Abstract
The purpose of this chapter is to examine the effect of joint liability lending on micro businesses in Madina municipality. Joint liability lending has become a popular and fashionable word in financial and development circles. It is a cross sectional survey study and used both primary and secondary data on joint liability lending. The study reveals that joint liability lending improves entrepreneurships and reduces poverty. There exist a significant relationship between joint liability lending and a high repayment rate. The implications are that individual within the group are encouraged to continue saving and microfinance institutions should continue investing in educating and training clients to improve upon their micro businesses.
Top1. Introduction
Microfinance institutions have played a fundamental role delivering broader access to financial services such as credit, savings and insurance to the poor; however, it is still unclear what policies allow microfinance institutions to successfully offer these services and whether or not the success of such policies depends on the socioeconomic environment in which the institution operates. Group liability claims to improve repayment rates and lower transaction costs when lending to the poor by providing incentives for peers to screen, monitor and enforce each other’s loans. However, some argue that group liability creates excessive pressure and discourages good clients from borrowing, jeopardizing both growth and sustainability. Therefore, it remains unclear whether group liability improves the borrowers overall economic situation and the poor’s access to financial markets. The purpose of this chapter therefore is to investigate whether joint liability lending can lead to entrepreneurial development and thereby reduce poverty.
The vast majority of studies in the microfinance literature have focused on the mechanisms behind the success of the group lending model that is used by the Grameen Bank in Bangladesh and by many other microfinance institutions around the world. On the theoretical side researchers have studied how joint liability contracts help to overcome the problems of adverse selection (Armendariz de Aghion & Gollier 2000), moral hazard (Stiglitz 1990; Varian 1990), and enforcement (Besley and Coate 1995).2 Some theories view the existing level of social capital as critical to the performance of group lending, and state that joint liability contracts can improve repayment because borrowers have better information about each other’s type; can more easily monitor each other’s investment; and can make use of social sanctions to force people to pay back a loan. Other theories contend that joint liability lending may succeed whether or not the contract is implemented among borrowers with high levels of social capital. Empirical studies show mixed results. Some of them provide evidence that social pressure or social cohesion are positively associated to the group performance (Wenner 1995; Abbink et al. 2006; Karlan 2001); while others show that strong social ties within borrowing groups make it more difficult to pressure members to repay loans (Wydick 1999; Ahlin and Townsend 2007). The effectiveness of microcredit as a tool to combat poverty is much debated now that, after years of rapid growth, microfinance institutions (MFIs) in various countries are struggling with client over-indebtedness and repayment problems. This chapter seeks to review and assess the role of joint liability lending in improving social entrepreneurship by focusing on the level of income, loan repayment and savings habits of beneficiaries of Joint Liability Lending.
Under joint liability lending, small groups of borrowers are responsible for the repayment of each other’s loans. All group members are treated as being in default when at least one of them does not repay and all members are denied subsequent loans. Because co-borrowers act as guarantors they screen and monitor each other and in so doing reduce agency problems between the MFI and its borrowers. A potential downside to joint-liability lending is that it often involves frequent and time-consuming repayment meetings and exerts strong social pressure, making it potentially onerous for borrowers. This is one of the main reasons why MFIs have started to move from joint to individual lending. The remainder of the chapter is organised as follows: section 2 reviews the literature on joint liability lending and a description of joint liability loans. Section 3 presents the relationship between joint liability lending and poverty reduction with empirical evidence. Then, section 4 presents strengths and weaknesses of joint liability lending and finally concludes.
Key Terms in this Chapter
Microenterprise: A business operating on a very small scale, especially one in the developing world that is supported by microcredit.
Joint Liability: Microfinance lending methodology where a group of individuals are all responsible for each other’s loans if one member defaults. Group liability may improve repayment rates but it also raises the possibility that bad clients will take advantage of good clients in their liability group.
Moral Hazard: Moral hazard occurs after the money has been disbursed to the borrower and it arises out of the fact that the borrower may have an incentive to breach the loan covenants by investing in ‘immoral projects’ which are unacceptable in the eyes of the borrower because inasmuch as they have a high possibility of gain to the borrower, they also have a high possibility of failure which will have the most detrimental effect on the lender. Information asymmetry causes moral hazard because of the lender’s lack of knowledge about the borrower’s activities.
Microfinance: A source of financial services for entrepreneurs and small businesses lacking access to banking and related services. The two main mechanisms for the delivery of financial services to such clients are: (1) relationship-based banking for individual entrepreneurs and small businesses; and (2) group-based models, where several entrepreneurs come together to apply for loans and other services as a group. In some regions, for example Africa, microfinance is used to describe the supply of financial services to low-income employees, which is closer to the retail finance model prevalent in mainstream banking.
Transaction Cost: A cost incurred in making an economic exchange. The economic exchange here represents the given out of loan facility to the group members and the group members paying back the facility.
Adverse Selection: A risk exposure that exists before the money is lent to group members. It occurs when bad credit risks become more probable to acquire loans than good credit risks. Because of information asymmetry, lenders tend to have a hard time differentiating between good credit risks and bad credit risks. As a result, lenders end up with a loan portfolio comprising almost entirely of bad credit risks.
Informal Economies: The part of an economy that is neither taxed, nor monitored by any form of government. The informal economy is the diversified set of economic activities, enterprises, jobs, and workers that are not regulated or protected by the state. The concept originally applied to self-employment in small unregistered enterprises. It has been expanded to include wage employment in unprotected jobs.