(IMF Working Paper, Prepared by Anupam Basu, Rodolphe Blavy, and Murat Yulek1, September 2004)
The technologies described above, based on the formalization of informal techniques and on group-based instruments, have been used to promote financial sustainability of MFIs. They have the advantage of addressing a number of problems faced by financial institutions when operating with the poor or with the informal sector, for example, asymmetry of information, lack of collateral, and difficult enforcement of legal rights.
The linking of savings and credit programs is often used as a way to overcome the problems caused by asymmetry of information between lenders and borrowers, and by the borrowers’
lack of collateral, although this limits the flexibility in allocating loanable funds. In particular, the weakest performers could drag down the performance of the entire group.
However, by making the group responsible for loan recovery and repayment, peer pressure acts as a substitute for collateral. MFIs can then save on transaction costs and increase the repayment rate. Hence, group-based microfinance techniques may also be viewed as a response to portfolio performance problems experienced with individual loans. At the same time individual lending technologies have also been successfully adapted to the microfinance context. In Ghana for example, the RCBs had initially focused on standard commercial loans to individuals and experienced a high volume of non-performing loans, but they later improved performance by adjusting the terms of the loans, generally to short-term (4-6 months), and by requiring weekly repayments, and retaining a compulsory up-front savings of 20 percent as a security.
Group lending with joint liability tends to encourage self-selection and group formation among good credit risks, addressing partially the problem of imperfect information faced by the lender, and thereby lowering the overall risk of the group lending scheme. This is because the risk of a potential default by any one individual is borne by the whole membership. A number of limits/risks may exist in group lending schemes with joint liabilities, where the behavior of one individual may affect the repayment of the group as a whole:
• First, under a group lending scheme, the burden of risk borne by an individual member of the group is higher than it would have been under a limited liability scheme. Thus for a group lending-scheme to be the preferred alternative to a limited liability scheme, the gains from lower overall risk under the former would have to outweigh the default risk that borrowers pass on to the nonborrowers of the group lending scheme.
• The second risk is a contagion effect whereby a default by one borrower affects the credit rating of the group as a whole and causes it to default.
• The third risk is a coordination failure problem as individual borrowers have an incentive to default when they expect other individual members of the group to fail.
This may prompt a default of the group even when all its members are solvent.
Some mechanisms have been designed to reduce the risk that individual behavior may impose on the group as a whole. Sequential lending, when loans are provided sequentially to different sub-groups of borrowers participating in a given group lending scheme, is one example, that reduces contagion and coordination failure risks.6 Also, self-selection leads to the formation of groups of relatively safe borrowers, hence limiting the transfer of risk from the group to the individual borrower. One concern is that group lending schemes have been argued to be overly conservative in risk-taking, selecting only the safest projects.
The obvious critical issue is whether MFIs have achieved financial sustainability, at least in the sense of achieving “break-even” in their current operations, if not also in fully covering their investment costs. There is little hard data available for African MFIs to answer this question, and one has only partial data at best. There is some evidence that MFIs are able to improve their financial performance, if they have autonomy over their management decisions; are allowed to set their lending and deposit rates to maintain a spread consistent with profitability; are vigilant in their efforts to avoid or reduce the incidence of nonperforming loans; and focus on addressing their capacity and skills supply constraints.
• In Benin, following the financial rehabilitation programs of 1989-93 and that launched in 1999 (described below in Box 4), many SLCs were able to substantially expand their deposits and loan portfolios, recover their nonperforming loans, and achieve break-even or positive net profits in their current operations.
• In Ghana, the performance in the rural microfinance (RMF) sector is reported to have improved in recent years. The combination of (i) a more commercial approach, (ii) a restructuring of the sector through re-capitalization and capacitybuilding, and (iii) strengthened regulation contributed to reduce drastically the proportion of distressed RCBs. At the level of S&Ls and credit unions, weak financial performance, mostly due to a welfare focus and policies of low interest rates, was reportedly improved through a greater commercial focus supported by better management and financial reporting. From 1996 to 2001, the proportion of “unsatisfactory” credit unions declined from 70 percent to 60 percent and that of those in the worst categories from 42 percent to 15 percent.
• In Guinea, the four existing MFIs are reported to have strengthened their financial performance over the period 1997–2003. They achieved this by lowering the share of non-performing loans (NPLs) in their total credit and raising their lending rates, and improved their prospect of achieving a more sustainable financial position. The share of NPLs in the four MFIs was considerably lower than that of the commercial banks, and with the aim of achieving financial sustainability, the MFIs maintained a wider interest rate spread than that prevailing in the banking sector.
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