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Master Thesis of 2004. Still gives you a fairly good overview about what's microfinance is about (and some "German English").
Master Thesis of 2004. Still gives you a fairly good overview about what's microfinance is about (and some "German English").

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Published by: Basti on Jun 02, 2007
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Source: Dornbusch and Fischer (1995), p. 406

Even if good investment opportunities for poor people exist, the question remains if it is

possible to distinguish between high and low risk borrowers. The problem of adverse

selection is overcome in a cost effective way in many MFIs.180

For the better off poor

for example, institutions like BRI base their decision on whether or not to approve a

loan by assessing the repayment ability of potential borrowers from their current income

flows and not from the uncertain returns generated by the loan.181


collateral is used in some cases to attract low risk borrowers.182

In contrast to

industrialized countries this is usually not done to cover the potential losses of the

lender, but to punish the defaulter and therefore increase her willingness to repay.183

Obviously this does not always work for the poorest, since they often neither posses any

goods that could work as collateral nor do they have sufficient earnings prior to

obtaining a loan for starting an income generating activity. Here the so called group-

lending model can help to identify creditworthy borrowers. The most prominent

institution using this approach is the Grameen Bank, which only provides credit to


See Farrington (2000), p. 20.


See Robinson (2001), p. 80; Robinson (2002), p. 238.


See Bester (1985), p. 850 et sqq.


See Schmidt and Tschach (2001), p. 15; Robinson (2002), p. 244.





members of a group of five. These groups are formed by their members without

interference of the Grameen Bank. Although in this particular case no joint liability

exists for the members of the group, nobody can receive a new loan if another member

of the group fails to repay on time.184

Therefore the group formation work as a

screening process. Since the borrowers do not want to risk their ability to obtain further

loans, they carefully select with whom to form a group. Usually the members know

each other for a long period of time and therefore they can make a meaningful judgment

of each others’ ability to repay the loan. Other MFIs even require the members of a

group to mutually guarantee each others’ loans.185

While this might further increase

borrowers’ efforts to search for trustworthy group members, it might also keep potential

borrowers from applying for a loan since she does not want be held responsible for

defaulting members. This mechanism enables MFIs to partly pass on the transaction

costs related to the selection of low risk borrowers, to the borrowers themselves.186

Many MFIs have also largely overcome the problem of moral hazard by creating

incentives to ensure a high repayment rate, even among the poorest. In some cases their

customers go hungry in order to pay back their loan even though no legal action would

be taken against them if they would refuse to do so.187

One way to achieve this is to

build up peer pressure through the formation of groups as described above.188


and probably the most important, is to limit access to future loans to those borrowers

who repay on time. The demand for successive loans is extremely high. In a 1996

survey, 98 percent of BRI borrowers planed to apply for another loan189

and in 1993

less than 30 percent of Grameen Bank loans went to first time borrowers.190


the poorest highly value the option to reborrow191

and many MFIs see this as their

primary incentive to ensure repayment.192

According to Schmidt and Tschach, “the net

present value of future access to credit works out to be roughly half the value of the

economic advantage to be gained from the intended non-repayment.”193

This can also


See Yunus (1998), p. 135.


See Schmidt and Zeitinger (1997), p. 6.


See Stiglitz (1990), p.353.


Own observation at the Grameen Bank in Bangladesh (2003).


See Hoff and Stiglitz (1990), p. 249.


See Robinson (2002), p. 251.


See Khandker, Khalily and Khan (1995), p. 93.


See Gibbons (2000), p. 15;Hashemi and Schuler (1997), p. 43.


See Gibbons and Meehan (1999), p. 160.


See Schmidt and Tschach (2001), p. 16.


explain the occurrence of a drop in the repayment rate once a MFI is no longer seen as

viable and therefore is not expected to provide loans in the future.194

With the help of the described mechanisms, MFIs around the world are able to keep

repayment rates high. A survey of 69 MFIs from 36 different countries, each serving

more than 10,000 clients in 2002, found the portfolio at risk (PAR)195

varied between

zero and 23.1 percent. While the average was 3.6 percent, the median was found to be

2.29 percent.196

One of the MFIs included in this sample is BRIs who’s 12-month loss

ratio has never exceeded five percent since the start of its transformation in 1984, and

from 1997 to 1998, the ratio actually fell from 2.2 to 1.94 percent.197

The latter deserves

special attention, because the Asian financial crisis reached its peak at that time with

Indonesia being hardest hit , as illustrated by a statement from The Economist in July

1998: "Even with the fierce competition from its neighbors, Indonesia would probably

walk away with the prize for Asia's most desperate banking system.”198

The findings that MFIs can adapt their services to low income people in order to ensure

a high repayment rate, and that poor people do not lack profitable investment

opportunities are illustrated in figure 4. From this diagram it can be seen, that under the

new assumptions the interest rate at which the bank maximizes its return differs for

large (I(l)*) and small loans (I(s)*). According to the assumption that micro-

entrepreneurs can realize a higher return on their investments, the bank can charge them

a higher rate of interest without bearing an increased risk. Nevertheless, in this example,

the bank would still serve the market for large loans first because of the higher

transaction costs for smaller loans.

The view, as described in figure 4, is shared among most traditional banks and investors

in industrialized as well as in developing countries. In addition to neglecting the

possibility of generating profits by offering microcredit themselves,199

they also hesitate

to lend to MFIs because they consider their business too risky.


See Schreiner (1997), p. 64.


“PARshows the real risk of the portfolio by comparing outstanding loan balances for loans with at
least one late payment to the outstanding loan portfolio.” Gross and de Silva (2002), p. 22.


Own calculations. See Appendix 2.


See Seibel (2000), p. 11.


The Economist (1998), pp. 92 et sqq.


Busch and Kort (2004), p. 8 .


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