Social ties and factors affecting repayment rate in microfinance groups: An empirical investigation

Abstract

Providing for credit in rural & low income areas has been a difficult task for primarily three reasons. These are a) Accessibility b) Huge information asymmetry between borrowers and lenders and, c) Lack of adequate collateral on part of borrowers. These factors have an impact of restricting lending in the rural areas. In their paper, Ghatak and Guinnane (1999) identify four problems that lending institutions face while lending in rural areas. a) The problem of adverse selection: Determining the level of risk of default of the borrower b) The problem of moral hazard: Ensuring that the borrower will use his/her loan in a manner so as to maximize the probability of repayment c) The problem of auditing: Monitoring the degree of success of the borrower’s project, so as to ascertain whether the borrower can repay the loan in the case that the borrower claims inability to repay d) The problem of enforcement: Enforcing repayment of the loan when the borrower strategically attempts to default Despite these problems, in the last four decades microfinance lending has done well to provide credit to the poorest. The microfinance programs in India and world over, though different in various aspects are based on one common premise i.e. group lending. In a typical group loan, borrowers with distinct individual requirements are required to form groups which apply for loans together. The whole group is liable if one or more group members default. Thus, joint liability provides an insurance against individual risks. Also, joint liability serves as an alternative for collateral. In case of individual loans, the above mentioned four problems correspond to problems that the bank must solve. In group lending, the lending institution shifts one or more of these tasks to the group receiving the loan. This shift of task is based on the premise that individuals possess large amount of information about each other’s behaviour, given that these people tend to live in close proximity to each other. Group lending is often commended for success of microfinance institutions. The repayment rates on these group loans are very high across the world, mostly more than 95 percent. This observation of micro loans been characterised by high repayment rates has motivated many theoretical and empirical studies. This paper is also motivated by the same characterisation i.e. high repayment rates. In this paper, we attempt to study the factors that affect repayment rates. In particular we focus on the impact of social ties on the repayment rates bases on empirical investigation of Grameen Koota branch (Channapatna Main) in Karnataka, India. The motivation to study impact of social ties on repayment rates comes from the fact that group lending is characterised by free rider problem and MFIs have attempted to solve this problem by self selection of groups. The assumption is that closer social ties will enhance peer pressure and enforcement. Besley and Coate (1995) show that the possibility of social sanctions on peers helps improve repayment. However, social ties having positive impact on repayment rates is debatable. Wydick (1999) in his empirical study on MFIs in Guatemala finds no evidence that groups made up of acquaintances have higher repayment rates than those consisting of strangers. Social ties might also have negative impact on repayment rate due to collusion or forgivingness towards defaulters. In this paper we conclude that social tiesi have negative impact on repayment rate based on empirical study and back it with theoretical predictions. Several papers earlier have empirically or theoretically studied factors that affect repayment rates. This paper has been divided into seven sections. Section II A discusses literature review on group lending and Section II B discusses literature review on social ties. Section III A discusses the early origins on microfinance; Section III B discusses recent origins and Section III C discusses microfinance in India. Section IV discusses the methodology of the study. Section IV A discussed the profile of Grameen Koota; a MFI based in India whose branch data we have used, Section IV B discusses the type of data available to us and Section IV C discusses the regression model. Section V discusses the regression results & analysis and Section VI concludes.