Bank-moneylender Credit Linkages: Theory And Practice

AN ASSIGNMENT ON

Bank-Moneylender Credit Linkages: Theory and Practice Financial Management

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1. Introduction In developing countries, to meet the credit demand of farmers, governments have sponsored formal institutions (e.g. banks). But, many of the formal institutions failed as they faced following problems in rural credit markets: loan disbursal, difficulty in differentiating between good and bad borrowers (adverse selection: banks access borrowers to whom they would otherwise not lend and borrowers access loans that would otherwise be beyond their reach), difficulties in observing and verifying output to a third party (costly state verification) and extracting repayments (enforcement). Also, lenders cannot verify borrowers’ dedication to their projects since they may divert the production funds (moral hazard). Informal private lenders such as moneylenders, friends, relatives, and landlords can overcome some of the lending constraints. They being close to villagers can meet creditdemand in a quick and flexible manner. In contrast to banks, moneylenders have superior information (or enforcement powers). Linking the formal and informal sectors can help to solve the problems. Linkages would exploit the advantages of each sector & would improve the overall efficiency of the financial system. For example, banks could issue large production loans and request moneylenders to monitor and enforce that loan. In monitoring the loan, moneylenders adapt their own flexible practices to the “bank” loan a well structured incentive system can potentially overcome problems faced by formal lenders. They must give incentives to informal lenders so that they’ll cooperate and not collude with borrowers. Compensation must be based on informal lender’s opportunity costs and information contribution.

2. Bank-Moneylender Linkages: Theory For sustainable linkages, not only moneylenders but also banks must willingly participate. The linkages can be divided into two broad categories: explicit and implicit. In the explicit linkages, banks hire moneylenders. In the implicit linkages, banks alter their own loan contract, aware of the presence of moneylenders. We will review four models of linkages. 2.1. Moral Hazard (MH): Moneylenders Monitor Borrowers The bank cannot explicitly observe how the borrower runs her project because it is too costly to observe it. The borrower will choose to undertake the good action (diligence) as long as the returns are greater than the bad (non-diligence). If the borrower is nondiligent, then she receives a private benefit which is an increasing function of the loan size. As in standard moral hazard models, an asymmetry rises. In case of non-diligence, borrowers share their lower expected returns with banks but can capture the full value of the private benefit.

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The bank does not extract the full amount in case of high income and leaves a surplus (referred to as the enforcement rent) which depends upon the amount of the borrower’s private benefit. In order to obtain positive profits, the bank would set a bound on the loan size, which would in turn limit the private benefit. The bank could increase its profits by hiring a moneylender. Assume that the moneylender has access to a linear monitoring technology which determines whether the borrower chooses a good or bad action. Now monitoring decreases the private benefit the borrower obtains. Now, in contrast to lending on its own, the bank can extract a higher repayment amount through the increased monitoring and leave a lower enforcement rent. However the bank needs to hire the moneylender and pays wages. The compensation differential directly relates to the monitoring costs and inversely relates to the diligence probabilities (4P). When the difference (4P) is large, the bank need not have to compensate the moneylender as much to ensure that the borrower chose diligence. Advantage: The bank pays lower wages when moneylenders do not provide a valuable monitoring role and consequently, banks need not employ moneylenders. It calls for a flexible credit policy across regions depending on moneylenders’ opportunity costs and borrowers’ diligence probabilities. If the incremental gain through monitoring is greater than the monitoring costs, banks can increase their profits by linking with moneylenders. 2.2. Enforcement (E): Moneylenders Enforce Repayments In the most commonly observed and suggested linkage, assume that banks on their own cannot enforce repayment and need to hire moneylenders. This linkage shares many features with the (MH) linkage, sometimes denoted as ex-post moral hazard. The smaller the differential probabilities, then a lower responsiveness of moneylender’s high wage to the repayment probabilities. In this case, the moneylender’s value added is small. The bank induces the moneylender to work harder by increasing his wages and may choose not to hire the moneylender. The linkage also reveals a self-equilibrating character: banks will not hire moneylenders when their value is less. In contrast to explicitly hiring money-lenders, banks “free ride” from the information of moneylenders. The following linkages address this option. 2.3. Adverse Selection (AS): Moneylenders Screen Borrowers The bank cannot differentiate between good and bad borrowers. Moneylenders, with better information, lend only to the good types. Good borrowers have a higher probability of high output than bad. The bank can first offer a pooling contract in which both types obtain the same loan. In order to attract the good borrowers it must provide the same terms as moneylenders. Notice that the banks’ repayments now take into account the presence of money-lenders by tieing their repayments to the moneylender’s cost of funds. Banks can distinguish between good and bad borrowers by using the additional information that the Page 3 of 9

good borrowers have access to moneylenders and that all borrowers rely on a critical minimum amount. The bank separates by deliberately under-financing the good, using the implicit knowledge that the good will resort to moneylenders for the rest of the funds. The bad will not obtain any funds from the banks & they cannot obtain the remaining funds from moneylenders. In other words, the bank offers two contracts: one with higher repayments and no financing (the bad will choose), the other with lower repayments and under financing (the good will choose). The bank lowers the good’s required repayments by the loan amount it obtains from moneylenders. The bank’s profits now from good types only since the bad now do not have access to bank loans. 2.4. Costly State Verification (CSV): Moneylenders Verify Output Since the bank now cannot observe if the incomes of borrowers are high or low, borrowers would always claim they suffered bad times and the bank will never lend. However, banks can separate good (high income) and bad (low income) borrowers again based on what they can observe, i.e. repayments. As in the (AS) linkage, repayments are not sufficient but banks can now employ an additional instrument, the threat not to lend anew. Only if borrowers repay, they will obtain more loans. The threat of termination provides good borrowers an incentive to repay. The bank thus requests repayments that will cover next period’s expected income. Moneylenders recognize this opportunity, the banks do not. Moneylenders with their superior information serve as linking agents by providing loans to excluded borrowers who can then repay banks and enjoy continued access. Advantage: Banks need not rely on the threat of termination to separate the good from the bad since the bad can now borrow from moneylenders. In a reversal of the (AS) linkage, the bad and not the good borrowers are active in both markets. Now the bank needs to induce the moneylender to participate. The bank’s repayments now relate inversely to the moneylender’s cost of capital. As in the previous linkages, this equation reveals a self-equilibrating character. With a higher cost to induce the moneylender to participate, banks require lower repayments from the borrowers.

3. Formal-Informal Linkages: Practice Many of the attempted linkages draw from Indonesia, “the world’s laboratory of rural financial markets.” Two general surveys on rural credit sponsored by the Asian Development Bank (ADB) delineate the adopted practices. The pay structure reflects of the bank officers lenders’ efforts at overcoming incentive problems. In Sri Lanka, banks use informal lenders termed PNNs. These 14,000 PNNs lend bank loans to borrowers with no documentation but have to follow bank regulated interest rates and loan amounts (ADB). Page 4 of 9

In Indonesia, regional development banks established KURKs, village units which disburse loans at weekly mobile bank offices. In order to monitor at this level, the KURKs actually hire ex-moneylenders as commission agents. The lenders receive four percent of collected loan installments. The whole system builds a web of incentives, with other participants such as the village headman screening borrowers and receiving one and a half percent of pre-tax profits. One of the KURKs’ successes was to minimize the guaranteed element in a bank worker’s pay. Another Indonesian bank (BUPB) offers field officers minimum guarantees plus two percent of fully repaid loans 7.5% of savings (which thus includes a link through savings). In eight other financial intermediaries in Indonesia, village agents (but not necessarily moneylenders) screen and collect loans. The agents’ wages depend on observable variables such as collected repayments, loan installments, and primarily adjusted profits. Profits are adjusted since some events go beyond the control of lenders. This flexible system varies in its implementation across villages in that wages are village specific and incorporate the variables outlined in the theoretical section. The term “onlending” refers to an implicit version of the above when lenders typically work as traders, i.e. inter-linked credit. In this case, banks aware of the moneylenders’ presence deliberately increase credit so that moneylenders may lend the increased loans without following bank regulations. Moneylenders would then lend on their own. The Philippines has a long history of deliberately increasing credit. On-lending is widespread even when banks do not deliberately increase credit. Credit-layering, an extreme version of on-lending, is a cascading series of transactions where banks lend to informal lenders who lend to others and so on. Frequently, borrowers from banks re-lend at higher interest rates: with examples from Thailand, the Grameen Bank, Malaysia and Pakistan. The above sources indicate that the percentage of loans that lenders on-lend range from 20 to 80 percent. With regard to the implementation, linkages (MH) and (E) have strong promise but a number of countries have not fully implemented them. This possibility does not seem to arise from the reluctance of moneylenders. In informal talks with moneylenders in India, many have offered to act as agents as long as they can lend with an agency commission to meet their operating costs. Policymakers’ attitude towards informal lenders varies in a number of countries. As mentioned in the Philippines, the government has actively intervened to incorporate the informal sector into the overall strategy of agricultural development. In sharp contrast, in India historically the government has actively excluded the informal sector. In the 1980s though, the Indian government as in many other countries has reversed its philosophy. By launching a program where commercial banks participated with informal lenders, linkages have become more viable in India. In the (AS) linkage, banks screen borrowers with the complicity of moneylenders. Though not the same implicit structure as the (AS) linkage, the aforementioned Indonesian banks engage in explicit screening mechanisms. In a scheme Page 5 of 9

in Indonesia (PSP-Kupedes), traders recommend borrowers. Customers with good banking records recommend members from their business networks as borrowers. The head of the network has his name and preferential treatment at stake which explains the low amount of defaults. Practically, banks can implement the (AS) linkage in the following manner. Suppose a bank operates in an area with active informal lenders. If banks know the required loan size of the project, they can deliberately under-finance borrowers knowing that low risk borrowers can always resort to moneylenders. The bank’s information requirement is high in this linkage. The bank must not only know the critical minimum amount required by the borrower but also their other financing sources with information such as borrowers’ liquid wealth and access to other lenders. Provide loans to borrowers who can then repay banks. Using ICRISAT data from Indian villages, he finds that in general repayments to banks fluctuate with income. However for households that obtain loans from moneylenders, banks’ repayments do not fluctuate with income. Thus, borrowers can use moneylenders to smooth cash flows so as to meet bank obligations better. In another interpretation of this linkage, banks provide production loans and moneylenders provide bridge loans in order to ensure access. In a similar but slightly different set-up in Bangladesh, “recovery agents” help borrowers roll over bank loans for a fee (ADB). Borrowers then obtain a new formal loan and found that even after paying the fee, found the loans worthwhile. Moneylenders in India provide bridge loans for borrowers who are waiting to receive sanctioned bank loans. In microfinance the above is known as informal “bicycling” which occurs when borrowers who repay a microfinance institution on time obtain immediate access to another larger loan. Informal lenders, aware of this situation, provide bridge loans to borrowers who are short of cash to pay the microfinance lender. Another aspect uncovered by the (CSV) linkage: the consequences of denying future loan access by formal lenders. For example, in the Philippines & Thailand, repayments deteriorated under the formal sector, borrowers were excluded and the lending shifted back to informal lenders. From these case studies, policymakers can follow a more inclusive approach to informal lenders in the launching of new credit programs. Informal lenders can serve an invaluable role in the incipient stages by enabling borrowers to enjoy continuing access to formal sector loans. As seen above, the evidences mainly from the largely successful Indonesian experiments serve as lessons for other countries. The question remains on the replicability of the Indonesian experiments. For example, Indonesian system works because of a clear system of control (the village head) which may not work in all places. Similarly, compensation to moneylenders reflects the opportunities foregone and these vary with respect to Indonesia. As mentioned before, in not all the cases the hired agents were ex-moneylenders. One would still expect moneylenders with the learned practice of lending to be the most adept at continuing this tradition. Alternatively, banks lend to NGOs, where NGOs Page 6 of 9

guarantee and assist in loan recovery as in Sri Lanka or Bangladesh. No study provides independent evaluation on the effectiveness of moneylenders with respect to nonmoneylenders. Training costs of staff represent a significant portion of microfinance institutions’ costs. In hiring moneylenders, banks need not expend resources on training since moneylenders have already incurred these costs. Furthermore, banks do not need to directly interact with moneylenders. The evidence squares with the theory with its emphasis on bank worker incentives and its flexibility. Not surprisingly, the Indonesian experiment was built on the work of foreign consultants who were adept at creating incentive based systems.

4. Linkages vs. Joint Liability Lending Most microfinance organizations adopt JLL as opposed to individual lending policies. The survey by Ghatak and Guinnane (hereafter G-G) denote this practice as a primary reason for their success. Note that even JLL institutions require a staff member to monitor and oversee the group. In contrast to JLL, linkages provide additional attractive features. Group lending or JLL circumvents the problems banks face by issuing joint liability contracts: members of a group are liable for one another. Formally, joint liability consists of the following for a two person group: if a borrower will repay her loan but her partner will not repay the loan, then the borrower must repay an additional monitoring cost to the bank. This incentive constraint replaces the moneylender’s participation constraint in the linkages. In Ghatak-Guinnane’s (hereafter G-G) survey of JLL, the alternative to group lending is individual bank lending. We will formally only analyze the effects of group lending on the (MH) contract. In the optimal contract, the bank rewards the successful borrower but penalizes the unsuccessful borrower. For large monitoring costs and high probability of a good outcome, group lending dominates linkages. The advantage of group lending is that it absorbs the monitoring costs within the group but requires a higher likelihood of a good outcome for success. In the (AS) version, the safe will associate with the safe and the risky are left with the risky resulting in positive assortative matching. Banks offer two contracts: one with high interest rates and low joint liability (the risky will choose) and one with low interest and high joint liability (the safe will choose). In the (E) case, if one member will not pay back but the other pays both her own and her partner’s JLL dominates individual liability. Also, if the community imposes social sanctions on a member who does not pay her partner’s then JLL becomes more attractive. For the (CSV) case, the bank has to induce the borrower to report the truth for high borrower’s returns and low partner’s returns. G-G argue that the partner has an incentive to audit the borrower due to partial liability. So now the bank need only audit when the whole group announces its inability to repay (which occurs with a lower probability). Group lending still introduces further constraints as borrowers are prone to collude with Page 7 of 9

each other. To avoid this possibility, we need to introduce a non-collusion constraint. With this constraint, for large monitoring costs borrowers will not reveal the truth about each other. Due to this limitation, many borrowers would graduate from group loans to linkages or individual lending to reach larger scales. The lending solution proposed by JLL creates its own problems since the solution relies on interdependence among borrowers. The incentive constraint imposed in JLL is not as innocuous as the participation constraint imposed in linkages since it introduces interdependence. Practically, in close knit village communities, borrowers reluctantly sanction delinquent borrowers. Friends do not make reliable group members since members are often softer on friends. Sometimes social ties among possible borrowers are too weak to support feelings of group solidarity as demonstrated in the failed transplant in Arkansas. On a theoretical level, interdependence creates the following: bad borrowers create negative externalities on good ones. The group-lending structure may be less flexible than individual lending for borrowers in growing businesses and those that outstrip the pace of their peers. Due to the interdependence, the JLL enjoys more success in areas of high population density and steady and frequent income streams. The obsession with the repayments record leads to some undesirable consequences such as violence against women (Grameen Bank). ADEMI in the Dominican Republic switched to individual lending because it felt that credit advisors relied too much on peer pressure for loan repayments and did not develop a significant relationship with clients. Group lending leads to excessive monitoring, pressure to undertake “safe” projects, and high costs of weekly meetings and staff training. Training cost form a large component of JLL programs. For example, with the Grameen bank, salary and personnel costs accounted for half of Grameen’s total costs. Over half of female trainees and a third of male trainees dropped out before taking first positions at Grameen. Until recently, the profitability of JLL justified some of the negative consequences. Some donors believe only five percent of all programs today will be financially sustainable ever. These difficulties of microlending lead one in search of a self-sustaining solution. The relative advantages of linkages over JLL are many: self-sustainability, no excessive bureaucratic layer, no pressure on neighbors, and the use of the specific capital of moneylenders. Linkages build on villagers who would not engender the suspicion of neighbors. Linkages could potentially achieve Hulme and Mosley’s three main conditions for successful credit programs: intensive loan collection, incentive to repay, and provision for voluntary saving. Linkages would bring the bank worker (moneylender) to the customer, within a self-interested and decentralized decision making process.

5. Conclusion The models indicate that banks and moneylenders complement each other, increasing the available lending opportunities. Banks need not always link with Page 8 of 9

moneylenders. Banks will link when the information value added is high, the monitoring costs or effort of the moneylender are low and the differential cost of funds is low. With complete data, an empirical exercise could map these values onto observable variables. The information value added can be captured with proxy variables which measure banks’ knowledge of borrowers. These include trustworthiness, access to collateral, access to credit information, legal recourse, or when idiosyncratic shocks form a major component of the output. The monitoring costs would be higher when lenders engage in higher marginal activities. Finally, the differential cost of funds is related to the monitoring costs above with the larger spread for less well developed and integrated the financial markets. The theory also reveals that wages should be contingent on repayments, which are observable. The linkages are also self-equilibrating in that payments to moneylenders adjust according to their contribution and costs. The above linkages are not purely theoretical; policymakers have implemented these in a number of developing countries. The practical execution of the linkages must overcome some issues which are absent in the theoretical models. Theoretically and empirically, linkages are at an inchoate stage. In exploring why linkages are not prevalent in developing countries, one can uncover some stumbling blocks that remain. Historically policymakers have viewed informal lenders such as moneylenders as exploitative. The ADB study reviews many cases and concludes that these views may be out-dated. For linkages to be effective, banks are needed alongside moneylenders. In certain cases, banks may not find it worthwhile to enter. The theory is based on knowledge spillovers since one bank would provide another bank with borrower training and management skills gratis. Second, banks may not enter for the same information and enforcement issues raised throughout this paper. Due to these reasons, commercial banks would still need additional “carrots” to enter rural areas while informal lenders need “sticks” in regulation, for viable linkages. In the future, in light of the new revisionist views of microcredit, policymakers can explore linkages more fully as an alternative credit delivery mechanism.

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