Week 9 - Lecture B

Week 9 - Lecture B - ECON 4411A, Fall 2011 Development...

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Unformatted text preview: ECON 4411A, Fall 2011 Development Economics Summary Notes: Week Nine, Lesson 2 More on Credit Markets Quote of the day: Education is not the means of showing people how to get what they want. Education is an exercise by means of which enough men, it is hoped, will learn to want what is worth having. RONALD REAGAN Implications of Group Lending 1. Positive Assortative Matching: This is a process of teaming up to- gether. Both bad and good risks equally want to team up with the good risk in a group but the advantage of group lending is that with informa- tion, if good risks can identify other good risks they will form a group together. Thus group formation has the property that it can drive out the bad borrower from the market which is not possible in individual lending where the bad can create an adverse selection problem. 2. Peer Monitoring: The assortative matching argument is based on the assumption that a borrower is either safe or risky. This is the case where it is hard to control what a group member does with her money but you can predict if they tend to be bad borrowers. However, it is possible that in some situations, group member can affect what each member does with the loan by monitoring and influencing the choice of individual projects. Recall that limited liability leads to excessive risk taking, because the borrower fails to fully internalize the costs of project failure. However, as the costs would be borne by the group members, they have a strong incentive to pressurize each other to avoid risky projects. Thus group lending has two effects that work in opposite directions. First, it increases the risk to on any one borrower in comparison to individual borrowing. This is a cost. Second, it creates pressures for peer monitoring to lower the level of project riskiness: this is a gain. 3. Potential drawback: There are some possible drawbacks of the Grameen setup. First, if one member really has financial constraint and defaults, the dominant strategy is for all to default because they all cannot get subsequent loans. The Grameen Bank avoids this problem by lending se- quentially to group members, thus minimizing the contagion effect of an individual default. Second, the peer monitoring effects might also lead to a group being over conservative in its choice of projects. Group members may put excessive pressures on each other to choose overly safe outcomes that are not socially optimal in terms of average profitability. Finally, group-based schemes may lack flexibility and one member can slow down the rate of growth for the others [refer to class explanation]. 1 Viability and Performance of Microfinance Institutions Though the Grameen bank has been successful in terms of reaching the poor, it is important to note that it may not be viable as a credit institution model....
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Week 9 - Lecture B - ECON 4411A, Fall 2011 Development...

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