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66
Understanding the Grameen Miracle:
Information and Organisational Innovation
Indrani Roy Chowdhury
A rigorous analysis of the institutional structures
underlying Grameen I yields some interesting economic
insights. The essential idea is that an appropriate
institutional design can help in tapping into the
informational pool available at the local level among the
borrowers themselves and something that may not be
accessible to outsiders. We argue that such simple and
unconventional contracts can harness market efficiency,
even though formal and conventional contracts may fail
to do so. This paper tries to demonstrate how exactly
innovative features like joint liability lending, sequential
lending, contingent renewal, etc, can serve the purpose.
I would like to acknowledge research support from the Planning and
Policy Research Unit at the Indian Statistical Institute, Delhi Centre that
made the writing of the paper possible.
Indrani Roy Chowdhury (indranirc1@gmail.com) is with the Department
of Economics, Jamia Millia Islamia, New Delhi.
O
ne of the most important research areas, dating back to
Schumpeter (1912) and Hicks (1969), deals with the role
of nancial intermediaries on the growth and develop-
ment of an economy. Levine (1997,

2003) discussed the positive
correlation and possible linkages between growth of nancial
sectors and overall growth and development of an economy. The
main ndings are that development of nancial instruments,
markets and institutions ameliorate problems of information, en-
forcement and transaction costs. This, in its turn, positively inu-
ences the savings rate, investment decisions, technological inno-
vations, and nally, the growth rate.
In a credit-starved developing economy, nancial intermediar-
ies actually bridge the gap between supply and demand and
thereby boost economic activity, productivity and growth. How-
ever, the performance of formal sector lending to the poor is
rather depressing in terms of penetration, outreach, targeting, as
well as repayment rates.
Hence, from a developmental perspective, nding an alterna-
tive means of channellising credit to the poor, thereby improving
access, is of primary importance in the ght against poverty and
inequality. It is now evident that the micronance organisations
have been quite successful in reaching the poor, and equally im-
portantly, doing so on a sustainable basis.
1
The Grameen Bank,
for example, has a repayment rate of over 90%, see, e g, Hossein
(1998) and Morduch (1999a).
This paper focuses on the institutional aspects of micronance
organisations, examining how their unique design help in solv-
ing some of the informational problems associated with rural
credit markets. This relates to the broader question of how a
m arket-oriented approach to facilitating nancial intermediaries
can actually make a dent in rural poverty.
In this context, we will discuss some of the organisational
i nnovations of the most celebrated micronance institution the
Grameen Bank in Bangladesh. The discussion will shed light on
how some simple and unconventional contracts can harness market
efciency, even when formal and conventional contracts fail.
The basic organisation of the paper is as follows: Section 1 dis-
cusses the importance of credit to the poor. Section 2 sets up the
basic framework, explaining the informational problem (or the
agency problem) associated with credit contracts, demonstrating
why raising the interest rate is not always a solution. Section 3
examines the role of micronance institutions in alleviating the
informational problems associated with credit contracts. It fur-
ther tries to analyse whether group lending through joint liability
is the ultimate answer or under what circumstances it might fail.
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Section 4 focuses on joint liability lending (JLL), examining the
role of dynamic incentive schemes like sequential lending,
progressive lending, sequential repayment and contingent
r enewal. The purpose is to highlight how these specic features
can reinforce the contract structure and exploit the efciency of
the market. Finally, Section 5 concludes with a discussion of the
Indian Self-Help Group and Bank Linkage Programme (SBLP) of
Indian scenarios.
1 Credit and the Rural Poor
Inadequate credit delivery to the poor can be largely traced to
market failure, leading to a large demand-supply gap in rural
credit markets. The formal institutions have surplus funds, but
they are reluctant to operate in rural markets, as is evident by
their gradual disappearance from the rural economy. Given the
small volume of a typical rural loan, lack of collateral, absence of
credit history, prohibitively high information costs and formal sec-
tor ofcials ignorance regarding their rural clientele, formal lend-
ers nd transaction costs to be prohibitively high. Another deter-
rence is the susceptibility of the rural poor to exogenous shocks,
with their unstable regular income and unforeseen expenditure.
Formal banking nds it easier and less risky to full its loan tar-
gets in the rural areas by providing loans to the bigger clients.
On the borrowers side, lack of rural market penetration, the
limited number of working days and hours create an accessibility
problem for the poor. Further, the cultural gap between the for-
mal sector ofcials and the rural poor leads to the problem in
complying with bank formalities, in particular in accessing subsi-
dised credit. Another signicant manifestation of this cultural
divide is the inability or the unwillingness of the banks to design
credit, or even savings schemes, especially for the rural poor. For
example, formal sector loans typically have very little exibility,
or access to consumption loans.
Attempts at credit-market intervention in less developed coun-
tries (LDCs) were not very successful in general. In India, for ex-
ample, subsidised loans were provided for the poor through the
Integrated Rural Development Programme (IRDP) (allocated 30%
subsidised credit to socially excluded groups and another 30% to
women) and various anti-poverty programmes during the 1970s,
1980s and the rst half of the 1990s. These programmes were,
however, heavily subsidy-driven, leading to some inherent weak-
nesses.
2
Once the banks are directed to provide subsidised credit,
this induces an excess demand in the market and provokes vari-
ous forms of clandestine trends and diversion of credit from the
targeted groups. Moreover, resources are often mismanaged. This,
along with interest rate restrictions, prevent the formal sector
banks from operating viably in poor areas.
3
In fact, credit subsidy
programmes failed to promote banking culture and generate self-
dependence among the poor, not only in India, but all across the
world (Morduch 1990; Varman 2005; Burgess and Pande 2005).
In the next section we turn to a more detailed examination of
informational asymmetry problems in LDCs.
2 Informational Problems in Rural Credit Markets
We begin by trying to formalise the informational problems in-
trinsic to any credit transaction. Consider two agents, a borrower
and a lender. The borrower has a project, but no money with
which to nance it, for which she has to depend on the lender.
The agency problem arises due to the lenders inability to verify
either the borrowers characteristics (e g, nature of the project,
risk involved, etc), or to verify the borrowers effort to realise
prots. Further, with infrequent transactions reputational effects
are quite weak for the rural poor. The absence of credit history,
collateral and weak legal enforcement mechanism, coupled with
limited liability, often accentuates the problem.
This informational asymmetry can usefully be classied into
three groups:
Adverse Selection: This arises because the lender may have lit-
tle, if any, reliable information about the quality of the borrower
(whether a good/safe, or a bad/risky borrower). This is the lem-
ons problem rst highlighted by Akerlof (1970). Further, acquir-
ing such information may be prohibitively costly.
Ex Ante Moral Hazard: Once the loan is granted, the lender does
not entirely know how the borrower will utilise the money. The
uncertainty could be either with respect to the effort level chosen
by the borrower, project choice, i e, whether risky or not, etc.
Ex Post Moral Hazard: Once the investment returns have been
realised, the lender may not be able to verify the magnitude of
the returns. In such a scenario, it is therefore tempting for the
borrower to suppress the protability of the project. Further, in
a poor economy, the borrowers are protected by limited liability,
so that in the case of project failure the bank will lose the
entire investment.
2.1 Adverse Selection (Hidden Types)
This subsection is based on Stiglitz and Weiss (1983). Banks face
borrowers with potentially valuable projects, but are unable to
discriminate between good (i e, safe) and bad (i e, risky) borrow-
ers. If borrower types were known then the bank could charge
different rates from different kinds of borrowers (relatively
higher interest from risky borrowers for their added risk of de-
fault). In the absence of such information, however, the bank has
to charge uniformly high interest rates to everyone to compen-
sate for the possibility of having risky borrowers in the client
pool. At this high rate of interest, however, the good borrowers
may not nd it worthwhile to borrow, despite having protable
projects. This is the problem of credit-rationing, which is essen-
tially the lemons problem in another guise. Hence, the credit
market intervention by merely raising the interest rate may not
ensure efciency.
Example: We use a simple stylised example to illustrate the idea.
Consider a poor economy consisting of 200 rational prot-
maximising individuals, 100 being good (safe) and 100 being bad
(risky) borrowers.
Each individual can invest Re 1 by borrowing in a one period
project. A safe borrower has projects that yield a return (Y
1
) of
Rs 2 with certainty on an investment of Re 1. Bad borrowers have
risky projects an investment of Re 1 yielding a return (Y
2
) of
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Rs 4 with probability p = and 0 with a probability (1-p) = 1/2.
Hence, if the venture succeeds, risky borrowers can earn higher
prot than safe borrowers (Y
2
> Y
1
). But when risky borrowers are
not successful, they earn zero and cannot repay the loan. For sim-
plicity we assume that both types have identical expected re-
turns; i e, the two types do equally well when returns are ad-
justed for risk (1/2 Y
2
= Y
1
).
Suppose for the banks an investment of Re 1 has an opportu-
nity cost of R = 1.8. (Under competition the return of Rs 1.8 is the
break-even point of the bank.) This is equal to the full cost of rais-
ing money from depositors. Thus a bank would agree to give a
loan of Re 1 to the poor provided the expected return is at least
1.8. Note that for any factor of interest, say x < 2, the banks ex-
pected return is ( x + .1/2 x = x). From the break-even
condition this implies that x must be at least 2.4 (3/4x =1.8, or
x = 2.4). Since the bank cannot practise price discrimination, the
presence of risky borrowers into the mix causes the bank to raise
interest rates.
At such high interest rates, however, the safe borrower will not
be interested in taking the loan at all. In fact, it is easy to show
that the only equilibrium involves the risky borrowers getting a
loan, which is the problem of credit rationing. Thus raising the
rate of interest may not bring efciency. Hence, the lenders lack
of information on the type of the borrowers (who can be good or
bad) leads to a situation where the lender may not able to nd an
interest rate that appeals to all creditworthy customers and al-
lows the bank to break even.
2.2 Ex Ante Moral Hazard
In a perfect world a project is worthy of getting a loan if gross
project returns net of all costs exceed the marginal cost of capital.
Suppose, however, that project success depends on the effort
level of the borrower. In an ideal situation the borrower will pro-
vide the effort necessary to make it a success. But that is not the
complete story since ex ante and ex post moral hazard is missing
from the framework. Ex ante moral hazard refers to the idea that
borrowers take non-veriable actions after the loan has been dis-
bursed, but before the project returns are realised. This hidden
action affects project returns, which in turn may generate inef-
ciencies since optimally the borrower may not want to lend at all,
or more generally, reduce the scale of the loan. We illustrate this
idea with a very simple model.
Example: Consider a poor borrower who is fund-constrained,
but has a potentially protable project that requires an invest-
ment of Rs 2. Project returns, however, depend on the effort put
in by the borrower. It is Rs 5 if the borrower works hard, and zero
if she shirks. Shirking, however, provides a private benet of say
Rs 3.5 (working as a labourer in somebodys eld). The moral
hazard problem arises because the lender cannot verify whether
the borrower is shirking or not. Given this, the borrower is neces-
sarily going to shirk when the loan is made. This is because her
payoff from working is at most (Rs 5-2) (since she has to return
the bank at least Rs 2), whereas her payoff from shirking is Rs 3.5.
Thus optimally the lender will not give a loan at all, since in case
of shirking the lender cannot recoup the loan.
Note though that the above analysis relies on two implicit
a ssumptions, rst that the borrower has no collateral, and sec-
ond, even if the borrower has some assets there is limited liability
so that these assets cannot act as collateral. How would the anal-
ysis change if the borrower had a pledgable asset worth Rs 2, say?
Note that in case of shirking, the borrower would now lose her
asset and obtain a net payoff of Rs 1.5 only. Thus optimally the
borrower would not shirk when she has a pay off of Rs 3 for
putting effort in the project, and the bank recoups its investment.
2.3 Ex Post Moral Hazard
Ex post moral hazard, or the enforcement problem, refers to
difculties that emerge after the loan is made and the borrower
has invested. Even if those steps proceed well, the borrower may
decide to take the money and run once project returns are
realised. This type of situation arises because the lender does
not fully o bserve the borrowers prots (so that the borrower can
falsely claim an exogenous shock), or even if the return is
observable, but not veriable. We again use a very simple model
to illustrate the idea.
Example: Consider a borrower who needs Re 1 to start a project
that yields Rs Y with certainty. Let the rate of interest be R (this is
either exogenously given, or comes from the break-even condi-
tion of the lender). Let the borrower have a pledgable asset of w
being used as collateral to get the loan. Clearly, the borrower
r epays if and only if Y-R < w.
Thus, from the lenders point of view it is risky to provide loan
to a borrower without collateral.
3 Group-Lending Solution
Throughout Bangladesh, a group of 40 villagers meet together
for half an hour or one hour, joined by a loan ofcer of the
Grameen Bank. The loan ofcer sits at the centre of the group
and begins his business. These 40 villagers consist of eight sub-
groups of ve members, each with its own chairpersons. The
eight chairpersons, in turn, handover the group passbooks to the
loan ofcer. The loan ofcer, in turn, duly records the individual
transactions in his ledger, noting weekly repayments of loan out-
standing, savings deposits and fees. All this is done in public
making the process more transparent.
This is the scenario that is repeated more than 70,000 times
each week by the Grameen Bank and has been adapted round the
world by Grameen replicators. There are other types of institu-
tions like the solidarity group approach by Bolivias Banc Sol
(three member groups), or the village bank approach adopted by
micro-lenders of more than 70 countries of Africa, Latin America
and Asia. For many, this kind group-lending has become synony-
mous with micronance. While micronance institutions can
take many forms, in this paper we shall focus on the Grameen
Bank, on Grameen I to be even more specic, where Grameen I
refers to the standard practice pre-1998 (Morduch 1998).
In the following section we discuss some institutional features
of the Grameen Bank, in particular joint liability, sequential lend-
ing, endogenous group formation, etc. We argue that these in-
stitutional features of group-lending play a prominent role in
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ameliorating the informational problems that plague rural
lending.
4
Further, these features are of general interest given the
hundreds of Grameen I replicators found in most LDCs.
3.1 Institutional Features of Grameen Bank
As the name suggests, micronance involves making small loans
to the poor. Further, micronance loans do not require collateral,
which is critical to any credit scheme aimed at reaching the poor.
It is built on the basic premise that human beings are necessarily
entrepreneurial, and it is the lack of adequate capital that pre-
vents many of them from breaking free of poverty.
Typically, under Grameen I, a group consists of ve members.
The loan is initially made to two members, and the repayment
starts within a few months of the initial loan. The repayment is in
small, but regular instalments. Once the rst two borrowers
manage to repay some of the initial instalments successfully,
another two borrowers get the loan, and so on. Generally, the
group leader is the last to obtain the loan. Note that this involves
s equential lending in that not all borrowers obtain the loan at
the same time. In addition, the lending scheme involves several
other interesting features. The rst is that of joint liability. This
says that if a group member is unable to repay an instalment,
then the other members are supposed to repay for them.
Many of the institutional features have a dynamic component
to them. For one, future loans to the group as a whole are contin-
gent on the group repaying its existing loan. In the literature this
is known as contingent renewal. Increasing loan size (progres-
sive loan) in case of repayment is another dynamic feature. Fur-
ther, successful borrowers are entitled to loans that may not be
strictly for productive purposes.
This informal lending design ts the credit needs of the poor
and combines the facilities of rotating savings and credit associa-
tions (ROSCAs) and local moneylenders. The compulsory savings
take care of collateral substitutes and exible repayment struc-
tures (regular and weekly repayment) take care of both the sup-
ply- and demand-side problems. This generates scale effects as-
sociated with formal sector banks along with very low transac-
tion (monitoring, screening and enforcement) cost.
Other institutional innovations involve lending to women.
Grameen in particular seems to focus on women-centric
schemes.
5
This raises some interesting questions, as to what
e ffect this has on women empowerment and on intra-household
bargaining. Another feature is the regular group meetings where
repayment records are discussed, in addition to motivational
training being carried out. It has been argued that this helps in
both creating a bonding among members and in social shaming
in case of default. The weekly meeting also provides a platform
for information sharing, creates social capital and helps in en-
hancing productivity.
6

At this point it may be convenient to list all the salient features
of Grameen I: (1) informal lending; (2) group-lending without
collateral; (3) compulsory savings; (4) JLL; (5) endogenous group
formation; (6) sequential lending; (7) contingent renewal;
(8) progressive and more diversied loan schemes with time;
(9) lending to women; (10) weekly meetings; (11) lender moni-
toring; (12) public repayment; and (13) social capital.
Since 1998, however, the Grameen Bank has moved to
Grameen II. The devastating oods that hit Bangladesh in 1998,
leading to a correlated shock of unprecedented magnitude hit-
ting many Grameen I recipients at the same time, triggered the
move. A strict adherence to joint liability would, of course, re-
quire that all such borrowers be debarred from future loans,
making Grameen I infeasible (Yunus 2001). This clearly called
for a change of approach.
Under Grameen II, the emphasis has shifted away from group-
lending (Yunus 2002). While some group elements are still
present, joint liability has been done away with. Critically default
does not necessarily lead to being debarred from future loans. In
case of default, the loan history of a person is wiped out and she
has to start from the basic loan again. The idea is that with in-
creasing loan size over time, this creates a very powerful incen-
tive for repayment. Many of the features of Grameen I, sequential
repayment, for example, continue under Grameen II. By all
a ccounts, Grameen II seems to be doing really well.
Despite this, Grameen I remains of interest for various reasons.
Apart from trying to understand what drove the most successful
micronance scheme ever, Grameen I is being followed in many
LDCs all over the world, including India. Thus, these institutional
features have policy implications for millions of borrowers still.
The rest of this section will be concerned with the incentive
effects of JLL, while other incentive schemes will be dealt with in
the following section.
3.2 Role of JLL in Inducing Peer Monitoring
The contract design in the presence of joint liability ensures that
in case of default payment, the group would be responsible for
repayment for the defaulting member. Following Banerjee et al
(1994) and Stiglitz (1990), we show how joint liability can help in
resolve the adverse selection problem through peer monitoring.
Moreover, JLL provides incentive for endogenous group forma-
tion leading to positive assortative matching (Ghatak 1999,
2000) and social capita formation (Besely and Coate 1995).
Consider a situation with one single lender and two borrowers.
There are two borrowers, with one having only a good project,
and the other one having both a good and a bad project. Both
projects require an initial investment of Re 1, which must be bor-
rowed from the lender. The good project returns Rs 2 to the bor-
rower, but the bad project returns only Rs 1.5, which, however, the
borrower can pocket. The informational problem arises because
the bank does not know about borrowers type. Consequently, if
the loan goes to the bad borrower, he will necessarily select the
bad project, when the bank obtains no repayment. Thus to break-
even in an expected sense, the bank must charge at least Rs 2 from
both the borrowers. But in that case the good borrowers may
decide to opt out of the market, which is the lemons problem.
While this problem will not arise if the lender could monitor
the borrowers, this is very costly given that typically the bank
o fcials are outsiders who have little information regarding the
borrowers. Interestingly, however, it is the borrowers themselves
who are likely to have more inside information. The question is
to devise mechanisms that would allow the lender to tap into
this information.
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We then argue that JLL provides a tool for doing precisely this.
Suppose that the lender makes a joint liability loan to groups
c onsisting of say, two borrowers. In that case several effects are
going to come into play. One effect is that of peer monitoring,
whereby borrowers monitor one another. This has been analysed
by Stiglitz (1990) and Banerjee et al (1994). While Ghatak
(1999, 2000) and Tassel (1999) examine the endogenous group
formation effects arising out of joint liability, Besley and Coate
(1995) examine the effect of harnessing social capital. In what
follows, we examine these effects one by one.
3.3 Role of JLL in Ensuring Assortative Matching
We then argue that joint liability can, via endogenous group -
formation, help in resolving the asymmetric information prob-
lem. Consider a scenario with two groups of borrowers, safe and
risky. Further, suppose that the lender opts for group lending.
The fact that borrowers endogenously decide on choosing their
own group is the key to the solution. Faced with joint liability,
safe borrowers form a group with safe types rather than with
risky types, so that safe type sticks together. The risky borrowers
have no alter native, but to form groups with risky types, leading
to segregated group-formation, referred to in the literature as
positive assortative matching (PAM).
Interestingly, this helps the bank to keep safe types in the mar-
ket and ensure efciency. Because the investment projects under-
taken by risky borrowers fail more often than those of safe bor-
rowers, risky borrowers have to repay for their defaulting peers
more often under group lending with joint liability, otherwise
they will be denied future access to credit. Safe borrowers no
longer have to cross-subsidise the default of the risky borrowers.
Consequently, there is a transfer of risk from the bank to the risky
borrowers themselves. This also implies that the safe types pay
lower interest rates than risky types. This allows the bank to be
better insured against defaults, and thereby, charges a lower rate
of interest rate for both the safe and the risky types. The lower
interest rates, in turn, encourage the safe borrowers to re-enter
the market, thus correcting the market failure.
3.4 Ex Post Moral Hazard and Joint Liability
We then examine a scenario where the problem is one of ex post,
rather than ex-ante moral hazard. The concern is now that the
borrowers can be tempted to pocket the prot without paying the
lender, i e, take the money and run. Clearly, bank credit is likely
to shrink if it anticipates that borrowers will escape repayment.
Group lending with peer monitoring can, however, induce
each group member to incur a monitoring cost of m ex post to
check the actual revenue realisation of the peer say Y with
probability . Further, suppose that in that case a social
penalty of will be imposed on the defaulting borrower. If X
denotes the gross interest rate set by the bank then, a borrower
will choose to repay provided
Y X > Y ( + X), i e, X < [ / (1- )] .
In the absence of peer monitoring we had = 0 and therefore,
no lending in equilibrium. Now why do we have monitoring
( > 0) in equilibrium? Here, it is the borrowers incentive to
minimise the probability of suffering from joint liability that
induces monitoring. Thus joint liability makes lending sustaina-
ble by inducing peer monitoring and overcoming enforcement
problems associated with ex post moral hazard.
4 Going Beyond Joint Liability: Sequential Lending and
Sequential Repayment, Lender Monitoring
While JLL undoubtedly played a critical role in the success of
Grameen I, one needs to go beyond this. It is not very clear
whether or not the static form of joint liability was really enforced
strictly. One reason as to why it may not have been is because of
the personal bonds that often developed between Grameen
o fcials and the borrowers.
As argued by Aghion et al (2005) this exclusive focus on JLL is
surprising. Also, while the empirical literature indicates that JLL
is important (see, e g, Wenner 1995 and Wydick 1999), there is
nothing to suggest that these dynamic institutions are not. More-
over, the ip side of joint liability is that it creates strategic com-
plementarities in the monitoring levels of the borrowers in a
group. A decrease in the level of monitoring by others in the
group reduces the individual incentive to monitor. The implica-
tion is that in equilibrium there may be undermonitoring.
The intuition for strategic complementarity is simple to under-
stand. A borrower has an incentive to monitor if other borrowers
monitor, since if she does not, she would be in trouble under JLL.
This works both ways. If she is a bad borrower and is being
monitored by her peers, she would lose all private benets from a
bad project. If she were a good borrower with a good project, she
would have to part with her project return, if she does not moni-
tor. Consequently, there may be virtually no peer monitoring in
equilibrium. The above argument identies one possible reason
why some group-lending schemes fail.
Moreover, as discussed earlier, group-lending schemes also in-
volve other subtle features. In fact, Aghion et al (2005) argue that
joint liability is only one of the elements that differentiate micro-
nance from traditional banking. Unfortunately, however, the
other elements have attracted relatively little attention in the lit-
erature. These include dynamic elements like sequential repay-
ment, sequential lending and contingent renewal.
The relative neglect of dynamic features is surprising given
that in reality micro-lending institutions do not always enforce
joint liability. Loan ofcers in Asia and Latin America, for exam-
ple, say that they see no reason to punish everyone for the actions
of a single person. In fact, in case of default, the original Grameen
idea was not that group members will have to pay for others, but
rather that they would be cut off from future loans. Furthermore,
some recent group-lending schemes, e g, ASA in Bangladesh and
even the Grameen, have seen a move away from strict JLL.
4.1 Sequential Repayment
As discussed earlier, sequential repayment refers to the feature
that while repayment starts within a month or so of the loans,
these come in small and easy, but regular instalments. This is
surprising since it is possible that the project may have not started
yielding any returns so soon. One possible answer to this puzzle
was provided by Jain and Mansuri (2003). They argue that
asking for early repayments forces the borrowers to look for
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subsidiary loans from family and even moneylenders. It is then
argued that such bridge loans will be forthcoming provided the
borrower is efcient and using the initial loan amount wisely.
This information is likely to be available with friends and family,
and perhaps even the local moneylender, but is unlikely to be
available with the micronance organisation that is an outsider.
The argument again relies on the basic idea that sequential re-
payment allows one to tap into information that is available at
the local level. Hence, it screens out undisciplined borrowers,
gives an early signal to the loan ofcers and peer group members
and allows the bank to get hold of cash ows before they are to-
tally misused (Rutherford 1997).
4.2 Sequential Lending
One major incentive of sequential lending is that it minimises the
contagion effect of involuntary default. Because of the sequential
nature, later recipients have an incentive to monitor which helps
to reduce the strategic complementarity problem. Moreover,
these dynamic incentives with small loan can be used for initial
screening of borrowers and help to sort out the worst prospects
before expanding loan scale.
In the Grameen Bank, for example, the groups have ve mem-
bers each. Loans are sequential in the sense that these are ini-
tially given to only two of the members (to be repaid over a p eriod
of one year). If they manage to pay the initial instalments then,
after a month or so, another two borrowers receive loans and so
on (Morduch 1999b).
7

The main theoretical contribution here is from Roy Chowd-
hury (2005), who argues that sequential lending allows one to
circumvent collusion possibilities among the borrowers. Consider
the Banerjee et al (1994) model discussed earlier, but with the
difference that both borrowers now have the possibility to select
a bad project. In that case the Pareto dominant outcome for both
borrowers will be to collude among themselves and not monitor
each other at all. Under such a scenario, however, sequential
lending can resolve this problem since the borrower who is sup-
posed to get the loan later on will not receive the loan unless she
ensures that the other borrower repays faithfully. Even in the
a bsence of JLL, sequential nancing may solve the under-
monitoring problem (Roy Chowdhury 2005).
4.3 Contingent Renewal
Contingent renewal refers to the fact that in case any of the mem-
bers of a group defaults, no member of the group receives any
further loans. Whereas in case the group repays it ensures the
future loan openings.
Roy Chowdhury (2007b) argues that in the presence of contin-
gent renewal, sequential lending performs an interesting role in
that it allows the bank to test for agent types. Suppose there are
two groups of agents, one good (with social capital) and the other
bad (i e, has no social capital). In the presence of contingent
r enewal there would be an assortative matching, with the good
borrowers clubbing together. This is because the cost of being
clubbed with a bad borrower is very high in the presence of con-
tingent renewal, since a good borrower loses all future borrow-
ing possibilities. Then, in the presence of sequential lending, the
bank can ascertain group types relatively cheaply, at the cost of
lending to a subset of the borrowers, so that the cost of bank mak-
ing a bad loan is minimised.
Interestingly, Grameen II has similar dynamic schemes where
magnitude of future loans depends on current loan history. In
case of default the borrowers are not completely cut off from ac-
cess to future loan, but her credit history is wiped out so that she
has to restart from basic loan.
4.4 Lender Monitoring
Along with the above discussed instruments if bank also moni-
tors then it creates a double safety net. It reduces the strategic
complementarity problem leading to a greater monitoring by the
borrowers themselves, which is called pump-priming (Roy
Chowdhury 2005). However, the pump-priming effect relies on
the presence of the JLL, bank monitoring by itself does not work.
5 Conclusions
A rigorous analysis of the institutional structures underlying
Grameen I provides many deep and interesting economic in-
sights. The essential idea is that an appropriate institutional de-
sign can help in tapping into the informational pool available at
the local level among the borrowers themselves (something that
may not be accessible to the outsiders, be it formal sector banks,
or even micronance organisations). The preceding analysis
demonstrates exactly how innovative features like joint liability
lending, sequential lending, contingent renewal, etc, can serve
this purpose.
Even in Grameen I, there are several issues that remain poorly
understood, e g, the focus on women. It may be conjectured that
this has to do with inter-household bargaining, arising out of the
different objectives and discounting patterns of men and women.
Unfortunately, however, there is very little formal theorising on
this issue. Turning to Grameen II, while some aspects borrow
from Grameen I and are therefore well understood, several issues
are not. Under Grameen II, for example, while joint liability has
been done away with, there are still elements of groups. Is this
more than just a carryover from Grameen I?
Turning to the Indian scenario, the self-help group (SHG)-
linkage programme is rapidly becoming the dominant micro-
nance paradigm in India (Morduch and Rutherford 2003; Basu
and Srivastava 2004, 2005; Ghate 2007). As the name suggests,
this involves non-governmental organisations (NGOs) playing the
role of mediators in organising micronance groups. Under this
programme borrowers endogenously form into SHGs, with ini-
tially the members saving regularly for a certain period of time.
Once a group manages to meet its savings target, then it is linked
to some bank (rural branches of state-owned commercial banks,
regional rural banks, cooperative banks, etc), which lends it a
further sum (usually up to four times the amount saved). Such
loans also involve features familiar from classic Grameen, in par-
ticular JLL. This process is usually facilitated by some NGOs.
Other features of the SHG-linkage programme include sequential
nancing, monthly repayment schemes, etc. Thus the SHG-link-
age programme seems to combine features of ROSCAs with those
of classic Grameen (Aniket 2005).
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72
The NGO starts the process of group building by initiating a
modied form of ROSCA.
8
Defaults in savings contribution are
addressed through sequential allocation from the pot, peer moni-
toring and social sanction. The SHG-bank linkage programme
improves on this pure form of ROSCA (where the saving pot is
only as deep as the pocket of its members) by linking the SHGs to
formal nancial institutions for external credit.
The saving pot is allowed to accumulate for approximately six
months during which time there is a moratorium on borrowing.
After six months, members can borrow at a rate of interest
specied by the NGO. Borrowing from the group fund is sequential
and the group itself decides the sequence in which members get
loans. In the early stages the sequential nature of borrowing is due
to the limited accumulated saving the group has at its disposal.
As impatient non-borrowers wait for a chance to borrow, they
monitor, and, if need be, audit the current borrowers aggres-
sively. Lending sequentially thus plays an important role in bind-
ing individuals within a group. This is more so because the non-
borrowers savings are under threat if not used properly and not
repaid in time by borrowers.
If the group is successfully able to manage internal group loans
during the early stage, the NGO links the group to external sources
of credit. These sources may either be a subsidised government
lending programme, or credit from a public bank. Part of the in-
terest payment made by the borrowers on the external credit
goes to the NGO. This tying up of NGO remuneration with repay-
ment of externally sourced loans gives the NGO strong incentives
to actively screen and monitor the groups.
External loans are transacted through the local public bank
branch and not through the NGO. Since the NGO is not allowed to
take up the task of nancial intermediation, there is no moral
hazard problem associated with the task of channelling credit.
NGOs are not even allowed to accept group savings for purposes
of safe-keeping. The group is required to directly deposit the sav-
ings into the group account in the local bank.
Joint Liability
After external credit is made available to the group, the group as
a whole is jointly liable in case of delay or default. The repayment
dues are deducted automatically from the groups savings depos-
ited in the bank account. Hence, by paying late a borrower jeop-
ardises non-borrowers savings and any such delay in repayment
bites the non-borrower immediately, making all the group mem-
bers jointly liable.
But this full and immediate joint liability can only be imple-
mented if there are a certain number of non-borrowers at any
given point of time. This is ensured by the sequenced nature of
borrowing which the group itself decides. For any non-borrower,
delinquent behaviour by present borrowers jeopardises not just
her opportunity to borrow in future, but also her present accu-
mulated savings in the group. Thus, the sequential nature of bor-
rowing favourably inuences a high rate of group survival, even
in the early stages.
As in the case of internal group loans, external loans have to be
fully repaid in 10 equal instalments and the repayment starts im-
mediately. Members borrow either to meet consumption needs or
to invest in projects with extremely short gestation periods.
The participating banks are free to set and modify interest
rates, taking into account local conditions. Chavan and Ramaku-
mar (2002) found that the cost of borrowing for SHG members
across the country is in the range of 24 to 36% per annum. Most
studies, e g, Harper 2002 and Puhazhendi and Badatya (2002),
have come to the same conclusions.
SHGs use the pooled savings together with the external loan to
provide loans to their members. The decision on who gets the loan
is taken by the group itself and not by the bank or the NGO. Members
keep track of the end use of loans: inappropriate loan utilisation
and issues like non-repayment of loans are taken care of within the
group. There is no monitoring of loan utilisation by the bank staff,
and in case of default by a group member no legal actions are taken.
The loan amount by the bank to the group is tied to the accu-
mulated savings in the group account with the bank. The maxi-
mum loan amount is a multiple (4:1) of the total funds in the
group account. This limit may be gradually reached starting from
a lower (2:1 or 1:1) ratio.
To summarise, the SHG-bank linkage programme has the fol-
lowing interesting features: (1) It provides a channel for scaling
up micronance operations using government funding via p ublic-
private partnerships whereby private agents, namely, NGOs, link
government banks to micronance recipients. (2) The NGOs may
or may not be involved in the project implementation stage.
Whether this is optimal or not, even when NGOs are motivated,
has been addressed by Roy and Roy Chowdhury (2009). (3) Links
further funding to SHGs to prior savings performance of the SHG.
(4) In case the NGOs are only involved in the savings stage, then
they help with setting up the group, accounting, opening an ac-
count in the bank, even some training activities. This has been
addressed by Aniket (2007) and Roy Chowdhury (2007a).
It would be of importance to examine how far our understand-
ing of Grameen institutions helps in designing better mechanisms
under the SHG-linkage programme. This, however, is beyond the
scope of the present paper and must await future analysis.
Notes
1 United Nations ofcially recognised micronance
as an important tool in achieving its Millennium
Development Goal of eradicating poverty by 2015
and declared 2005 as the International Year of
Microcredit (UNCDF 2006).
2 With subsidies amounting to $6 billion between
1979 and 1989, a period of rapid IRDP growth. Re-
payment fell below 60% in 1989 and came down
to just 31% by 2000. Only 11% of all IRDP borrow-
ers borrowed more than once (Pulley 1989, Meyer
2002). The credit contract was weakly designed
with no incentive for repayment. Since most bor-
rowers took only one loan and with no assurance
that with repayment they will have access to larg-
er loan amounts in future, most borrowers chose
to default bringing down the overall repayment
rates to dismally low.
3 The directed programme affected the banks per-
formance in various respects. Credit was not allo-
cated to the most productive recipients, bankers
incentives to collect savings deposits were dimin-
ished by steady ow of capital from the government.
Banks were forced to forgo loans before elections.
4 For various important issues of group lending see
the JDE (1999).
5 Women have a less mobility and represent a more
homogeneous group. In a rural structure there is
a strong community base so information harness-
ing basically through women is cheaper.
6 Even in the case of individual liability without
peer monitoring and social sanctions rewarding
group success by promising joint benet, can be
used as an alternative device to solve informational
problems. This typically improves the repayment
rate above the typical individual liability case
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73
without joint benet. Moreover, this alternative
instrument has an effective mechanism of creat-
ing social capital.
7 As an example of a group-lending scheme that
does not involve sequential nancing, consider
the Banco Sol programme in urban Bolivia.
8 Besley et al (1993) discuss the advantages of and
reasons behind sustainability of ROSCAs. One ad-
vantage is that if an individual desires to acquire
an indivisible good, by joining the ROSCA, she
can expect to attain it earlier than if she had cho-
sen to save all by herself. A ROSCA gives each
member access to all other members savings
p eriodically.
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