Theory of Joint Liability Lending

Joint liability lending implies the act of financial institutions lending to a chosen group of borrowers, and making them jointly liable for the repayment. These institutions make it their business to grant loans to people not considered creditworthy by the mainstream. The very concept of joint liability is coined and implemented where conventional method of loan recovery fails, particularly when the borrowers lack collaterals. The programmes that are based on this principle have been praised for providing access to credit to poor households in both developed and developing nations (Park & Shen, 2003). This practice traces its roots back to the mid-nineteenth century, where a credit cooperative movement was successfully introduced in Germany, incumbent upon the idea of joint liability. The programme showed a remarkable track record of successful repayment, and was widely imitated in numerous locations on the European continent (Ghatak, 2000). This proves that giving loans to groups has been given due recognition during older times and it had been found to be successful.

The Grameen Bank’s Group Lending programme in Bangladesh and the SHG lending programme in India have several distinctive factors. The rural and urban poor are granted access to small loans for small-scale non-agricultural enterprises. This scheme

requires no collateral from the borrowers, and the interest rates remain on par with those charged by conventional banks. In the case of India, the commercial banks act as micro- finance institutions and lend micro loans to the clients. People intending to take out loans are advised to form small self-selected groups within their respective localities. The loans are then granted to each individual; however, liability is jointly distributed among the group, making each member liable for each other repayments.

The two distinguishing features of the contractual method employed by Grameen Bank and other lending institutions in explaining their spotless repayment record are the self-selection of group members, and joint liability. Under joint liability, a borrower’s payment is higher when the group members’ repayment rate of loans is higher. If borrowers have some information about each other’s projects and they are allowed to select their own group members, the carefully choose their externalities through joint liability which will make them to select their peers based on the information available (Ghatak, 2000).

The advent of joint liability is positive vis-à-vis group formation matching. i.e., safe borrowers will tend to stick together, which leaves risky borrower little choice but to band together. This is rather intuitive, due to the fact that safe partners repay more often, and are more efficient in income generating activities and earning higher incomes. This enables them to organize and repay their debts in a systematic manner than the risky partner. (Ghatak & Guinnane, 1999). Banks do not know details regarding the type of borrowers, as they lack screening tools such as collaterals. Furthermore, the poverty of the potential borrowers compels the banks to grant loans at the same nominal interest rate. This has the effect of singling out risky borrowers, as the safe borrowers are more than willing to accept a higher degree of joint liability.

Group lending slashes transaction costs, which are detrimental for borrowers taking out small loans. Peer pressure, social capital, members from the same locality and other

bonds of kinship and occupations support the credit contracts, which is not possible with other conventional banking systems (Besley & Coate, 1995; Ghatak & Guinnane, 1999).

By utilising the local information and the social capital present among the borrowers, the joint lending liability (JLL) can effectively address the four major problems faced by lenders, such as: i) To establish what type of a risk the potential borrower has (adverse selection) ii) To ensure that once the loan is made, it will be utilized properly and will be in a position to repay it (moral hazard) iii) To be able to find out how to handle project failures and learn to handle the inability to repay (auditing costs) iv) To find methods to force the borrower to repay the loan if they are unwilling to do so (enforcement) (Ghatak & Guinnane, 1999). However, Besley & Coate (1995) pointed out the fact that borrowers, who are capable of repayment under the auspices of individual liability, might be powerless to do so in the context of group liability. This situation is especially poignant when the members of the group come to the realization that they are incapable of meeting payments as a group. If faced with such a situation, no further loans will be granted (if rules are adhered to), and group members who would otherwise repay would decide to default instead, due to the fact that the encouragement in the form of future credit is non-existent. This model is also beneficial in that it illustrates how social collaterals can enhance joint liabilities (exception in the case of the default situation described above). (Giné & Karlan, 2009).

JLL is considered superior than conventional bankers in the social context for two distinct reasons. Firstly, members of a society are more aware of each other’s strengths and shortcomings. Secondly, JLL succeeded where credit markets failed, where a bank is incapable of implementing approvals against poor people who difficult on repayment of their loan, due to their poverty (Ghatak, 2000). Theories regarding peer monitoring are encouraged by the fact that group members are compelled (via incentives) to take remedial

action against a partner that is misusing their loan due to the presence of joint liability (J. E. Stiglitz, 1990). M. Sharma & Zeller (1997) expressed caution in relation to joint liability lending for what is termed as possibilities of group members to invest in high-risk projects. This is based on the fact that group members invest in high-risk projects, where they are jointly liable for repayment. The investment project risk will, therefore, be a burden to the whole group rather than to the individual member. Furthermore, the entire group defaults because they are influenced by the default of other group members, and this is described as a domino effect or debtor. (Besley & Coate, 1995).

Due to JLL, four mechanisms of design stand out: 1. The use of group liability to reduce screening, monitoring and delivery costs 2. The promises of repeat lending as a repayment incentive 3.The use of regular and more frequent payments, 4.The offer or sometimes requirement of savings (Yaron et al., 1997). Thus, in the context of group lending, individual borrowers are liable not only for themselves, but for others in the group as well, but savings in the form of better selection of projects allows banks to pass on certain benefits to the borrowers, usually in the form of in the reduced interest rates. The microcredit SHGs works on basis of the joint liability where small groups of homogenous women are entitled to credit and thus are jointly liable to repay their loans. The poor households who were neglected by the formal financial institutions are provided with financial services through SHGs for the purpose of income generating activities envisaged to improve their socio and economic status and to help them escape from the trap of poverty. This theory gives a broad spectrum to the research objectives, the role of microcredit to women SHGs in terms of their financial sustainability. Thus, group lending improves welfare and raises the repayment rates, which in turn improves the socio- economic standing of women in the microcredit programmes.