Microfinance and street children: is microfinance an appropriate tool to address the street children issue ?

1.2. Mechanisms

When talking about microfinance mechanisms, we are generally referring to the specific mechanisms surrounding the process of lending to poor people. Indeed, this is one of the major concerns of microfinance institutions: how to deal with poor people, lacking collaterals and hence being very risky, and to guarantee a good repayment in order to stay «alive».

Four types of mechanisms are generally listed: group lending, dynamic incentives, frequent repayment schemes and collateral substitutes.

1.2.1. Group lending

The formal banking sector teaches us how credit is generally delivered to individuals with physical collateral. Poor people do generally have no collateral. Therefore, the microcredit movement introduced a new delivery methodology called «group lending».

This word «refers specifically to arrangements by individuals without collateral who get together and form groups with the aim of obtaining loans from a lender» (Aghion and al., 2005). However, the loans are provided to the individuals and their projects, the group only being there to serve as a «guarantor» (this concept is called «joint liability»). The size of the group is variable, depending on the MFI choice.

Aghion and al. (2005) describe the process of a Grameen Bank group lending:

«The group - called Kendra - consists of five borrowers each; loans go first to two members, then to another two, and then to the fifth group member. As long as loans are being repaid, the cycle of lending continues. But, according to the rules, if one member defaults and fellow members do not pay off the debt, all in the group are denied subsequent loans.»

In order to reduce transaction costs, the loan officer meets seven other groups at the same time. All those 40 persons, called «centre», meet usually in the village.^52(*)

Because the joint liability contract implies generally that all the members of the group will not get any subsequent loans in case of default, they will have a high incentive to repay the loan of the potential defaulter.

Group-lending has interested a lot academic economists, and many economic papers analysed the effectiveness of such methodology; It is celebrated as a «contractual innovation that has achieved the apparent miracle of enabling previously marginalized borrowers to lift themselves up by their own bootstraps by creating `social collateral` to replace the missing physical collateral that excluded them from access to more traditional forms of finance» (Conning 2000).^53(*)

The potential benefits of group-lending can be summarized in two points:

a. Mitigation of Adverse Selection problems:

Adverse selection problems occur when lenders can not distinguish risky borrowers from safer borrowers (Aghion and al., 2005) because of the information asymmetry problems.

Ghatak (2000), and Aghion et Gollier (2000)^54(*) state that the group-lending methodology helps to overcome adverse selection problems as borrowers, by forming their own groups, will use their own information to find the best partners^55(*). In such a process, the safe borrowers will naturally form groups among themselves as they will look for group members who would able to manage their credit in a good way (Calles, 2005), and the risky borrowers will consequently be «obliged» form groups together. This leads to a segregated outcome referred to in the labour economics literature as «assortive matching» where the MFI has easier to detect bad groups (Aghion and al, 2005).

b. Overcoming Moral Hazard:

«Moral hazard in lending refers to situations where lenders cannot observe either the effort made or action taken by the borrower, or the realization of project returns» (Simtowe and al., 2005). Two types of moral hazard are generally identified: ex ante and ex post.

Stiglitz (1990)^56(*) argues that ex ante moral hazard can be overcome as the borrowers monitor each others' choice of projects and inflict penalties upon borrowers who have chosen excessively risky projects. Indeed, a «bank» can not do that, as «borrowers are protected by limited liability since they have no collateral to offer; in other words the «bank» cannot seize more than the borrowers' current cash flow» (Aghion and al, 2004). In that case, social sanctions may be exercised, as a borrower can denounce her/his peer's «misbehaviour».

This moral hazard concerns a pre-investment situation.

Interestingly, group-lending is also said to help overcome moral hazard generated after the poor client has made investment and generated profit; this is called ex post moral hazard. Indeed, the bank being unable to check whether the borrower may want to escape with the money generated by the investment without paying back the lender or to pretend that his return realization is too «low» to payback, other members of the group may want to afford a certain monitoring cost to check the revenue realization of their peer (Aghion and al, 2005).

This monitoring - whose cost has though to be small - is induced by the joint-liability contract which creates pressure on the borrower and her/his peers; in other words, sanctions can arise if one member can not repay, and can therefore guarantee better repayment rates.

Thanks to these two potential benefits, combined with a potential reduction in the transaction costs of the organisation, group-lending is said to overcome credit market inefficiencies.

However, some authors pointed out that group-lending is not without problems. Indeed, as the groups are self-formed, collusion problems may arise.

For example, Sadoulet (2005) points out 3 potential pitfalls. First, the clients may collude against risks by choosing partners wanting to default. Second, they can collude against bank and inflict no punishment, since they agree to default. And third, joint-liability may not be costless for the borrower and can increase cost of repayment, hurting therefore repayment rates.

Considering this, many organisations started to reconsider their group-lending contracts. Grameen II reflects such reconsideration. Indeed, under Grameen II, Dr Yunus^57(*) wanted to open new scopes for the bank and to readjust its current practices with its cumulated learnings. In such a perspective, Grameen II tries to lower the pressure on the borrowers by developing other innovative ways of guaranteeing a good repayment rate (Rutherford, 2004). Individual lending is therefore more emphasized and group-lending is more based, for the members, on a problem solving process, where they will try to help each other solve the problems underlying repayment rates, rather than to make a high pressure on its borrowers.^58(*) As pointed by Yunus (in Rutherford, 2004), his original concept of group-lending was not aimed at «guaranteeing» the loans of its members, but simply to help the members solve the problems that underlie repayment difficulties, stating that joint liability arose from the imagination of economists. So, Grameen II is returning to its initial statement.

* ⁵² «Loan delivery costs fall dramatically due to the simultaneous delivery of multiple loans and reduced time needed for credit approval» (Karlan, 2001, quoted in Calles, 2005).

* ⁵³ Quoted in Simtowe and al. (2005)

* ⁵⁴ Quoted in Aghion and al. (2004)

* ⁵⁵ This process is called « peer selection » (see Morduch 1999)

* ⁵⁶ Quoted in Aghion and al. (2005)

* ⁵⁷ The founder of the Grameen Bank

* ⁵⁸ Dr Yunus states that it was its initial idea when starting Grameen Bank and points out that «joint liability» arose from the imagination of economists and was not his initial objective.