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1. BANKING & FINANCE (CBS)
SECOND SEMESTER 2015/2016 ACADEMIC YEAR
MICROFINANCE – (CBBF 304)
LEVEL 300
DATE: Monday 25th April, 2016
TOPIC: THE EMPIRICS OF MICROFINANCE: WHAT DO WE KNOW?
By Niels Hermes and Robert Lensink (2007)

2. The Empirics of Microfinance: What Do We Know?
A Critique on a Paper by Niels Hermes and Robert Lensink
By
Cypran Akubude
INTRODUCTION
Lack of collateral and access to credit has been one of the reasons why the traditional banking
institutions do not extend credit to the poor. This has led to the increment in the poverty level of
these individuals. For this reason, MFIs came into existence to play the role of providing
financial services to the poor. The requirement of no collateral increases the risk of default and
information asymmetry. Thus, the joint liability group lending model was developed to curb this.
There have been debates on whether MFIs can provide services to the poor in a sustainable way
and communicate the benefits of these services so as to reach those left out by the traditional
banking institutions. Robinson (2001) stated that there is an absurd gap between the supply and
demand for microfinance services. Among the economically active poor of the developing world,
there is strong demand for small-scale commercial financial services for both credit and savings
but the demands for these services are rarely met by the formal financial sector. One reason is
that the demand is generally not perceived. Another is that many actors in the formal sector
believe wrongly that microfinance cannot be profitable for banking institutions (Robinson 2001).
In this critique, we will be analyzing and evaluating the effectiveness of joint liability group
lending in reducing information asymmetries and also looking at the relationship between the
financial performance of MFIs and their outreach services to the poor in developing countries.
1. THE ECONOMICS OF JOINT LIABILITY GROUP LENDING MODEL
The joint liability group lending model is based on the concept of joint liability. Matching this
concept to microfinance group lending model, it means that when an individual within a group of
borrowers defaults either intentionally or unintentionally in repaying back her loan, the group of
borrowers will be jointly held liable in order to repay back the loan. As a result, this group is
based on standardization and discipline. Information asymmetry is a situation whereby a party
has more information in a particular activity than the other giving them an edge over the other.
This can be either adverse selection or moral hazard, or even both. In the case of microfinance,
the likelihood of information asymmetry occurring in the event of granting credit to the less
privileged people could be very high since these MFIs do not require them for any provision of
collateral as a means of security. The point here now is to determine whether joint liability group
lending can reduce information asymmetry.
1.1.Literature Review and Methodology
Firstly, we have decided to take a critical review of the quantitative research conducted by four
authors and their empirical evidence that joint liability group lending can reduce information
asymmetries as cited in Hermes and Robert (2007).

3. Wenner (1995) provides one of the first empirical studies on the determinants of repayment of
groups, using information of 25 groups from a lending program in Costa Rica. His analysis
indicates that repayment performance of groups improves when groups have written (formal)
rules stating how members should behave.
Sharma and Zeller (1997), using data of 128 groups from four group lending programs in
Bangladesh find that groups that were formed using a self-selection (screening) process show a
better repayment performance.
Paxton et al. (2000) used data of 140 groups from a group-based lending program in Burkina
Faso. They show that the homogeneity of the group in terms of their ethnicity, occupation,
income etc., reduces its repayment performance.
And lastly, Hermes et al. (2005) elaborates on this last result and investigates the role of the
group leader in reducing moral hazard behaviour, using data of 102 groups from two Eritrean
group lending programs. They find evidence that monitoring and social ties of the group leader
reduces moral hazard behaviour of group members. In a related paper they also find evidence
that the role of the group leader is most important in improving repayment performance of the
group (Hermes et al., 2006).
1.2.Results
Based on the empirical evidence of these fabulators, we can observe that joint liability group
lending model plays a very crucial role in determining the effectiveness of the repayment of
loans by poor borrowers and for the reduction of information asymmetries. We also agree to
these arguments even though there have been some critiques about its reliability.
According to Hermes and Robert (2007) as cited in Lapenu and Zeller (2001), from a recent
survey of a sample of microfinance programs, only 16% of these made use of the so-called group
lending to provide credit to the poor; yet they served more than two thirds of all borrowers from
the microfinance programs included in the survey. Our proposition here is that if most
microfinance firms presume that the group lending model has the ability of reducing information
asymmetries, then why would majority of them still offer credit to the poor through the
individual lending model? The answer to this question will be dealt with after discussing the
financial performance and outreach.
2. FINANCIAL PERFORMANCE AND OUTREACH
2.1.Financial Sustainability
The second topic in this essay seeks to explain the trade-off between the financial sustainability
and outreach of microfinance programs. The term financial sustainability of MFIs seeks to
determine the feasibility of the institutions in becoming profitable and if they are capable of
providing its financial needs into the foreseeable future without relying on donors and other
financial assistance.
Robinson (2001) stated that in the 1990s, the importance of financial sustainability of MFIs gave
rise to an important debate between two approaches on how to fill the absurd gap (that is
reaching those individuals who do not have access to the traditional banking services). These
approaches are the financial systems approach and the poverty lending approach. Both
approaches share the goal of making financial services available to poor people throughout the
world. But the poverty lending approach focuses on reducing poverty only through credit. All
MFIs provide credits which attract low interests therefore; there is a higher probability that

4. institutions using this approach will likely be financially unstable. Well, through research
findings, Robison discovered that institutions using this approach are widely NGOs and donor
funded institutions.
We can prove our preference of the financial systems approach for achieving financial
sustainability with a diagrammatical illustration extracted from Robinson (2001) pg. 94.
Note: Unit desas is the lowest level unit of the Bank Rakyat Indonesia (BRI) micro banking system that provides micro financial
services to the village (desa).
The diagram above shows the pictorial representation of the portfolio of microfinance services of two profitable MFIs (i.e., the
Grameen Bank and Unit desas) in the microfinance industry in addition to the level of value for each individual portfolio (i.e.,
loans and savings).
2.2.Measuring Outreach
Outreach at a glance means the number of clients served. But, Meyer (2002) noted that outreach
is a multidimensional concept. In order to measure outreach we need to look in to different
dimensions. The first is simply the number of persons now served that were previously denied
access to formal financial services. Usually these persons will be the poor because they cannot
provide the collateral required for accessing formal loans. They are perceived as being too risky
to serve, and impose high transaction costs on financial institutions because of the small size of
their financial activities and transactions. Second is the depth of poverty and the last being the
variety of financial services provided. In this critique, we will be focusing on the number of
active clients as a measure of outreach to the poor.
2.3.Literature Review and Methodology
According to Befekadu (2007), the MFIs participation in several developing economies is
escalating from time to time. Various studies on different countries on the performance of the
MFIs confirm this (Adongo and Stork 2005, Zeller and Meyer 2002, Meyer 2002, Cull et al.
2007). For example, in Bangladesh a microfinance institution called Grameen Bank at the end of
2000 reported 2.4 million members, where 95 percent of them are women, with $225 million
outstanding loan. In addition, Thailand also has reported impressive outreach through agricultural
lending by the Bank for Agriculture and Agricultural Cooperative (BAAC) (Meyer 2002). In
general, a number of MFIs have registered impressive outreach in several developing economies
including India, Cambodia, and others (Meyer 2002).
A survey by Cull et.al (2007) on the performance of leading MFIs in 49 countries finds
interesting results. They found out that over half of surveyed MFIs are profitable after making

5. adjustment of subsidies. It also identified no evidence of trade-off between being profitable and
reaching the poor.
2.4.Analytical Technique and Findings
After investigating outreach and financial sustainability of MFIs let’s see how they interact with
each other. There have been arguments that there is a trade-off between reaching the poor and
becoming profitable, rationalizing that high number of clients with small loans will lead to high
cost of lending thereby lead to profit loss. In this regard, finding of this study is however
encouraging.
Befekadu (2007) used a quantitative analysis to measure the correlation between the number of
active clients (NAC) and profit performance (PR). As can be observed from the figure below,
simple correlation test between number of active clients (NAC) and profit performance (PR) of a
microfinance institution has shown strong positive correlation between them.
Correlation Result between Number of Active Clients (NAC) and Profit Performance (PR)
of MFIs on 2007 data
2.5.Results
Based on the quantitative analysis by Befekadu (2007), we can draw an inductive conclusion that
there is no trade-off between the financial performance of MFIs and the outreach of microfinance
services to the poor but rather they are positively correlated. This is because, the results of the
correlation between profit performance and number of active clients shows a direct relationship.
This means that as profitability increases, outreach also increases in the same proportion, and
vice versa.
3. CONCLUSION
In this critique, we have examined two topics, that is, the economics of joint liability group
lending model and its effectiveness in reducing information asymmetries, and the performance of
MFIs in relation to outreach and financial sustainability. We have reviewed and reported on some
literature items that are central to the work, methodologies in which data was collected, the
analytical techniques, results and findings based on the topic discussed.
In the case of joint liability group lending model, we have found out that groups that have written
(formal) rules stating how members should behave , groups that were formed using a self-
selection (screening) process, and monitoring and social ties of the group leader all reduce
information asymmetry that are likely to occur between group members and MFIs.
In the latter part of the topic, we looked at the trade-off between financial sustainability and
outreach. From a quantitative research conducted by Befekadu (2007) using a correlation

6. research approach, the results showed positive relationship between financial performance and
outreach. Therefore, our study does not show any evidence of trade-off between the two as Neils
and Robert hypothesized on but rather a positive correlation was observed between the two.
4. BIBLIOGRAPHY
1. Adongo, J. and C. Stork (2005), "Factors Influencing the Financial Sustainability of
Selected Microfinance Institutions in Namibia", NEPRU Research Paper, No. 39.
2. Befekadu, B. K. (2007). Outreach and financial performance: analysis of microfinance
institutions in Ethiopia. UNCC, Addis Ababa, Ethiopia.
3. Cull, R., Demirgu¨c¸-Kunt, A. and Morduch, J. (2007). Financial performance and
outreach: a global analysis of leading microbanks, Economic Journal, vol. 117, pp.
F107–F133.
4. Hermes, N., Lensink, R. and Mehrteab, H.T. (2005). Peer monitoring, social ties and
moral hazard in group lending programmes: evidence from Eritrea, World Development,
vol. 33(1), pp. 149–69.
5. Hermes, N., Lensink, R. and Mehrteab, H.T. (2006). Does the group leader matter: the
impact of monitoring activities and social ties of group leaders on the repayment
performance of group-based lending in Eritrea, African Development Review, vol. 18(1),
pp. 72–97.
6. Lapenu, C. and Zeller, M. (2001). Distribution, growth and performance of microfinance
institutions in Africa, Asia and Latin America, FCND discussion paper 114, Washington,
DC: International Food Policy Research Institute (IFPRI).
7. Meyer, R. L. (2002), "Track Record of Financial Institutions in Assisting the Poor in
Asia" ADB Institute Research Paper, No 49, December 2002.Robinson, M. (2001). The
Microfinance Revolution: Sustainable Banking for the Poor, Washington, DC: The World
Bank.
8. Paxton, J., Graham, D. and Thraen, C. (2000), Modeling group loan repayment behavior:
new insights from Burkina Faso, Economic Development & Cultural Change, vol. 48(3),
pp. 639–55.
9. Sharma, M. and Zeller, M. (1997). Repayment performance in group-based credit
programs in Bangladesh: an empirical analysis, World Development, vol. 25(10), pp.
1731–42.
10. Wenner, M. (1995). Group credit: a means to improve information transfer and loan
repayment performance, Journal of Development Studies, vol. 32(2), pp. 263–81.