARD Illustration 3.1: Individual Lending with Possible Collateral <ul><li>IF </li></ul><ul><ul><li>An MFI...
EX POST MORAL HAZARD Illustration 3.1: Individual Lending with Possible Collateral-Sensitivity <ul><li>Borrower's collater...
EX POST MORAL HAZARD Illustration 3.2: Group Lending <ul><li>IF </li></ul><ul><ul><li>An MFI has lent money to individuals...
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Group lendingprimer

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Transcript of "Group lendingprimer"

  1. 1. The Economics of Group Lending This is completely based on The Economics of Microfinance (2005) Beatriz Armend á riz de Aghion & Jonathan Morduch The MIT Press, Cambridge, Massachusetts
  2. 2. The Principal-Agent Relationship <ul><li>PRINCIPAL [Uninformed] </li></ul><ul><li>AGENT [Informed] view of “contracts” </li></ul><ul><li>Moral Hazard: Fire insurance example </li></ul><ul><li>Adverse Selection: Health insurance example </li></ul>
  3. 3. Understanding Credit Using the Principal-Agent Relationship <ul><li>The Principal is </li></ul><ul><li>The MFI </li></ul><ul><li>The Agent is </li></ul><ul><li>The Borrower </li></ul><ul><li>The MFI can choose individual or group lending technologies </li></ul>
  4. 4. Basic Assumptions: “No-fat” model <ul><li>Assume MFI is in a competitive market: Would like to charge an interest rate that covers cost of funds, operating expenses and possible default </li></ul><ul><li>Borrower either Safe Type [invests in Month 0 in specific project and earns income with certainty in Month 1] </li></ul><ul><li>OR </li></ul><ul><li>Risky Type [invests in Month 0 in specific project and either earns a higher income than Safe in Month 1 or earns zero income </li></ul><ul><li>Unless otherwise explicitly assumed, borrowers have no collateral–loan repayment [principal+interest] has to be made out of income from the specific project] </li></ul>
  5. 5. ADVERSE SELECTION Illustration 1.1: Individual Lending <ul><li>IF </li></ul><ul><ul><li>An MFI faces a potential client group that includes both Safe and Risky borrowers </li></ul></ul><ul><ul><li>Cannot distinguish between them </li></ul></ul><ul><ul><li>And wishes to sanction individual loans </li></ul></ul><ul><li>THEN </li></ul><ul><li>The MFI will have to increase its interest rate to take care of possible defaults by Risky borrowers. The interest rate will depend on: </li></ul><ul><ul><li>The fraction of Safe borrowers </li></ul></ul><ul><ul><li>The probability that Risky borrower is successful </li></ul></ul>
  6. 6. ADVERSE SELECTION Illustration 1.1: Individual Lending-Sensitivity <ul><li>Fraction of Safe borrowers in the population 40% </li></ul><ul><li>Probability that a Risky borrower is successful 50% </li></ul>
  7. 7. ADVERSE SELECTION Illustration 1.2: Individual Lending <ul><li>IF </li></ul><ul><ul><li>An MFI faces a potential client group that includes both Safe and Risky borrowers </li></ul></ul><ul><ul><li>Cannot distinguish between them </li></ul></ul><ul><ul><li>And wishes to sanction individual loans </li></ul></ul><ul><li>THEN </li></ul><ul><li>The interest rate the MFI has to charge may become so high that Safe borrowers no longer wish to borrow, and the MFI is left with only Risky borrowers </li></ul>
  8. 8. ADVERSE SELECTION Illustration 1.2: Individual Lending-Sensitivity <ul><li>Risky Borrower: Gross revenue if successful 267 </li></ul><ul><li>AND Probability of success 75% </li></ul>
  9. 9. ADVERSE SELECTION Illustration 1.3: Group Lending <ul><li>IF </li></ul><ul><ul><li>An MFI allows potential borrowers to form groups with joint liability </li></ul></ul><ul><ul><li>The bank offers all groups the same interest rate </li></ul></ul><ul><ul><li>AND potential borrowers know each other’s type [Safe OR Risky] </li></ul></ul><ul><li>THEN </li></ul><ul><ul><li>Borrowers sort themselves into groups: The Safe partner with other Safe and the Risky with other Risky </li></ul></ul><ul><ul><li>Also although the bank charges all groups the same interest rate, the Risky end up paying more than the Safe [a well-deserved fate] </li></ul></ul>
  10. 10. EX ANTE MORAL HAZARD Illustration 2.1: Individual Lending-Without Collateral <ul><li>IF </li></ul><ul><ul><li>An MFI has lent money to an individual without collateral </li></ul></ul><ul><ul><li>The borrower can choose </li></ul></ul><ul><ul><ul><li>To expend effort and earn an income with certainty </li></ul></ul></ul><ul><ul><ul><li>Or “slack” and either earn a positive income or earn zero </li></ul></ul></ul><ul><li>THEN </li></ul><ul><ul><li>Beyond a certain interest rate the borrower will choose NOT to expend effort but to slack </li></ul></ul><ul><ul><li>If this interest rate is less than the rate that covers the MFI’s cost, the MFI may find it optimal NOT to lend </li></ul></ul>
  11. 11. EX ANTE MORAL HAZARD Illustration 2.1: Individual Lending-Without Collateral -Sensitivity <ul><li>Cost to borrower of effort 0.30 </li></ul><ul><li>Profit to borrower with effort 2.0 </li></ul><ul><li>Probability of positive profit without effort 80% </li></ul>
  12. 12. EX ANTE MORAL HAZARD Illustration 2.2: Individual Lending-With Collateral <ul><li>IF </li></ul><ul><ul><li>An MFI has lent money to an individual with collateral </li></ul></ul><ul><ul><li>The borrower can choose </li></ul></ul><ul><ul><ul><li>To expend effort and earn an income with certainty </li></ul></ul></ul><ul><ul><ul><li>Or “slack” and either earn a positive income or earn zero </li></ul></ul></ul><ul><li>THEN </li></ul><ul><ul><li>Even if the MFI charges a higher interest rate than in Illustration 2.1, the borrower may choose to expend effort </li></ul></ul>
  13. 13. EX ANTE MORAL HAZARD Illustration 2.2: Individual Lending-With Collateral-Sensitivity <ul><li>Borrower's collateral 50% </li></ul>
  14. 14. EX ANTE MORAL HAZARD Illustration 2.3: Group Lending <ul><li>IF </li></ul><ul><ul><li>An MFI has lent money to individuals who are members of a group with joint liability </li></ul></ul><ul><ul><li>Each borrower can choose </li></ul></ul><ul><ul><ul><li>To expend effort and earn a certain income </li></ul></ul></ul><ul><ul><ul><li>Or “slack” and either earn a positive income or earn zero </li></ul></ul></ul><ul><li>THEN </li></ul><ul><ul><li>Even if the MFI charges a higher interest rate than in Illustration 2.2, the borrowers may choose to expend effort </li></ul></ul><ul><ul><li>More importantly, the borrowers may not “slack” at all </li></ul></ul>
  15. 15. EX POST MORAL HAZARD Illustration 3.1: Individual Lending with Possible Collateral <ul><li>IF </li></ul><ul><ul><li>An MFI has lent money to an individual with possible collateral [less than the total repayment of principal+interest] </li></ul></ul><ul><ul><li>The borrower invests in a successful project that earns income with certainty </li></ul></ul><ul><ul><li>The borrower can choose either to repay or default </li></ul></ul><ul><ul><li>The collateral is seized if the default is detected by the MFI </li></ul></ul><ul><li>THEN </li></ul><ul><ul><li>Then the borrower will default if the interest rate is set too high </li></ul></ul><ul><ul><li>The MFI may decide not to lend </li></ul></ul>
  16. 16. EX POST MORAL HAZARD Illustration 3.1: Individual Lending with Possible Collateral-Sensitivity <ul><li>Borrower's collateral 140% </li></ul>
  17. 17. EX POST MORAL HAZARD Illustration 3.2: Group Lending <ul><li>IF </li></ul><ul><ul><li>An MFI has lent money to individuals who are members of a group with joint liability </li></ul></ul><ul><ul><li>A group member can monitor peer at a cost, possibly observe the actual income of peer and apply “sanctions” if borrower tries to default </li></ul></ul><ul><li>THEN </li></ul><ul><ul><li>The threat of sanctions may reduce default depending on </li></ul></ul><ul><ul><ul><li>The monitoring cost </li></ul></ul></ul><ul><ul><ul><li>The probability of observing actual income of peer </li></ul></ul></ul><ul><ul><ul><li>The value of social sanctions imposed on defaulter </li></ul></ul></ul>
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