tawandamusarurwa
Nixon Chekenya
ONE key challenge for growth in developing countries in general and rural markets in particular is lack of access to credit, especially in Zimbabwe’s rural areas in which the majority of individuals and households do not have collateral to secure a bank loan.
These individuals, due to inability of banks to monitor and enforce loan repayments, are forced to either borrow from informal sector and loan sharks at usurious interest rates or are simply denied access to credit.
A potential solution to this problem is the implementation of peer-monitoring contracts by rural banks and microfinance institutions (MFIs).
As opposed to conventional standard in bilateral (creditor-borrower) debt contracts, these agreements are premised on a collective basis, a group of borrowers with no collateral who are linked by a “joint-responsibility” default clause: if a group member defaults, other members are obliged to repay her share of the debt, or else the entire group loses access to future refinancing.
Collective credit agreements with joint responsibility have the merit of inducing peer monitoring among group members, thus transferring a portion of the costly monitoring effort usually incurred by banks onto the borrowers.
In practice, economies such as the Philippines and Bangladesh have used peer-monitoring arrangements in microlending extensively.
In order to ensure that peer monitoring is successful, there is need to focus on the distribution of risk within the peer group, the structure of monitoring is appropriate and making sure an optimal group size (not too big or small) exists.
There is need for innovative ways by rural banks and MFIs in crafting optimal design of collective agreements with joint liability.
These agreements can potentially induce peer monitoring, reduce the probability of strategic default and enhance the lender’s ability to elicit repayments.
The resulting benefits from such agreements in terms of extended credit must be compared to the administrative costs and monitoring efforts that such agreements impose upon participant borrowers.
In any given case, the relative benefits from peer-monitoring arrangements are maximised when risks are positively correlated across borrowers and when the group size is neither too small due to a joint responsibility cost sharing and commitment effects, nor too large owing to a free-riding effect.
The decision to default on a credit arrangement can be attributed to borrowers being either unable or unwilling to meet their debt obligations.
This can be a challenge.
However, joint responsibility agreements can prevent defaults, especially of the latter kind, which are popularly known as strategic defaults.
Borrowers in Zimbabwe’s rural areas have a comparative advantage in monitoring each other owing to geographical proximity, trade links and social ties.
This is also true for most emerging and developing markets.
Also, these grouping arrangements imply that borrowers have access to superior enforcement technology in the sense that they can impose social sanctions on peers who default strategically.
These two features provide a rationale for rural banks and MFIs to engage in group lending in collective debt contracting, whereby participant borrowers within a group are held jointly responsible for the group loan facility.
The logic is simple.
Borrowers under joint responsibility lose access to future credit in case the group defaults.
They, therefore, have an incentive to monitor each other and to enforce debt repayments by threatening to impose social sanctions and destroy the social reputation of peers defaulting strategically.
This comparative advantage on borrowers’ side regarding monitoring and loan enforcement, as well as joint-responsibility contracts involve economic efficiency gains.
With optimal monitoring structures, it is clear that servicing rural markets is a justified cause.
Despite this being a noble pursuit, my argument so far has to be interpreted with caution.
There are considerable challenges associated with group lending. One is free-rider problem.
A larger group size may discourage individual commitment and monitoring effort.
However, for the firm, with a larger number of peer borrowers, there is an increased likelihood of at least one borrower being fortunate and able to repay for a peer borrower who defaults strategically, thus cancelling out (mathematically) the free-rider problem.
On the other hand, a larger group size tends to increase peer-monitoring effort, due to a joint-responsibility, a cost-sharing and commitment effects. This, together with the fact that the rural bank or MFI is better insured against individual defaults when the number of borrowers in the group increases, tends to make the bank’s net payoff per borrower an increasing function of group size.
This positive correlation between size and efficiency, however, is mitigated by the fact that a larger group size increases the scope for free riding in debt-repayment decisions.
*Nixon Chekenya is a lead research fellow & teaching assistant at the Department of Agricultural & Applied Economics (W. Davis College of Agricultural Sciences & Natural Resources)
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