Microfinance in the 21 St Century : How New Lending Methodologies

The literature on microfinance has largely attributed the industry’s success to joint liability and peer monitoring, which are direct results of the group lending methodology. As individual lending has become more common in microfinance, especially in Latin America, we need to revisit the reasons for these successes. This paper uses a dynamic model with endogenously determined repayment incentives to discourage strategic default, or failure to repay a loan once a positive outcome is realized. In addition, the microfinance institution (MFI) is constrained to be fully self-sufficient, following “best practice” guidelines of the industry. The paper introduces a negative and unanticipated economic shock, such as burglary or illness, which can disrupt the microentrepreneur’s ability to repay the loan. When the lender cannot distinguish between strategic default and default as a result of a shock, the model shows that it is not necessary to stop lending operations indefinitely to microentrepreneurs who default—the current practice of most MFIs. The model also suggests how the requirement of donor agencies that MFIs become self sufficient may hamper the extension of credit into more remote and higher risk populations. This is done in a context that does not require the group lending methodology to provide repayment incentives to the borrower. This paper revisits the reasons for the success of microcredit, campaigns for a more formal banking sector practice by looking at a borrower’s credit history, and shows donors that sustainability is not always possible if it is the poor they aim to reach. * I am greatly indebted to Monique Cohen who gave me many stories and wonderful insight during my time at USAID. I am also grateful to my advisor, Roger Betancourt, for his continuing support and advice, as well as Mushfiq Mobarek, who gave comments on a previous draft. Any errors, of course, are mine. Email address: [email protected] 1 Accion International is one group which is changing their lending over from group lending to individual lending (de Aghion and Morduch, 1999). 2