In a model for lending in developing nations, a Bangladesh bank relies on peer pressure for collateral.
New York Times; New York, N.Y.; Nov 22, 2001; Hal R. Varian

THE village moneylender in Bangladesh charges interest rates of over 150 percent a year. Citibank would love to get that kind of return on its investments -- so why isn't Citibank lending money in Bangladesh villages?

This is a serious question, in terms of both policy and profit. The painfully high interest rates charged by moneylenders in developing countries suggest that marginal investment opportunities there are much more profitable than in advanced industrial nations.

So why isn't there a rush of investment from Western banks to exploit these profitable opportunities -- and, as a byproduct, increase the pace of economic development in these countries?

There are several barriers to entry in the lending business in developing countries, many of which have to do with the information advantages that incumbent moneylenders have over potential entrants.

To begin, the local moneylender is intimately familiar with his clientele, and this gives him a huge information advantage over a bank officer in selecting reliable loan recipients. At the same time, the moneylender is in a very good position to monitor borrowers since he can check up on their activities daily.

Local moneylenders are also familiar with village customs and practices and can offer useful business advice; they are also in a good position to provide informal insurance to the loan recipients, too, since they know when a nonperforming loan is caused by outside causes, like bad weather, and when laziness is the cause.

Finally, moneylenders operate at a much smaller scale than Citibank does. Most of these loans are minuscule by Western standards, and Citibank just is not set up to handle tiny investments, even if they are potentially very profitable.

These factors -- selection costs, monitoring costs, local experience, insurance and inappropriate scale -- conspire to create a virtual monopoly for the moneylender. Even moneylenders from neighboring villages might find it hard to compete with someone who has an intimate knowledge of a particular village's inhabitants. The result is tens of thousands of tiny monopolies and many profitable projects that are never undertaken because of the high cost of borrowing.

But there is hope. About 25 years ago Muhammad Yunus, a Bangladeshi economist trained in the United States, developed a lending model that managed to overcome these kinds of barriers. His business model for microcredit has been immensely successful, spawning imitators the world over.

Most of these lenders are nonprofits, but they are self-supporting nonprofits, which do not require subsidies or loan guarantees. There are even a few for-profit enterprises experimenting with the Yunus microcredit model.

Mr. Yunus put his plan into effect through an institution he called the Grameen Bank.

The critical feature of the program is that a candidate for a loan must form a group with four other people who are not family members. Two members of the group originally receive a loan, and if they do well, the others then receive loans.

The borrowers are encouraged to assist each other, and all loan disbursements and repayments are made publicly, in front of other groups. Loans are always for one year, at a fixed interest rate of 20 percent, and they are always for modest amounts: no more than a few hundred dollars.

The borrowers use the loans to buy looms, chickens, cows and make other small capital investments. They start repaying the loan two weeks after getting it, and once they have repaid the initial loan, they are allowed to apply for new ones.

How does this business model solve the information problems described above? First, take the selection problem. The Grameen design provides strong incentive for good borrowers to join together, since they don't want to risk losing a loan because of one failure or troublemaker. The fact that they cannot join with other family members removes one sort of pressure to dilute group quality.

Second, the members of the group have an incentive to monitor one another's activities actively. They can provide advice, assistance, education and, if necessary, insurance. The group members themselves are in the best position to know whether a recipient is slacking off or has just had a run of bad luck, and they have great incentives to monitor their behavior in an honest and helpful way.

Third, all of this selection, monitoring, educating and insuring is done not by high-paid professionals, but by Bangladeshi peasants. The transactions costs of using groups are far, far lower than are the transactions costs for traditional bank loans.

There are other interesting economic angles. Over 90 percent of the borrowers are women. This isn't so much an ideological choice as a pragmatic one -- women turned out to be better credit risks. They were more tightly tied to the home and had fewer outside temptations, so they focused much more intently than did male borrowers on completing their projects.

All this seems to work. The bank says it has a repayment rate of 99 percent, and over 92 percent of the bank's shares are owned by the borrowers. Peer pressure can be an immensely strong force, and the Grameen Bank has figured out how to make it work in the cause of economic development.

Experiments elsewhere haven't been uniformly successful. In some countries, the poverty stricken do not have enough group solidarity to provide the necessary discipline. In more urban settings, it may be difficult to find appropriate small-scale investments. But there are numerous successful operations inspired by the Grameen bank.

One program, Project Enterprise, runs a Grameen-type program for minority entrepreneurs in New York.

To answer the question posed in the first paragraph: Citibank and other Western banks are well aware of the Grameen model. In 1999 the Citigroup Foundation donated $1 million to the program.

Citibank, along with others, is currently experimenting with microlending in India and other developing countries. Multinational banks may yet find ways to break the moneylenders' monopolies and finance microinvestment in poor countries.

Access to capital is critical for economic development. Grameen and its many offspring, both nonprofit and for-profit, offer an exciting model for alleviating poverty.