Joint liability as a collateral substitute

Of the five institutional programs listed in Table 2.1 that championed innovations in the new development finance, by far the GB’s contractual joint liability group credit approach holds the highest appeal to a vast majority of the poor and development agents (Morduch 2000). Three fundamental features have been pointed out as holding the key for GB’s success: these are new management structures, new group lending contracts, and the possession of new attitudes on the part of intervention aid recipients (Wenner 1995; Morduch 1999a; Besley and

Coate 1995). Fine-tuned over time by trial and error, the GB’s group-lending contract effectively makes a borrower’s partners jointly liable for the repayment of uncollateralised loans (Bornstein 1996; Ghatak and Guinnane 1999), and this process mitigates the problems created by informational asymmetries between creditors and debtors prevalent in the credit contracts and loans markets (Bornstein 1996; Wenner 1985; Besley and Coate 1995; Armendariz and Morduch 19997; Morduch 1999a). As a result of the absence of the collateral assets usually demanded in financial institutions for borrowings, group credit with joint liability partners has strong incentives to monitor one another to improve repayments. This process ultimately results in the expulsion of risky borrowers from group participation (Wydick 2001). The group lending with joint liability also offers benefits to both the lender and the borrowing groups in the sense that both parties profit from the transaction: the mechanism effectively transfers the lender’s screening and monitoring costs to the borrowing group on the one hand, and on the other hand this entitles the group members to receive loans from the lender with lower interest rates that are passed on to them as a result of the reduced costs. In effect, group borrowing with joint liability provides an effective way for banks to overcome adverse selection, moral hazard, and enforcement problems that are prevalent in the loan markets. The novel solutions offered by the borrowing group with joint liability features are discussed as follows.

The first solution or benefit offered by the GB’s methodological device touches on the collateral asset requirements for borrowing. The joint liability social asset redresses the problem of the collateral usually required of an individual credit contract. The only thing expected of the poor is the ability to find other poor entrepreneurs who are willing to accept one into their solidarity fold, and are prepared to support one to repay any given loans on time. The strategy thus encourages high loan repayment without collateral assets (Conlin 1999).

Second, since the loan taken is usually for self-employed economic enterprises (Morduch 1999a), the facility provides the would-be entrepreneurs with the opportunity to escape poorly paid jobs to operate their own business. This strategy has been used in Bangladesh to serve six-and-a-half million poor borrowers with loans, ultimately reflecting self-employment, of which the majority were women (Acher 2006). It has also been found in Bangladesh that the total level of employment created with a joint liability group loan was 19% higher than the control group, and the members also hired outside labour three times more than the control

group (Chowdhury et al. 1991). Besides, the number of income earners per household increased by 1.61 times per household samples studied in comparison to 1.38 for the control group.

Third, the dynamic incentive for a joint liability group lending strategy not only reduces the overall loan-related administrative expenses that are passed onto the borrowing group in the form of low interest rates (Ghatak 1999), but also provides a way to charge clients differential interest rates (to both safe and risky types of borrowers – Ghatak 1999).

Fourth and more interestingly, is that group credit with joint liability commitment has proven to reach the poor and in the process empowers them, particularly women who have been difficult to reach by other alternative programs (Morduch 1999a). There are other studies that report that a joint liability group credit scheme enhances the security and the dignity of the participating poor women (ILO 2001) through the provision of complementary services, for example, education, health, gender roles and the legal rights of the clients (Morduch 1999a). In view of this, it is clear that the GB’s joint liability group borrowing has an advantage over the agricultural subsidised credit approach of the 1950s to the early 1980s. This suggests that the group microcredit with joint liability approach of the post-1980s not only provides direct and tangible benefits to the poor, but also does so more swiftly (Rhyne and Jackelen 1991). On the lending side, the advantages of the group joint liability credit programs are as follows. Firstly, the system addresses the asymmetric distribution of information on the likelihood of loan default risk on the part of borrowing group members, thereby lowering the screening of the lender’s costs. The borrower’s risk, which is often difficult and costly to ascertain, involves two direct positive variable outcomes for the lender: the first is the loan repayment, and the second involves the expected profit. This sets in motion a process whereby the borrowing group utilises local knowledge advantage about each other’s assets, capabilities, and character traits necessary to sort and self-select members (Conlin 1999). Thus the high transaction costs in conjunction with the high risks that are borne by the financial intermediaries are not only due to the lack of good information on the credit history of the borrowers, and the absence of moral hazard, they are also largely responsible for the imposition of high interest rates on uncollateralised loans to cover costs and risks (Stiglitz and Weiss 1981).

Secondly studies report that GB’s group credit with a joint liability contract approach has a high repayment performance of around 95–98% (Wenner 1995; Christen et al. 1995; MicroBanking Bulletin 1998; Colin 1998; Besley, Coate, and Loury 1993; Ghatak 1999; Hussain 1988; Van Tassell 1999). These studies, however, were unable to pinpoint the GB’s specific profits on its programs; hence the high loan repayment performance in the GB’s programs does not suggest that profits are made. This issue will be revisited later in the chapter along with other deficiencies and shortcomings of the GB’s programs in order to demonstrate the vulnerability of the schemes that operate on the budgets of external financiers.

On the basis of the joint liability benefit flowing from the GB’s innovative lending strategy, there have been calls from some practitioners and development partners for the model to be expanded to many poor households worldwide. The former president of the World Bank, Mr James Wolfensohn, has even backed such calls during the 1997 Washington DC Microcredit Summit when he stated that helping 100 million households with microcredit programs would translate into helping as many as 500–600 million poor people (Morduch 1999a). Thus the family becomes the focus of the new development finance. Since the former president of the World Bank made the statement at the Washington DC Microcredit Summit, an assortment of the GB model has sprung up worldwide, including advanced economies such as the USA and Canada. Whilst many of these programs serve a small number of borrowers, a few others, particularly in Asian and South American countries, serve millions of borrowers and savers (Morduch 1999a and 2000; Meyer 2002b). The benefits and advantages of the GB’s innovations aside, the spread of its copycat model worldwide has been criticised on a number of grounds as discussed below.

Despite the GB’s strong repayment performance of its methodological model reported in many studies, the approach has been subjected to a number of attacks, ranging from the subsidy dependency badly criticised in some studies (Morduch 1999a, 1999b, 2000) to a host of other deficiencies and inadequacies discussed hereunder.

The first point of criticism centres on the group size. If the group size is large, it diminishes the effectiveness of the joint liability solidarity. The group members would find it extremely difficult to repay the loans of co-group members defaulting repayment. Although group size is not a problem in the GB’s group lending programs since its groups are made up of a 5-

member solidarity team (Bernstein 1996), it is, however, a problem in some programs modelled on the GB model: for example, the Village Bank’s programs of the Central and South American countries made up of around 30–50 members per group (Paxton 1996; Paxton and Cuevas 2002). When the group number is increased it could give rise to unintended adverse effects ranging from social ties to a free rider problem (Besley and Coate 1995; Ghatak and Guinnane 1999) discussed as the second point below.

The second problem is closely related to the first in the sense that a large group size could cause coordination difficulties resulting in the group members not knowing each other well enough to promote solidarity and oneness, or knowing each other but interacting less regularly due to other commitments as in the case of the GFF program of Arkansas State of the USA (Taub 1997). In other words, regular interactions usually required for the promotion of oneness and group solidarity were lacking in the GFF program, hence this was one of its problems (Taub 1997). Other financing methods that could support product design for a specific target group include the small group self-financing intermediary programs versus the community-based credit unions, and the community banks versus commercial banks or even financial companies (Woller, Dunford, and Woodworth 1999).

The third and perhaps the most significant problem is that group credit with a joint liability contract or social collateral relies on social ties among borrowing group members (Floro and Yotopolous 1991; Impavido 1998). But there is little to achieve or gain when the social ties among borrowing group members are too weak to support the feelings of oneness or group solidarity. Again, this was the problem initially encountered in an attempt to transplant the Grameen-styled microcredit programs to wealthier countries like the USA and Canada (Taub 1997; Conlin 1999). These findings diminish the significance of the Floro and Yotopolous (1991) research as well as the Impavido (1998) study that revealed, among other things, that strong social ties existing among the borrowing group members were the key factors responsible in securing high loan repayments in the GB’s programs. But Wydick’s (2001) research argues that social ties could only have played a minor role in compelling the high loan repayment of group credits reported as 67.1% among the Guatemalan borrowing group members as opposed to 10% respondents who only formed groups with people they were already in regular communication with, and another 18.6% respondents asserted that they had formed groups with their pre-existing business associates (Wydick 2001). Going by these findings, the threat of a social sanction variable or the variables of peers monitoring other

peers or peers exerting pressure on other peers to repay a loan are thought significant in improving the repayment performance, but the origin of such threats or peer monitoring of other peers or peers exerting pressure on other peers when repayment is breached, stemmed from the need to maintain an affordable credit source rather than on these other variables detailed above in the case of the Guatemalan borrowing groups (Wydick 2001).

The fourth problem dwells on individual differences that may arise when group members are unwilling, for whatever reason, to put pressure on the delinquent partners to repay their loan or to impose sanctions on them, hence this is a fundamental principle of the enforcement mechanism upon which the group joint liability formation was based in the first instance. The enforcement mechanism therefore can only work when borrowers are in a position to take such threats seriously, and this can only occur when the lenders themselves are willing and able to make good of their threat of sanctions when repayments are breached (Wydick 2001). But experience has shown that this does not happen in practice due to a couple of considerations (Wydick 2001). First, the NGOs (or private institutions) that provide these loans see themselves on a social mission rather than in the business of making profits: a fact which their clients know quite well, and are ever ready to exploit. The second consideration relates to the government angle. It is rare for governments that provide these loans (sometimes described as social loans) to be around to carry out their threat of sanctions due to political reasons or repercussions, for example, voter backlash or voter payback during elections (Wydick 2001). From this standpoint, it would appear as if the origin of the high loan repayment had stemmed from the need to remain in or with a group in order to continue to access an affordable credit source rather than on the threat of social sanctions or other variables outlined above (Wydick 2001).

Fifth criticism is on the GB’s social mission agenda in relation to the low interest rate operations. The GB-operated interest rates are much lower than their counterparts in the same country (Bangladesh) because loans were obtained easily from donor sources on soft terms or from governments on substantially subsidised rates (Morduch 1999a; Morduch 999b). The operation of any business on the budgets of external financiers is not only fundamentally shaky but it also renders the receiving institutions or persons vulnerable to attacks and criticisms.

repayment performance (Morduch 1999b), and are thus an indication that profits were not being made, thereby suggesting their lack of a self-financing capacity (Morduch 1999b). It has been chronicled that GB programs were continuing to receive loans or credits at concessional terms from a variety of sources (local and international) at their opportunity costs, which when calculated, amounted to the tune of US$26–30 million Morduch (1999b). From Bangladesh alone, for example, the GB got loans at concessional rates of 5–6%, which was lower than the official deposit rate of around 6–8% in the 1990s and also much lower than the market lending rate of 14–15% in 1993–1995, going by the GB’s accounts audited over the period by external auditors (Morduch 1999b). From an international dimension, the GB had also obtained loans for its programs from a variety of countries ataconcessional rate of 0–3% between 1985 and 1996, which were repayable in taka (Bangladeshi local currency). It has been argued that the GB’s subsidy dependence limited its ability and scope to operate interest rates that were comparable to its friendly microfinance competitors in Bangladesh (Morduch 1999b). Its (GB’s) competitors in the same country, for instance, the Bangladeshi Rural Advancement Committee (BRAC) was charging a 30% nominal interest rate to similar clients of GB’s base rate of 20% nominal interest for general loans in 1991, having been only 16% earlier (Morduch 1999b). A sustainable MFI that pays a commercial cost for its funds must also charge an interest rate that reflects this or diversify its financial services. To do otherwise would mean that it could not operate sustainably.

Morduch’s (1999b) findings suggest that there was nothing in the Bangladeshi laws in 1991 that precluded or limited the operators of GB programs from mobilising voluntary savings deposits from their clients other than the ‘forced savings’ that were imposed on their teeming millions of borrowers. On the contrary, the savings mobilisation in Indonesia has worked well with the result that as many as 16 million savers as opposed to 2 million borrowers operate accounts at any given time as at 1996 (Robinson 2002). This is a clear indication that the banking industry uses the savings deposits of its clients to provide credits to others. Some experts argue that the poor household’s welfare can be greatly enhanced with the provision of savings services in lieu of subsidised loans that limit the savings mobilisation, and in turn fuels cheap credits (Morduch 2000). This has given rise to hotly contested debates among many thinkers on how best to use the new development finance (microfinance) programs to lift many people out of poverty. Some scholars, for instance, argue that a sustainable MFI (i.e. one that could pay a commercial cost for its funding without losing money) must also charge an interest rate that sounds abnormal in the normal commercial bank market or arena of

political discussion, and that the lower the usury limit, the more borrowers there are at the lower end of the spectrum who cannot be served sustainably (Christen and Rosenberg 2000). The merits and the demerits of these debates are discussed below.