Microfinance and Mechanism Design: The Role of Joint Liability and Cross-Reporting

Abdul Karim, Zulkefly (2009): Microfinance and Mechanism Design: The Role of Joint Liability and Cross-Reporting.

Abstract

Since the establishment of Grameen Bank in 1976 by Professor Muhammad Yunus , many economists have studied extensively, either theoretically or empirically, the success of the Grameen Bank in eradicating the poverty problem in Bangladesh. Therefore, this paper aims to apply the mechanism design theory in microfinance by examining the role of joint liability and cross-reporting mechanism in the loan contract which designing by microfinance lender. In doing so, this study simplified the joint liability mechanism proposed by Ghatak (1999, 2000) and cross-reporting mechanism by Rai and Sjostrom (2004). Based on the joint-liability mechanism, it is clearly stated that the microfinance lender can minimize or avoid the adverse selection problem in the credit market through peer selection and peer screening. In the meantime, the joint liability mechanism is better than individual lending in terms of increasing the social welfare among the poor borrower, charging lower interest rates and generating high repayment rates. In contrast, Rai and Sjostrom (2004) argue that joint liability alone is not enough to efficiently induce borrowers to help each other. Indeed, the cross-reporting mechanism is also important for lenders in order to minimize the problem of asymmetric information in the credit market. The cross-reporting mechanism is also efficient because it can influence the borrower to be truthful-telling about the state of the project and subsequently can minimize the deadweight loss (punishment) among the borrowers. In comparison, without cross-reporting, the lending mechanism is inefficient because the borrower will be imposed harsh punishment from the bank and the bank can undertake auditing or verify the state of the project and punish accordingly.

• Item Type: MPRA Paper
• Language: English
• Keywords: Microfinance; mechanism design; joint liability; cross-reporting
• Subjects: B - History of Economic Thought, Methodology, and Heterodox Approaches > B2 - History of Economic Thought since 1925 > B21 - Microeconomics; N - Economic History > N2 - Financial Markets and Institutions > N20 - General, International, or Comparative; C - Mathematical and Quantitative Methods > C7 - Game Theory and Bargaining Theory > C70 - General

References

Armendariz, B., & Gollier, C. (2000). Peer group formation as an adverse selection model. The Economic Journal, 110, 632-642.

Armendariz, B., & Morduch, J. (2000). Microfinance beyond group lending. Economics of Transition, 8, 401-420.

Armendariz, B., & Morduch, J. (2007). The Economics of Microfinance. The MIT Press: Cambridge.

Banerjee, A., Besley, T., & Guinnnane, T. (1994). Thy neighbour’s keeper: the design of a credit cooperative with theory and a test. Quarterly Journal of Economics, 109, 491-515.

Besley, T.J., & Coate, S. (1995). Group lending, repayment incentives and social collateral. Journal of Development Economics, 46(1), 1-18.

Bond, P., & Krishnamurthy, A. (2002). Regulating exclusion from financial markets. Mimeo, Northwestern University.

Brau, C.J., & Woller, M.G. (2004). Microfinance: A Comprehensive Review of the Existing Literature. Journal of Entrepreneurial Finance and Business Venture, 9(1), 1-26.

Chowdhury, P. R. (2005). Group-lending: sequential financing, lender monitoring and joint liability. Journal of Development Economics, 77, 415-439.

Conning, J. (2000). Monitoring by delegates or by peers? Joint liability loans under moral hazard. (Mimeo, William College).

Ghatak, M. (1999). Group lending, local information and peer selection. Journal of Development Economics, 60, 27-50.

Ghatak, M. (2000). Screening by company you keep: joint liability lending and peer selection effect. The Economic Journal, 110 (465), 601-631.

Ghatak, M., & Guinnane, T.W. (1999). The economics of lending with joint liability: theory and practice. Journal of Development Economies, 60, 195-228.

Hassan, M.K. (2002). The microfinance revolution and the Grameen Bank experience in Bangladesh. Financial Markets Institutions & Instruments, 11(3), 205-265.

Jain, S., & Mansuri, G. (2003). A little at a time: the use of regularly scheduled repayments in microfinance programs. Journal of Development Economics, 72, 253-279.

Laffont, J-J., & N’Guessan, T. (2000). Group lending with adverse selection. European Economic Review, 44, 773-784.

Maskin, E., & Sjostrom, T. (2001). Implementation Theory. Hanbook of Social Choice Theory, Vol. 1, K.Arrow, A. Sen and K. Suzumura. Eds. North-Holland.

Morduch , J. (1999). The Microfinance Promise. Journal of Economic Literature, 37 (4),1569-1614.

Rai, S.A., & Sjostrom, T. (2004). Is Grameen Lending Efficient? Repayment Incentives and Insurance in Village Economies. Review of Economic Studies, 71 (1), 217-234.

Sengupta, R., & Aubuchon, C.P. (2008). The Microfinance Revolution : An Overview. Federal Reserves Bank of St. Louis, Review, 90(1), 9-30.

Stiglitz, J.E. (1990). Peer monitoring and credit markets. The World Bank Economic Review, 4(3), 351-366.

Stiglitz, J.E., and Weiss, A. (1981). Credit rationing in markets with imperfect information. American Economic Review, 71 (3), 393-410.

Townsend, R.M. (1979). Optimal contracts and competitive markets with costly state verification. Journal of Economics Theory, 21(2), 265-293.

Townsend, R.M. (2003). Microcredit and Mechanism Design. Journal of the European Economic Association, 1(2-3), 468-477.

Yunus, M. 1999. The Grameen Bank. Scientific American, November, 144-119.