Group versus Individual Lending: A Review

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1 PAT June, 2012; 8 (1): 40-51; ISSN: Online copy available at Publication of Nasarawa State University, Keffi Group versus Individual Lending: A Review M. G. Maiangwa Department of Agricultural Economics and Rural Sociology Institute for Agricultural Research Ahmadu Bello University, Zaria. Abstract Lack of access to financial services not only retards economic growth, but also increases poverty and inequality. Access to financial services therefore increases incomes through productive investment, helps create employment opportunities, provides social security and loan protection, provides facilities for accumulating and safely keeping savings, and reduces the vulnerability of the poor by helping them to smooth their income patterns over time. However, since the demand for financial services is very diverse among the poor, these services must be well-adapted to the particular requirements of potential clients. This paper reviews the advantages and disadvantages of both group and individual lending approaches, and provides examples of some successful rural financial institutions in developing countries that have provided loans to groups and individuals. Key words: Lending, financial institutions, the poor, developing countries Introduction The overall objective of agricultural and rural finance policy is to secure the availability of appropriate and affordable financial services to rural households. According to Coffey (1998), this involves a shift in emphasis from the supply of predetermined financial products to the provision of demand-led financial services. The agenda for rural finance is multi-faceted because the array of providers and clients and their needs are diverse (World Bank, 2002). Different types of financial institutions and strategies are required, as there is no single best type (IFAD, 2000). This means that institutions and strategies must be tailored to the potential of an area, the cultural environment and the requirements of the clients. Besides, since the demand for financial services is very diverse even among the poor, there is a growing belief that any sustainable response will have to be pluralistic (IFAD, 2001). Microfinance Institutions provide loans either through groups or lend directly to individuals. Proponents of the group lending approach highlight the cost-reducing aspect of this methodology, while defenders of individual lending emphasize the advantages of flexibility in meeting loan demand, achieving a high loan product quality, and reducing credit risks (Klein et al., 1999). Small loans to groups of poor borrowers have become immensely popular in recent years in large parts of the developing world and have begun sprouting in poverty-

2 PAT 2012; 8 (1): 40-51: ISSN: ; Maiangwa: Group versus Individual Lending: A Review.41 stricken pockets of the developed world as well. Such loans usually target groups with no access to formal lending institutions and have become the cornerstone of many development strategies (Chatterjee and Sarangi, 2004). In such group lending arrangements, borrowers who cannot offer any collateral are asked to form small groups. Such group members are held jointly liable for the debts of each other. Formally speaking, what joint liability does is to make any single borrower s terms of repayment conditional on the repayment performance of other borrowers in a pre-specified and self-selected group of borrowers (Ghatak, 1999). Indeed, the remarkably successful experience of some recent group lending programmes in terms of loan recovery rates such as those in Bangladesh, Bolivia, Malawi, Thailand and Zimbabwe, has aroused a lot of interest in replicating them in other countries (Huppi and Feder, 1990). It has been shown that microfinance institutions offer group loans when the loan size is rather large, refinancing costs are high, and competition between microfinance institutions is low. Individual loans, on the other hand, are offered when the loan size is small, refinancing costs are low, and competition is intense. Infact, it has been predicted that individual lending in microfinance will gain in importance in the future if microfinance institutions continue to get better access to capital markets and if competition further rises (Lehner, 2008). A review of the strengths and weaknesses of both group and individual lending approaches is critically important on account of arguments to the effect that: (a) microfinance institutions across the world are moving from group lending towards individual lending, even though this strategic shift is believed not to be substantiated by sufficient empirical evidence on the impact of both types of lending on borrowers; (b) the microcredit industry is changing in various ways and that, in particular, increased scale and professsionalisation has led a number of leading microfinance institutions to move from group or joint-liability lending, as pioneered by the Bangladeshi Grameen bank in the 1970s, to individual microlending; (c) a large part of microfinance institutions offer individual instead of group loans (Lehner, 2008; Attanasio et al., 2011). This paper reviews the principal advantages and disadvantages of group-based and individual lending arrangements. It also provides examples of successful rural financial institutions in developing countries that have incorporated these arrangements into their loan delivery mechanisms. Group Lending There are two modalities of group lending. One, a lender may provide funds to a group or a collective entity such as a cooperative or a village bank which then

3 PAT 2012; 8 (1): 40-51: ISSN: ; Maiangwa: Group versus Individual Lending: A Review.42 disburses the loan to individual members according to agreed criteria. In such a case, the group is jointly liable for the entire amount of the loan. Second, funds may be lent to members individually who are organized in groups, in which case the group jointly guarantees all loans or simply furnishes information about individual participants (Huppi and Feder, 1990, Klein et al., 1999). Advantages of Group Lending The advantages of group lending include: (i) Increases the lender s outreach capacity by reducing administrative costs of reaching dispersed individuals and processing loans. For example, Zimbabwe s Agricultural Finance Corporation (AFC) incurs very small costs (1 percent of loan capital) by lending only to established groups (Bratton, 1990; Stiglitz, 1990). Also, a fall in transaction costs occurs when instead of individual visits of clients, group meetings are held. In addition, the contact with banks which poor borrowers typically are not used to is facilitated (Armendariz de Aghion and Morduch, (ii) 2000). Reduces the lender s costs by maximizing the use of insider information and by relying on peer borrower screening. Since the bulk of a lender s transaction cost is related to the assessment of creditworthiness and the viability of loan recovery, farmers who have some social and economic ties can enhance their prospects as borrowers by forming a group that can provide external lenders with valuable information about its members. Social and economic links also give group members the option of applying sanctions to pressure their peers to perform. Thus, group members perform loan monitoring and loan repayment as well (Huppi and Feder, 1990; Klein et al., 1999). Thus, peer-monitoring in group lending schemes transfers the monitoring role from the bank to the borrowers and acts as an incentive device. The benefits from peer monitoring are largest when risks are positively correlated among borrowers (Stiglitz, 1990; Armendariz de Aghion, 1999). (iii) Decreases borrowers costs. For example, a comparative study in the Dominican Republic found that effective annual borrowing costs were 15 percent for a group and 18 percent for individual borrowers (Adams et al., 1981). Generally, group borrowers saved on fees for collateral registration, expenses on certificates needed for loan applications, and transportation costs for visiting lenders (Huppi and Feder, 1990; Holt and Ribe, 1991). (iv) Allows risk pooling through joint liability. Joint liability improves loan repayment in two ways. First, group members can put pressure on potential defaulters when their own interests are at stake. Secondly, the risk that the whole group will default diminishes with increased membership, unless all of the

4 PAT 2012; 8 (1): 40-51: ISSN: ; Maiangwa: Group versus Individual Lending: A Review.43 (v) members activities are highly correlated (Huppi and Feder, 1990; Holt and Ribe, 1991). Experience suggests that the use of legal procedures to obtain repayment is in most instances as difficult and costly when dealing with a group as with an individual. Thus, a lender s ability to deny credit to groups if any member defaults is often the most effective and least costly way to encourage loan repayment. Also, using a solidarity group approach with joint liability for borrowing assumed by a group of borrowers can be a viable alternative to the more traditional collateral required by banks (Saito et al., 1994). Group-based lending minimizes both asymmetrical information, that is, when lenders know little about borrowers, and moral hazard, that is, the danger that, because a borrower does not bear the downside risk of his/her actions, he/she will undertake riskier projects, making it less likely that the loan will be repaid (Hung, 2004). Thus, group liability solves the typical asymmetric information problems of adverse selection and moral hazard, resulting in high repayment rates. The underlying rationale is that there are efficiency gains from group formation that compensate for information asymmetries, since group members know each other well. Moreover, they have the ability to impose non-pecuniary punishments on fellow group members that the lending institution is incapable of doing (Chatterjee and Sarangi, 2004). (vi) Group lending achieves self-selection of borrowers and because co-borrowers act as guarantors, they screen and monitor each other and in so doing, reduce agency problems between the microfinance institution and its borrowers (Attanasio et al., 2011; Ghatak and Guinnane, 1999; Ghatak, 2000; Van Tassel, 1999). (vii) Even if borrowers do not know each other s type, group lending may be feasible due to lower interest rates as a result of cross subsidization of borrowers (Armendariz de Aghion and Gollier, 2000). (viii) Group lending has a disciplining effect: joint liability may deter borrowers from using loans for non-investment purposes. Attanasio et al. (2011) found from results of informal transfers in Mongolia that borrowers in group-lending villages were less likely to make informal transfers to families and friends, while borrowers in individual-lending villages were more likely to do so. (ix) Helps achieve improved bargaining. Reduced transaction costs and a lower risk of default increase the attraction of lending to groups. Participating members improve their access to credit and obtain better terms than they would qualify for as individuals. In many cases, group arrangements provide financial services to individuals who would otherwise have no access to credit (Huppi and Feder, 1990);

5 PAT 2012; 8 (1): 40-51: ISSN: ; Maiangwa: Group versus Individual Lending: A Review.44 (x) Offers human resource development for highly disadvantaged members. March and Taqqu (1986) in their study of women s informal associations found that women form groups for economic and political purposes as well as for support (such as child rearing). Groups help women find work, spread information, offer training, and provide access to resources in societies where women are excluded from more formal networks (Holt and Ribe, 1991). Disadvantages of Group Lending The disadvantages of group lending include: (i) Possibility of occurrence of moral hazard. Under a system of joint liability, all members are liable for the costs of default by any member. This implies that the risk is borne by the group whereas the benefit is reaped by the individual. Since the social cost of individual default exceeds its private cost, joint liability may increase the risk if group cohesiveness is limited and mechanisms for enforcement and penalization fail to operate effectively. Group members have little incentive to repay if the majority of their peers default (Huppi and Feder, 1990; Holt and Ribe, 1991). (ii) Though groups have a great potential for enabling members to reach their goals, group formation is by no means an easy and costless task. Risk heterogeneity in a borrowing group may arise due to the social identity of the agents. Since social identity is a key variable for group formation in traditional and developing societies, ignoring social identity and group formation costs can lead to the failure of a joint liability programme (Chatterjee and Sarangi, 2004). Thorp et al. (2003) investigated different examples of group benefits and costs and demonstrated that the chronically poor face greater disadvantages in forming groups. (iii) Due to group formation costs, group lending programmes may not be able to reach the poorest sections of society or some safe borrowers may get excluded from the programme. For example, Amin et al. (2003) have found out that in northern Bangladesh, group lending programmes are successful in reaching the poor, but have been less successful in reaching the more economically vulnerable sections of the community. Thus, with costly group formation and state verification, individual liability lending may be better than joint liability lending (Chatterjee and Sarangi, 2004). (iv) Joint liability microfinance programmes are less successful in areas of low population density and weak social ties. The reasons cited for the failure is that low density makes it hard to find partners who might be far away and/or have weak social ties. In otherwords, a heterogeneous (in terms of social and cultural factors) population makes it hard to form groups (Chatterjee and Sarangi, 2004).

6 PAT 2012; 8 (1): 40-51: ISSN: ; Maiangwa: Group versus Individual Lending: A Review.45 (v) (vi) A potential downside to joint-liability group lending is that it often involves timeconsuming weekly repayment meetings and exerts strong pressure, making it potentially onerous for borrowers. This is one of the main reasons why microfinance institutions have started to move from joint to individual lending (Attanasio et al., 2011). The condition that group members are responsible for the defaults of individual members encourages borrowers to apply for the same loan size, rather than fitting loans to the loan repayment capacity of individual group members. This may cause negative solidarity in the group, which means that the whole group defaults if one member fails to repay his loan (Klein et al., 1999). (vii) Group maintenance costs are high, as group members needs and circumstances diverge over time, thus weakening cohesion. Loan officers may have to participate in regular group meetings to attempt to strengthen the loan administration responsibilities of the group, the group cohesion and the sense of peer responsibility amongst the group members (Klein et al., 1999). (viii) Group lending offers less flexible terms and loan repayment installments. All group members receive and repay their loans in the same cycle. Even when graduation to individual lending is permitted, the lack of sufficient written records on borrowers hampers individual loan appraisal (Klein et al., 1999). (ix) (x) (xi) Repayment discipline on loans obtained through group guarantees may be hampered if collection from group members in lieu of one member s default is difficult, due to cumbersome legal proceedings (Feder et al., 1986). This is made worse if lenders are dependent on external sources of funds that mandate lending to particular target groups (Huppi and Feder, 1990). Evidence from empirical studies suggests that in many cases, the repayment performance of such loans was not better than that of unguaranteed individual loans (Adams and Ladman, 1979; Onchan and Techavatananan, 1982; Desai, 1983). The demand for credit within a group may change over time, forcing clients with small loans to be liable for larger loans of their peers. Stiglitz (1990) points to the higher risk borrowers assume when they are not only liable for themselves but also for their group partners. The growth of group lending programmes may slow down when new borrowers with looser social ties enter and, consequently, the group lending technology loses some of its power. (xii) There is also the potential for abuse of power and corruption by a powerful group leader. Conversely, if a good group leader leaves, then the group will be severely impaired (Klein et al., 1999).

7 PAT 2012; 8 (1): 40-51: ISSN: ; Maiangwa: Group versus Individual Lending: A Review.46 Individual Lending In individual lending, individual borrowers rather than group members are personally responsible for the full and timely repayment of loans received. The screening of potential clients is carried out by assessing their individual loan repayment capacity and their willingness to repay. Innovative microlenders examine the household s cash flow and check the credit history of the loan applicant to get a complete picture of his/her loan repayment capacity and creditworthiness. Advantages of Individual Lending The advantages of individual lending include: (i) The personalized nature of individual lending facilitates the granting of loan products that fit the client s demand and his/her loan repayment capacity. This (ii) reduces loan default risk; Individual lending encourages the development of a closer relationship and strengthens mutual trust between the lender and the borrower; (iii) Individual lending increases compliance with contractual loan obligations; (iv) Better client knowledge from individual lending simplifies the appraisal of repeat loans and reduces the risk of loan default. Accumulated client information may reinforce current financial services and lead to the development of new loan products (Klein et al., 1999). (v) Under individual lending, borrowers are exempt from the negative effects of group lending schemes such as bearing additional risk, loss of privacy from disclosing their financial situation and investment projects to potential peers, or time spent on group meetings (Lehner, 2008). (vi) By offering individual loans, a microfinance institution can attract relatively more new clients (Gine and Karlan, 2006). (vii) Businesses funded with individual loans grow more than those funded with group loans (Madajewicz, 2008). (viii) Some microlenders attempt over time to introduce more individualized lending terms for the members of joint liability groups. These initiatives combine the cost savings of working with groups with the high quality of providing individual lending services to group members (Klein et al., 1999); Disadvantages of Individual Lending The disadvantages of individual lending include: (i) In individual lending, a lower number of clients is served;

8 PAT 2012; 8 (1): 40-51: ISSN: ; Maiangwa: Group versus Individual Lending: A Review.47 (ii) Although individual lenders employ both conventional guarantees and loan collateral substitutes, the minimum guarantee requirements may still remain beyond the capacity of most low-income households (Klein et al., 1999); (iii) The process of collecting detailed information on individual clients is a costly exercise for microlenders; (iv) In individual-based lending arrangements, the amount of finance available is limited (Saito et al., 1994). Successful Rural Financial Institutions with Group and Individual Lending Programmes Four rural financial institutions (RFIs) in developing countries widely perceived to be successful are the Grameen Bank (GB) in Bangladesh, the Bank for Agriculture and Agricultural Cooperatives (BAAC) in Thailand, the Badan Kredit Kecamatan (BKK) and the Bank Rakyat Indonesia Unit Desa (BUD) in Indonesia. GB and BAAC have relied heavily on self-help groups to promote and deliver loans, while BKK and BUD have incorporated local officials, including village heads, into the client selection and loan approval process. The establishment of, and reliance on, self-help groups has been a crucial factor in the delivery mechanism that links the RFI with the individual borrowers. The sense of affiliation to the group and the clear perception that each individual s performance is crucial in determining the success or failure of the group has resulted in efficient, successful financial intermediation. The small size of the group (5 members in GB and up to 30 in BAAC) eliminates or drastically reduces the emergence of free riders (those members who do not contribute fully to group activities, knowing that they will still be able to reap all of the benefits), and has a very favourable effect on RFI costs (Yaron, 1995). The savings in transaction costs achieved through reliance on self-help groups and peer pressure has been crucial to RFI s level of self-sustainability and outreach achieved. Since 1984, BRI has been a major provider of microfinance, mobilizing microsavings and offering small and micro loans to individuals and groups at the village level. Local borrowers participate by attending the loan interview, and the village head assists in screening borrowers by issuing a certificate of ownership or tenancy. In these ways, the BRI system overcomes the lack of adequate information on a potential borrower s credit-worthiness that has long been a problem for RFIs. Also, the standing of the village head in the community gives him the ability to influence others who are seeking savings alternatives and sources of credit (Yaron, 1995). By the year 2000, BRI s 3700 rural sub-branches had 2.6 million active borrowers and some 25.1 million savings accounts (Seibel, 2001). By implementing sound policies, including a massive

9 PAT 2012; 8 (1): 40-51: ISSN: ; Maiangwa: Group versus Individual Lending: A Review.48 staff retraining programme, BRI made its microfinance unit a tremendous success. Part of this success stems from the bank s recognition of the need to reach out to the rural poor as well as to wealthier clients. Conclusion and recommendations Low-income producers in developing countries need cost-effective and sustainable financial services to increase their productivity and income. For example, the availability of inputs and technologies will be to no avail if these producers have no means to obtain or use them. This will require building rural financial infrastructures that are diversified according to local conditions, enhancing institutional sustainability with outreach to the poor, ensuring the participation of all stakeholders, and fostering a conducive policy and regulatory environment. The recommendations from this paper are: (i) (ii) There is need for the participation of all stakeholders, including the poor, in the development of rural finance. Stakeholder participation is necessary to ensure an integrated approach to the development of an effective system of rural finance. Also, since participation is a cornerstone of self-help organizations, the active involvement of members is required to build institutions at the local level and to promote members economic self-sufficiency. There is need to build a differentiated rural finance infrastructure with diverse strategies for meeting the needs of different segments of the society. This will require market research to investigate prospective clients to assess their needs and develop a product or service delivery model suitable for local circumstances; (iii) The creation of financially and institutionally sustainable microfinance institutions both capable of, and committed to, the needs of poor microentrepreneurs will lead to the sustained expansion in the range and improvement in the quality of key financial services available to poor microentrepreneurs and/or a permanent reduction in the price of services. This will contribute to increased incomes among the microentrepreneurs utilizing those services and their employees and improved household welfare among the families of microentrepreneurs and microenterprise workers. (iv) Instruments for lending to farmers who lack collateral should be developed, for example, by using group schemes, or joint liability. This strategy should also encourage private and cooperative saving and loan institutions in rural areas. (v) Targeted lending will facilitate access to credit by groups traditionally ignored by the formal financial sector such as smallholders, women and micro-enterprises in rural areas. It can also help overcome obstacles such as poor information, lack of lender experience and expertise in lending to these groups, and absence of lender confidence in the borrowers.

10 PAT 2012; 8 (1): 40-51: ISSN: ; Maiangwa: Group versus Individual Lending: A Review.49 (vi) Well-functioning group lending schemes require effective management. Selfmanaged groups usually perform better than groups whose activities are managed by outsiders such as extension agents or employees of the financial intermediary. Self-management encourages group cohesiveness and may thus make it easier to exert pressure on potential defaulters. (vii) For both group and individual lending, loans should never finance the total investment costs requested. Lenders should require an equity contribution from the borrower to complement the external resources. This equity participation increases the stake that the borrower has in submitting a realistic loan application, thus actively promoting the success of his business. References Adams, D.W. and J. Ladman (1979). Lending to rural poor through informal groups: A promising financial market innovation?, Paper presented at the 17 th International Conference of Agricultural Economists, Banff, Canada. Adams, D.W., A. Antonio and P. Romer (1981). Group lending to the rural poor in the Dominican Republic: A stunted innovation, Canadian Journal on Agricultural Economics,: Amin, S., A. Rai and G. Topa (2003). Does microcredit reach poor and vulnerable? Evidence from Northern Bangladesh, Journal of Development Economics, 70: Armendariz de Aghion, B. (1999). On the design of a credit agreement with peer monitoring, Journal of Development Economics, 60: Armendariz de Aghion, B. and C. Gollier (1998). Peer group formation in an adverse selection model. The Economic Journal, 110: Armendariz de Aghion, B. and J. Morduch (2000). Microfinance beyond group lending, Economics of Transition, 8: Attanasio, O., B. Augsburg, R.D.Haas, E. Fitzimons and H. Harmgart (2011). Group lending or individual lending? Evidence from a randomized field experiment in Mongolia, Working Paper No. 136, European Bank for Reconstruction and Development. Bratton, M. (1990). Non-governmental organizations in Africa: Can they influence public policy?, Development and Change, 21: Chatterjee, P. and S. Sarangi (2004). Social Identity and Group Lending, UN Economic Working Paper No. UNEC R. Coffey, E. (1998). Agricultural Finance: Getting the Policies Right, Agricultural Finance Re-visited No. 2, FAO and GTZ.

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