From No Collateral No Loan to No Collateral No Default : The Economics of Group Lending Microfinance

In this study, we are exploring the economic mechanism that makes group lending microfinance working to extend loan to the poor without collateral while ensuring repayment. In group lending microfinance, MFIs are lending the poor without collateral and the borrowers who pledge no collateral repay loans whenever they are able to. The point is interesting from the fact that if the borrower defaults, she would have to loss almost nothing since, there is no collateral. The reality is, however, that MFIs extend loans without collateral and are rewarded with higher repayment rates. Having no-pledgeable assets by the poor neither prevents MFIs to extend loans nor does it leads borrowers to simply default. This study aims at exploring the economic mechanism through which group lending works. We see that joint liability group lending promotes peer monitoring, eliminates shirking in the group and ensures effort from the borrowers which in turn promotes repayment. We also, find that if loans are associated with dynamic or progressive lending, that is, if successful repayments are rewarded by a larger new loans, we do not need joint liability obligation to ensure repayment. Group lending microfinance with or without joint liability, we thus see, has certain mechanism that leads to assortative matching of borrowers, reduces effective interest rate, leads to peer monitoring and finally enforces repayment as long as borrowers are able to.