Lending to self-employed poor people who have little or no collateral poses two main challenges to lenders: controlling the cost of making thousands of tiny loans, and securing repayment. Microlenders use a combination of techniques to meet these challenges:
- Group or individual lending based on an analysis of the character and cash flow of the borrower (or borrower’s household), rather than automated credit scoring
- Low initial loan sizes, with gradually larger amounts available in subsequent loans
- An understanding that borrowers who repay their loans faithfully will have prompt access to follow-on loans
- In some cases, a requirement that borrowers deposit “compulsory savings” before receiving the loan to demonstrate their willingness and ability to make payments and/or to provide a partial “cash collateral” for the loan
These techniques are not new: most of them have been used for centuries in lending to low-income people. In modern microfinance, they are used in individual lending programs and in three broad types of group lending—village banking, solidary group lending, and community-managed savings and loan programs.
Village banking organizes borrowers, usually women, into groups of 20-40. The microlender makes a loan to the group, which then on-lends to its members. Liability is joint: the whole group is responsible for the entire loan, so members are responsible for assessing each other’s repayment capacity.
In solidarity group lending, borrowers usually receive individual loans but are organized into smaller groups of five or so. Members may be jointly liable for each others’ loans, but joint liability is becoming less common.
In community-managed savings and loan programs, the role of the microfinance institution is to form and train the group rather than to lend to it. Some or all of the lending within the group is financed by the group’s own savings. No professional staff are involved in lending or collecting savings. Self-Help Groups in India make up the largest community-managed model; many of these groups get external loans from banks.
In individual lending, borrowers aren’t required to spend time in groups or take responsibility for each other’s loans. Instead, loan officers must analyze each borrower’s willingness and ability to repay, a task which takes considerable time, skill, and training. The operating cost for each loan is generally higher in individual lending than in group lending, so individual loans tend to be bigger.
Generally, clients prefer borrowing as individuals rather than in groups because they would rather avoid the burden of being responsible for each others’ loans. But group methods are cheaper and allow lenders to reach poorer and more remote clients.
Topic Contact: Greg Chen
- Due Diligence: An Impertinent Inquiry into Microfinance (Center for Global Development)
- Microfinance Handbook (World Bank)