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DETERMINANTS OF MORAL HAZARD IN MICROFINANCE: EMPIRICAL EVIDENCE FROM JOINT LIABILITY LENDING PROGRAMS IN MALAWI Author(s): Franklin Simtowe, Manfred Zeller and Alexander Phiri Source: African Review of Money Finance and Banking, (2006), pp. 5-38 Published by: Giordano Dell-Amore Foundation Stable URL: http://www.jstor.org/stable/23026339 . Accessed: 27/08/2013 03:02
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DETERMINANTS OF MORAL HAZARD EMPIRICAL EVIDENCE FROM JOINT PROGRAMS IN MALAWI

IN MICROFINANCE: LIABILITY LENDING

Franklin Simtowe - Universityof Bonn Manfred Zeller - University of Hohenheim Alexander Phiri - University of Malawi 1. Introduction information Imperfect adverse moral selection, common is the causes hazard, at least lack four in credit markets, problems and lack of enforcement. namely, It is now

of insurance

with the lack of collateral that moral hazard, knowledge coupled by the poor fail for them. The problem of moral hazard key reason why credit markets may in risk sharing under conditions such that their private arise when individuals engage affect the probability distribution of the outcome. It occurs in a princi ly taken actions when actions taken by an agent are not pareto-optimal. pal-agent relationship as a contractual innovation that has Liability Lending (JLL) is celebrated of enabling the apparent miracle borrowers to lift previously marginalized themselves 'social collateral' to replace the up by their own bootstraps by creating them from access collateral that excluded to more traditional forms missing physical achieved is that the poor are given access to credit without and in the event collateral, grams of default, be punished a mere denial of future access to credit. beyond they cannot This form of limited liability can induce borrowers to take risky decisions. In an effort to fully explain the success of JLL in mitigating moral hazard have theorists models that attempt to explain proposed enhancing repayment, the most notable theories of moral this is possible. hazard are models Among under joint can liability lending that group members, each other's investment by the lending are given be used to mitigate moral hazard. jointly liable to the loan, and effort, thereby Joint

of finance (Conning 2000). Nevertheless, the problem with joint liabilitylending pro

and how by

Stiglitz (1990) and Ghatak and Guinnane (1999). Stiglitz shows how peer monitoring
assumed monitor monitoring who are JLL, Through will be induced it is to decisions and of both the cost of reducing moral hazard. mitigating

borrowers Thus, to ensure that repayment assumption As modification

consequently their loan, and monitoring managing peers safe decisions that would them from falling into they take protect in reality, monitoring can be costly and thus the However, problems. hold. made by Stiglitz cannot tasks from Further, taking a model they into show account on the assumptions by Stiglitz, of costless the the Ghatak and

institution

a diversion

toring is costly. still be achieved borrower's further borrower's

monitoring, condition under cost

Guinnane a (1999) propose that peer moni by showing which optimal contracts can

to repay the loan will depend willingness from the same institution. Ghatak and loans project yields enough output so that

of monitoring. add that a They also on how they value the access to Guinnane observe that if a (1999) he/she is able to repay the loan,

he/she will do it only if the benefit of defaulting, the interest, is less than the (dis

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AFRICAN REVIEWOF MONEY, FINANCE AND BANKING- 2006

net benefit of continued counted) the value of future extent does ard?' Following studies empirical the

access access

to credit. to credit of moral to test

This reduce

raises the

the question: To incidence of moral a limited number

what haz of

theories proposed have been conducted

hazard, only their validity.

occurrence credit groups. et In Malawi, moral hazard is common among Diagne note that peer in credit groups from Malawi and al (2000) monitoring rarely occurs it occurs it does not lead to improvements in repayment because the that when main reason for default in the Malawi Rural Finance credit groups Company (MRFC) to repay unwillingness to repay was found ingness It accounted for 25 groups. no study has been high incidences to which extent the ture likelihood by testing of moral moral the is the inability to repay. The unwill of default the MRFC credit among in MRFC of all defaults credit groups. However, percent conducted in Malawi to assess the driving forces behind such hazard. hazard of this paper the the objective is to examine Thus, in credit groups and analyse determinants of occurs It is an attempt to contribute to moral hazard litera peer selection, peer and matching problems framework proposed by Diagne collected monitoring, influence social the ties, incidence peer of and hazard) (moral to be the first cause not the

of its occurrence. extent incentives

to which

pressure, dynamic moral hazard. We (1999) with some We Aghion (1999). Research Institute which are non-farm framework ly. In section loans. and

a theoretical adopt extensions proposed use

data from Malawi, in 1999. The data comes (IFPRI) of the Malawi Rural Finance beneficiaries In section the description and present

and Guinnane by Ghatak Paxton and de (1998), (1996) Food Policy by the International from 99 credit all of groups, farm and theoretical

5, we

a brief 2, we present of data are presented discuss while results,

(MRFC) Company's review of literature. The in section section 3 and

4, respective 6 concludes.

2. Moral

hazard

in group

based

credit:

a review

of theories

and

related

research

2.1 The dynamics of joint liabilitylending Matin (1997) describes joint liabilityas a contract in which the provision of the
such as an individual's access to credit, is made conditional on the good, It refers to a situation of the public such in which provision good, group repayment. are liable for repayment of a debt or obligation and a creditor two or more parties or jointly. Most can be compensated from them either individually loan con group private

tracts in developing countries have a joint liability clause.

This partly explains the

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F. SIMTOWE, M. 2ELLER, A. PHIRI - MORAL HAZARD IN MICROFINANCE

in economic is a potential break through strategy without to land title or collateral poor, for example otherwise never access The prem loans that they would individually. ise of group with joint liability is that if one borrower cannot pay a loan, then lending other members of the joint liability group will do so (Ahlin and Townsend 2003). belief that development access group joint liability lending as it enables the Figure joint liability ment. Each clause the loan 1 shows lending in the of loan transactions and stages presentation of borrowers to repay starting from identification through in the figure is associated with a problem that the joint liability to address, and a hypothetical or theoretical solution. Following a relational model the stages ends of monitoring, return realization, with penalties of non-refinancing of problems Risk investment 1 Loan contract Failure Repay - time and solutions or non repayment in case of default. joint liability loan

stage is assumed receipt The are

repayment. Figure

process

1: A dynamic

presentation

in a multistage

Unwillingness to repay

d ! Peer selection [0 Monitoring (monitoring by peer and MFI) f 0 Intragroup insurance (peer support)

, [0 Enforcement sanctions through (peer pressure)

Source: Adopted withsome modification from Sadoulet (2004) of the period a pool of potential borrowers beginning you have trying to credit. However, is conditioned that a upon group affiliation. Realizing borrowing with the lender, each borrower, through borrowing group will sign a joint liability contract tries to match with members of similar risk type. As proposed peer selection by Ghatak reduces the incidence of adverse the self-selection selection. (1999a), process access At the

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AFRICAN REVIEWOF MONEY, FINANCE AND BANKING- 2006

the selection is the investment At this stage, the lender is Following stage period. with an ex ante faced moral hazard This occurs when a borrower either problem. decides to invest in a risky project or misuses the funds or when the borrower does not apply theory, tary enough monitoring monitoring by the be peer effort to manage the investment, which may lead to low returns. In can be used to mitigate this problem. However, complemen from microfinance officers institutions can also (MFIs) signifi the incidence ex ante moral hazard. Since monitoring by MFI officers costly and unsustainable, joint liability lending emphasizes on

reduce cantly is assumed to monitoring The number joint post

by peers. involves some investment of which outcomes. The investment may fail due to a the control of the borrowers such as beyond now is that there exists limited Under liability.

third stage of reasons, shocks.

are

idiosyncratic

liability lending the defaulters' paying moral hazard. lending returns contracts. of the the funds

do not have in can assist problems repayment The final problem is related to ex (intra-group insurance). This is a second dimension of the general moral hazard issue in It occurs when the levels of effort have been carried out and the loan have been when a borrower finds it optimal to realized, loan to other purposes. In joint liability loans, sanctions can solve the problem of ex post

The problem members that

investment

diverge

implementing moral hazard.

for repayment of the and social peer pressure

2.2

Empirical

studies number hazard and of empirical studies have been and repayment performance Zeller (1997) as analyze opposed the role to conducted in JLL cohesion group flow and on schemes. and the deter Zeller intra structures repayment with respect

A very limited minants of moral (1998) and Sharma insurance group and show that performance to occupation achieve ance assesses higher services the

of social

in heterogenous social cohesion

in joint and

enables improved Moreover, liability schemes. group heterogeneity other socio-economic characteristics enables performance, presumably to borrowers with by peers of moral because repayment

homogenous information

repayment provided

to groups of intra-group insur problems. Among

the few attempts are studies by Wydick (1999) and Hermes et al (2005). Wydick
incidence evidence provides information flow. key variables hazard credit in Guatemala among groups because of social cohesion and liability works the study fails to assess the extent to which Nevertheless, of group such sanctions as, incentives, dynamics dynamic that joint and better other and

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F. SIMTOWE, M. ZELLER, A. PHIRI - MORAL HAZARD IN MICROFINANCE

matching study the that social moral The

problems incidence ties and among

influence of moral

the hazard

incidence

of moral

hazard.

Hermes

hazard

peer monitoring borrowers.

credit groups from Eritrea among are key factors the influencing

and

et al (2005) observe of

likelihood

is discussed joint formation self through

role of peer selection in mitigating adverse selection and hence moral hazard Ghatak that despite information (1999b). by Ghatak argues asymmetry, allows for pareto in credit markets if group superior equilibrium liability lending is conducted will result assortative the appropriately. into members matching hazard, outcome Ghatak with shows how groups less formed Ghatak interest homogenous end groups to a lower quality. up with equilibrium lending. through shows that

selection

moral directly reducing ing to a pareto superior The

process, which leads relative

risk borrowers, rate lead

to individual

of peer in improving in group credit is significance monitoring repayments for example, of authors. observes that the by a number Stiglitz (1990), MFIs that borrowers is ensuring exercise in the use major problem facing prudence of the funds so that the likelihood of repayments is enhanced. notes Stiglitz (1990) highlighted that a partial solution is peer monitoring: to this problem or group giving neighbours members the responsibility to monitor each other. The incentive for peer monitoring comes from the fact that peers are supposed to pay loans for any defaulting group members. the incentive rationale for the use of group as a method Studying lending of financing Che observes that the joint liquidity-constrained entrepreneurs, (2002) liability (2002) uidity ects are with make lowers the out points risk effect, but creates a free-riding Che risk of default liquidity problem. that in the static setting, the free-riding dominates the liq problem thus making unattractive. when the proj However, lending group over time, the joint liability feature the group members provides of exercising attractive, peer monitoring relative to individual monitoring, is all that that even the Grameen and sanctioning, which can lending. et al. (1993) Fuglesang argue matters it comes most when to micro lenders that are famous

repeated a credible means the group

lending to the

that

on peer emphasis institutions by lending rates. They observe improving repayment for the joint liability methodology such as the monitoring

In contrast

and locally upon highly motivated rely heavily tors and organizers. this observation, Following (2000) Conning at monitoring, such monitors delegated might not be just as good ter at enforcing loan than peer in which monitors, repayment other purposes. clauses or may be serving my be superfluous

of Bangladesh do in fact also recruited loan staff officers as moni whether questions and perhaps bet case joint liability

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AFRICAN REVIEWOF MONEY, FINANCE AND BANKING- 2006

The pressure

role of peer pressure is discussed model in which borrowers are

by Diagne

to apply or tolerate social willingness be used to mitigate default in situations An extension sanctions. of the model proposes behaviour The loans cessful burden in the mized and the among role is also of dynamic importance borrowers. in enhancing in Besley and

incompletely sanctions and

a peer (1998). Diagne proposes informed about their partners' shows how peer pressure can

where defaulters are intolerant of potential and Paxton further by Diagne (1998) (1996) incentives and incentive match in inducing safe

of sanctions discussed

the Coate

members group may wilfully decide of having to repay the unsuccessful of strong social ties among presence because potential defaulters are afraid community.

of individuals their to repay how moderately suc (1995). They show not to repay their loans because of the members' loan. They note however, that willingness members, group of facing sanctions wilful from default both is mini the bank

the

Ahlin and Townsend further attempt to extend (2003) of the models. some unexamined dimensions by testing duction of productivity differences across Based groups. function can be decomposed production multiplicatively risk factor and a piece related to human human the age capital, capital. the they assign In their empirical

models existing repayment One such test is the intro on the into that the assumption a piece related to the as loaned and capital

such productive inputs, derivative of the utility difference analysis

level of education positively average land holding size (another productivity In the on repayment impact performance. on moral hazard and

with respect to represented they find that productivity by influences the aver However, repayment. in the model) variable considered had no next section we present a theoretical

framework

its extensions.

3. Theoretical

and

empirical

framework

Salanie the standard moral hazard model assumes that the (2000), Following cannot observe the effort level of the agent. Once a contract has principal directly n possible been the agent must choose between actions a ,an. These signed m outcomes which we may denote actions one among x? xm. Assume produce further that when the agent chooses action observes the outcome a the principal xy The with a probability that is receives a when the principal positive. agent wage p/, Wj the outcome for the principal is (xy - wj). The specification observes x,. The income for the Agent's von Neumann-Morgenstern function can be written as u (w) - a, utility

10

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F. SIMTOWE, M. ZELLER, A. PHIRI - MORAL HAZARD IN MICROFINANCE

where of the When be

u is increasing his literature, the principal as:

and von

concave.

Assuming

Neumann-Morgenstern offers a contract Wj the

for the principal as in most is written as x - w. utility function can utility maximization problem agent's neutrality

written

If the agent

chooses

a, then

the (n-1)

incentive

constraints

is

i=i

m m 2 PijU(Wj) - a, ^ 2 pk,u(w,)-ak
i=i where k=1, agents' n and constraint) k * i. participation is also problem constraint:

(ICk)

(2)

The ual

utility maximization

subject

to the following

(individ

rationality

2] PijUfWj)- a,> n j=1

(IR)

(3)
on the basic a First

from taking an outside where option. Building /i is the utility derived in the standard model stated above, specified principles Stiglitz (1990) moral hazard model for credit markets which can be presented in two the

proposes

model is presented under individual and then later under lending is presented. The model shows that joint liability lending can be used group lending to mitigate the moral hazard members. The model starts problem among group by a single borrowers' loan (individual that assuming liability) under the assumption two values, rowers are risk neutral. takes Output high V" and low Y1. Normalizing low bor the

stages. a scenario

sents the utility the agent can obtain by taking on an outside option. This participa
tion constraint, as which follows: also implies that the projects are socially profitable, can be expressed pV^

values to 0, the output is high with probability Assum output p and 0 otherwise. 1 unit of capital, then the repayment to the lender project requires ing that each plus will only be willing to borrow if the utility from bor interest equals p > 1. Borrowers results from the payoffs) is no smaller than some (which utility y that repre rowing

p 2 fJi

(5)

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AFRICAN REVIEWOF MONEY, FINANCE AND BANKING- 2006

for which they incur a disutilitycost of i yp2(where ^>0). Following this specification
a social

borrowers

choose and

actions,

which

can

be

thought

ot as

a level

of effort p E [0,1], can be com

puted. Under individual lending the following equilibrium value of p will be chosen Ghatak and Guinnane (1999): = y"+V(y")2-4Pr 2y
it is assumed Under joint liability scenario that when a borrower's fails the project is liable for the amount for each member to care about partner q. This is an incentive the safety of the project chosen and it is acknowledged as a justifica by the peers tion for peer monitoring. If one of the members chooses an action p' then the payoff function of a borrower who chooses action p is

surplus

the

equilibrium

p which

is subject

to moral

hazard

max pY"-rp-qp
(p) Assume taking that the

(1-p') - - yp2
I borrower action p' as chooses given. action Then p to maximize her best response his

(7)
individual payoff, is given by:

his partner's

function

P-^f^^P'
two the values while individual

(8)
that of

At the equilibrium the p under joint liabilityjust like under individual liabilityhas
of the joint liability expression is lower than the denominator shows how the equilibrium value of p and liability. The model to individual rate is higher under joint liability compared lending. outlined above as assumes well as that they members any can monitor each regarding hence

repayment The actions choice

model perfectly of p.

others their

at no cost,

enforce

agreements

However, in reality,peer monitoring can be costly. In addition, joint liabilitylend


ing allows for the repayment this model sanctions promises. imposition Ghatak of sanctions on group members that make and (1999), of monitoring and Diagne (1998) Guinnane therefore, further on their renege an extension of for the extensions effect of to the

ences

model by including the impact peer pressure and dynamic incentives in inducing repayment. Ahlin and Townsend (2003) propose the inclusion of productivity differ
across hazard through and groups an increase show how in payoffs high productivity for safe projects. leads to a reduction in moral

the cost by including in choosing the level of p.

considerations makes

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F. SIMTOWE, M. ZELLER, A. PHIRI - MORAL HAZARD IN MICROFINANCE

Guided incidence whether of moral covariates

framework we identify variables that are associated with the by this theoretical of moral hazard from the data set. The empirical focuses on testing strategy or not particular covariates, vector X = (X; with the incidence X) are associated hazard. can The probability be written as P(H9 of moral =1 IX9). hazard This leads in a specific of group g as a function to the following likelihood function:

G n p (H9 = 11 X9)HS[7-P (H9 = 11X9)]'-"9 9=1


The where g's moral hazard model P(H9 =1 IX9) can of parameters and (1 is an Mx1 vector values for the M covariates. likelihood of a group the reporting by a latent variable y* which thus be written M/^ as X3 is an vector

(9)
a function, containing P(p' X9),

group

The be sion

incidence can be

of moral expressed

hazard as

is assumed in a regres

to

determined relationship:

follows

yt = P'i x, + m
where the variables X is a vector of the associated likelihood of characteristics, occurrence of moral hazard. What we observe is a dummy which, hazard, it is hypothesized p', is a vector

(10)
they affect of coefficients for that

with moral

In practice

y* is unobservable.

variable

defined

as

y= 1
y - 0 From

otherwise the relations 2 and 3 we get

ify,*>0

(11)

Prob (y,= 1) = Prob (u, > - p' Xj) = 1 -F(-p'Xi


In this case the observed values of y are just realizations

(12)
of a binomial process

with probabilities given by (12) (Maddala 1997). Hence the likelihood function is l = n f (- p xi) n [1 -F(-p'Xi)] (13) 1
y=0 y=

The functionalformof F in (13) willdepend on the assumptions made about fx, in (10).
In this cumulative moral we assume study normal distribution is done using that m are IN(0,<52). of the error terms, probit model. Because the of this estimation assumption of determinants of a of

hazard

the

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AFRICAN REVIEWOF MONEY, FINANCE AND BANKING- 2006

The

moral

hazard

model Pr=2 i=1

was

specified

as

follows:

Prob (y=1) = a + 2
Dinc=2 + 2 06/*6i m Where: s are s are s are s are s are s are a set a set a set a set a set a set lm=3 + 2 i=i

Pvxv + 2

Scr-4 i=1

P2iX2i + 2

pm=3 i=1

+ 2 P 31X31

st=6 i-1

Pai** + Z

pp=2 i=1

+ 05/*5/

(14>

Ctr=5 07/*7/ + 2 08/*8/ i=i

of variables of variables of variables of variables of variables of variables

(Pr=2) (Scr=4) (St=6)

that

measure

that measure

s are a set of variables

that measure (pm=3) that measure the strength of social ties within the group that measure the quality of peer pressure (Pp=2) that measure the quality of dynamic incentives (Dinc=2) (lm=3) that the proxy the degree of incentive match

group productivity the quality of screening the quality of peer monitoring

4. Data The Institute offices Malawi. study is based on data 99 collected MRFC Food Research by the International Policy in 4 of the 27 satellite credit groups located are located in 4 different districts of offices

in 1999 (IFPRI) of MRFC. The The groups

from four

satellite

on information obtained from selected based randomly the three regions of MRFC's Information The four sites cover Management System. Malawi South and Because of logistical the sample constraints, (Central, North)1. frame of the groups in each satellite office was restricted to 2 field offices only2. were 1997 were classified into 3 categories: status, repayment groups fully and nothing-paid A stratified random sam partially-paid groups groups. to randomly was then used select the sample from the three pling procedure groups A group selected strata. was classified as fully paid if the 1997 loan was fully group as a partially-paid if only part of the 1997 group loan had paid. It was classified group Using paid groups, been as nothing-paid if no paid at the time of the survey. And a group was classified for the 1997 loan. For each member had paid anything and three group, a group leader selected members were interviewed for each One randomly group. non-participant and one 1 See 2 The past participant randomly selected but living in the same village were also the

Map of Malawi in the Appendix forthe study sites. average number of offices per satellite office is five.

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F. SIMTOWE, M. ZELLER, A. PHIRI - MORAL HAZARD IN MICROFINANCE

A detailed structured the formation, questionnaire covering composition to each The ques repayment history of the group was administered respondent. tionnaire included aimed at quantifying the degree of information specifically questions within each asymmetry group and the extent to which peer selection, peer monitoring and peer pressure had been taking place. Also collected was using the questionnaire and the extent 4.1 to which the joint-liability and conduct has been enforced in each loan cycle.

interviewed.

Formation,

structure

of the groups

The sample consisted of both farm and non-farm credit groups. As indicated in were tobacco credit groups followed 2, the majority Figure (47%), by the non-farm business Maize and cotton accounted for 17 percent and 8 groups (28%). groups of the sample, percent respectively. Figure 2: Types of credit groups

These operated loans,

four types of credit groups to three different joint liability programs belong MRFC seasonal Mudzi seasonal loans, by MRFC: agricultural agricultural and Mudzi non-farm businesses. There are significant differences in the

and target population of the programs. There are also significant orientation, design, in the design differences and operation between the groups in the seasonal agricul tural programs on the type of crop for which the loans are intended depending cotton and rice (Diagne et al 2000). maize, (tobacco, Based the groups on information formed from group by ordinary leaders, village Table residents 1 indicates that only 25 (through of percent selec

were

on their own

peer

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AFRICAN REVIEWOF MONEY, FINANCE AND BANKING- 2006

extension workers and the Credit Assistants tion). The agricultural (Field Assistants) formed 44 percent and 16 percent of the groups, The importance of the respectively3. with FA's in the formation of the groups is consistent with the policy followed by MRFC ers, to group formation. The policy consists of letting the agricultural extension work respect who are under the ministry of Agriculture and are called Field Assistants (FA) in to its Credit Assistants to borrow Malawi, identify and propose (CA) the groups wanting The CAs then perform the screening and It is generally assumed from the perspective of formed proposed by the FAs have been endogenously It is however not clear as to the extent to which such ities. undertake MRFC the group training activ that groups identified and through a peer selection process. whose formation was initi groups

from MRFC.

to be endogenously self formed. Anecdotal sto by FAs and CAs can be considered indicated a lot of influence on who ries during the field survey, however, that FAs exerted in the groups. In a number of cases FAs included friends and relatives in to be included the credit the CAs which led to group default in some cases. It appeared, that however, groups in a group than the FAs were usually more objective when selecting members as stories of default due to biased selection were rarely reported in groups formed by 11 percent CAs. Village chiefs formed about of the credit groups. In some cases chiefs also in the same to be involved of including relatives and reported malpractices of the In addition chiefs only formed 11 percent although during group formation. their influence is also felt in groups that were formed by the FAs or CAs because in Table called of the groups formed by the FAs/CAs, 1, in about 24 percent village them to the village to come and form the groups. Ordinary villagers in onlv 17 percent of the groups. to have called the FAs/CAs

ated

were friends

groups, as indicated chiefs were had

reported

in initiat of their main job, FAs appear to have more influence Due to the nature of tobacco and maize to (47%) groups (41%) compared ing the formation groups In contrast, the CAs are more cotton and business (23%). groups (27%) groups in the formation of non-farm business to tobacco influential compared groups (25%)

(12%), cotton (15%) and maize (19%).


The als that indicate issue had

if some of screening was addressed leaders individu by asking group wanted to join the group had their applications turned down. Results 43 percent of the groups showed some evidence of screening, that about

3 extension workers,also known as Field Assistants in Malawi, play a Diagne et al (2000) emphasize that agricultural role in the formationof MRFC credit groups. For planningand administration purposes, Malawi is divided very important into Extension Planning Areas (EPAs) headed by an AgriculturalDevelopment Officer(ADO). MRFC field credit offices (which are the firstcontact points of borrowers) are located in the EPA offices and handle both the farm and non-farm groups. In all EPAs both the CreditAssistant and the Field Assistant work under the directsupervision of the ADO although the first is a paid employee of MRFC whereas the Field Assistant and the ADO are employees of the Ministry of Agriculture.

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F. SIMTOWE, M. ZELLER, A. PHIRI - MORAL HAZARD IN MICROFINANCE

as

indicated was

group

Screening business maize nism grown nature

number of membership applications rejected by the positive On average about 4 members were formed. per group being in maize is more evident groups (51 %) than in tobacco (43%), of high maize staple the

when

the

rejected. non-farm

and cotton (42%) (31 %). The evidence to the fact that groups may be attributed for self selection because maize is a main by almost of tobacco 30 all farmers. allows On the other for the self selection

levels of screening among lack a built-in mecha groups food in Malawi and has to be capital to start and earlier. labour intensive

hand,

process

About institutions past failed

to other credit of the groups had been affiliated previously percent MRFC. Thus despite the screening members from before joining process where loans been credit collected, may not have rigorously programs

A matter of fact according to default were part of the existing MRFC groups. leading of the groups included to Diagne et. al (2000) about 80 percent surveyed past mem 41 percent or another NGO. Overall about of group members were bers of SACA from another The nature in which members or members NGO. either SACA past formation group borrowers from themselves friends. group Table of how difficult it can be to exclude takes is evidence place risky can since chiefs or other local authorities groups village impose or indirectly their relatives and to the groups either through directly are usually for purposes by type 1 left with no choice credit. except joining a of receiving 1

borrowers good Potentially that is full of risky borrowers 1: Characteristics of groups 1

Characteristic

Tobacco (n=46)

Maize (n=16)

Cotton/Rice (n=8)

Non-farm business (n=28) 14 14 25 39 7 61 15 24 3 42 4 57

Total (n=99)

Who initiated the qroup Villaqe chief (%) Ordinary villaqe residents(%) MRFC credit assistant (%) Field Assistant (extension) (%) Other Who called the FA/CA Nobody Villaqe Chief Ordinary villaqers Aqe of the qroup (years) Evidence of screeninq (%) Averaqe number rejected Previously affiliates of other NGOs/past SACA Source: RDD/IFPRI1999 RuralFinance Survey

9 22 11 58 0 58 25 13 4 43 4 20

6 44 19 25 6 47 37 14 5 51 4 13

25 38 13 25 25 71 11 18 8 31 3 25

11 25 16 44 3 58 24 17 4 43 4 30

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AFRICAN REVIEWOF MONEY, FINANCE AND BANKING- 2006

4.2 Group composition


on group on homogeneity of groups in composition mainly focused in Table of wealth, social status and kinship. Results 2 indicate that 62 gender that were slightly heterogeneous in terms of the groups contained members percent of wealth while only 21 percent indicated that the group members were very hetero Questions that 55 group members of the groups were percent homoge were mixed

terms

The remaining 17 percent indicated geneous. nous. With regards to gender composition, with about women 66 percent composition. As

families of their respective


authorities). About 8% generally composed the groups where

regards

the

social

status,

90

village authorities (village chiefs or other traditional


members from from more more from families one one of FAs village or CAs. 21 Groups percent number are of than than village. In about

percent

of the

groups

included

members

from

included came

of members members

the average of came was 3. About 78 percent of the groups from which members con villages from previous credit In general PASTSACA members tained members programs. A good accounted for 41 percent of the group members. of groups exer proportion cise are excluded for default) as witnessed of sanctioning (members by 29 percent in which members were excluded for default. As a result of the exclusion groups of defaulting allow new members to join. As indicated in Table members, 2, groups of the groups admitted new members in their groups 26 percent during the respec tive loan cycle. the Table 2: Group composition 1 1 1 1 r

Tobacco (n=46)

Maize (n=16)

Cotton (n=8)

Non-farm business (n=28)

Total (n=99)

Group wealth distribution About the same (%) Slightly different(%) Very different(%) Group with mixed gender (%) Percent women in a group (%) Groups with members from village authority (%) % of member from villages authority's family (%) 25 21 15 13 20 13 65 23 62 50 93 27 60 13 77 56 86 59 25 16 91 26 76 11 65 24 25 100 89 16 62 21 55 66 90

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F. SIMTOWE, M. ZELLER, A. PHIRI - MORAL HAZARD IN MICROFINANCE

Tobacco (n=46)

Maize (n=16)

Cotton (n=8)

Non-farm business (n=28)

Total (n=99)

Group wealth distribution Groups with family members form CA or FA family (%) Number of villages from which members come Groups with members from PAST SACA or another NGO (%) % members from PAST SACA or another NGO Evidence of sanctions (members excluded for default) Groups with new members admitted (%) Source: RDD/IFPRI1999 RuralFinance Survey 4.3 Peer Peer monitoring monitoring and peer pressure 10 3 80 38 38 18 2 2 95 73 23 51 12 3 73 43 8 26 8 2 65 26 22 22 8 3 78 41 29 26

was peer monitoring access to information

of joint liability lending. is an important In the IFPRI study aspect the extent to which assessed members have by examining and by assessing the extent to which group members are will

activities to enforce loan use and report monitoring proper extent of peer was also assessed monitoring by observing rules followed One such rule that directly relates to monitoring is a rule by groups. on joint enterprise were asked whether ownership. Groups they had any rules that encouraged Table tion joint 3 shows ownership the extent can be of enterprises.

in peer ing to engage misuse of loans. The

of groups.

al knowledge Also about loans. that even Lack members

members' of group of the composi general knowledge 14 percent of the members did not have any gener seen, of the sizes and demographic of their respective composition groups. lacked about the sizes and terms 15 percent of their group knowledge As of knowledge on the general characteristics involved in monitoring. are not actively that claimed to know something members was that a wide extent. variation flow The in their information among number responses members The of the group is an indication results also reveal that about regarding the characteristics characteris same group by the in group to the

among there question tics indicating was limited

to some

average

belonging of group meetings

attended

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AFRICAN REVIEWOF MONEY, FINANCE AND BANKING- 2006

CA

in each

year per activities

group per year was month. Field Assistants because of the nature

14.

This

translates to be The

were

said

more

of their work.

into slightly more than a visit per in their monitoring influential number of meetings held average

without the presence of the CA was 21 per year while the average by members number of non-meeting visits to the chairpersons and defaulting members follow-up 11 per year. by the CA was Peer authorities in Table was defined to take place when members to the village pressure complained or took (threatened to take) punitive action defaulters. As indicated against was applied in 39% of all groups before or after the due date. 3, peer pressure was pressure applied it was due date, paid before in 37% of the groups. This peer defaulters to repay their in 57 of the groups where loans percent in inducing some default only successful shows how less frequent peer pressure

Although were ers ceed to partially repay

takes in joint liabilitygroups from Malawi and how more likely it is to fail than suc
in inducing 3: Extent peer pressure Tobacco (n=46) Peer Monitoring Proportion with no general knowledge of composition (%) Proportion with no knowledge of total Group loan size and terms of the loan (%) Number of meting by CA per year Number of meetings without CA Number of non-meeting visits by CA Rules encourage joint enterprise ownership Peer pressure Groups where peer pressure was applied after or before due date(%) Peer pressure before due date (fullypaid groups) (%) Peer pressure before due date (not fullypaid groups) (%) Peer pressure applied successfully (%) Source: RDD/IFPRI 1999 RuralFinance Survey Maize (n=16) Cotton/Rice (n=8) Non-farm business (n=28) Total (n=99) loans. Table and of group members' general knowledge of the composition of groups

Characteristic

8 11 14 20 11 66

34 25 13 19 11 53

32 29 16 28 11 50

13 16 16 22 10 43

14 15 14 21 11 56

35 17 55 23

54 29 87 80

39 11 45 45

37 18 47 36

39 19 57 37

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F. SIMTOWE, M. ZELLER, A. PHIRI - MORAL HAZARD IN MICROFINANCE

4.4

Group Table

repayment 4 shows was

outcomes group

and

moral

hazard

total (14%) sales and were tus Table

loan

ex-post defaulted.

mainly due at the point of sale. non-farm business

Delinquency to the fact that MRFC The groups

outcomes. In general, 23 percent of the repayment rates were lowest tobacco among groups makes direct loan deductions from tobacco rates were highest cotton among (42%), to group status, regard repayment were partially paid while 49 percent differences in group sta repayment

delinquency

results

that 51 percent indicate There are no significant fully paid groups. across the four types of groups. 4: Ex-post group repayment out comes

With (31 %). of the groups

and

incidence

of moral

hazard Total

Type of group Tobacco (n=46) Maize (n=16) Cotton (n=8) Non-farm business (n=28) Delinquency rates (%) of total loan value Group repayment status by due date (%) Fully paid group Partially paid group Reasons for default (%) 25 20 8 20 4 5 2 4 13 36 36 8 14 0 0 0 0 6 17 25 39 24 0 2 0 1 2 21 7 24 36 1 4 3 1 2 51 49 50 50 0 100 53 47 14 27 42 31

(n=99)

23

49 51

Wilfuldefault (able but unwilling) Failure caused Failure cause by natural disasters by mismanagement

25 18 16 24 2 4 2 2 7

Not enough profit Theft Family problems Illness Death of borrower Others Source: RDD/IFPRI1999 RuralFinance Survey

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AFRICAN REVIEWOF MONEY, FINANCE AND BANKING- 2006

As default

regards occurs

the when -ante

reasons is a form

individuals

ing to pay

which

for default, five percent defaulted twenty wilfully. Wilful have enough return to repay the loan but are unwill of ex post moral hazard. Loan default due to miss-man

moral was in 16 percent This of the groups. hazard) reported of the loan defaults caused hazard. The inci percent by moral that they dence of moral hazard is highest maize among groups (36%) implying lack some mechanism of enforcing and repayment. Other major probably screening include low profits (24%) and failure caused disasters causes of default by natural agement (ex a total gives of 41 assess factors that can be used to explain such high incidences.

(18%). The high incidence of moral hazard is used as a justification in this study to

4.5

Description

of Variables Variable

in the model

Dependent

if the group The variable is dichotomous the value of one dependent taking the incidence of moral hazard and it is zero otherwise. The incidence of reported of each the chairperson moral hazard in each credit group was captured by asking about whether some had defaulted members wilfully, or whether they had group misused know the loan behaviour leaders for an investment. group Normally, in the group and thus we expect the information to be reliable. it was both this question, to observe possible Following ex ante moral hazard. From the 99 credit groups, 46 groups the reported meant of all members hazard. default It should as members be may out, however, pointed contribute to pay that not all moral haz the defaulters' loan. funds that were

they provide ex post and incidence ard leads

of moral to group

Explanatory

variables

From the theoretical framework discussed


based on

earlier, the empirical specification is

of explanatory variables 8 categories whose full descriptions and a priori of their effect on moral hazard are defined below. The explanatory vari expectations ables in the model include vari variables, peer monitoring peer selection, screening, ables that capture the extent of social and sanctions. In addition to ties, peer pressure of extra variables, these variables we use this study to test the significance which have been in literature as having for inducing or mitigating moral hazard reported potential additional variables are in the following behaviour borrowers. Such among categories: and variables incentives that capture variables, dynamic prob productivity matching lems. Descriptive statistics of the explanatory variables are presented in Table 5.

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F. SIMTOWE, M. ZELLER, A. PHIRI - MORAL HAZARD IN MICROFINANCE

Table

5: Descriptive

Statistics Mean S.D. Exp sign -+ + + 0.14 2.76 0.82 0.61 1.50 0.57 0.14 0.27 0.343 2.039 0.383 1.083 3.012 0.496 0.349 1.080 0.500 0.485 0.415 2.732 1.051 5.563 0.393 0.201 0.462 + -+ -+ -+ + + + + -+ -+ -+ -+

Indipendent Variables Productivity AVGLAND EDUCATION Screening SCREEN FASCREEN PEERSELECT VHSCREEN Peer monitoring JOINTENTERP GCOMPNAI GLONCNAI Social ties COWEALTHOMO VILLAGENUMBER PMFAMVG POLITCLAN CHAIRFAMILY GENDERHOMO Peer pressure PRESUDUEDATE LEFEXCMG

Description

Average land holding of group members in hectares Average years of formaleducation of group members Whethersome individualswho wanted to join the group rejected extension worker(1=yes, 0=no) Group was formed by the Agricultural Whethergroup was initiatedby peers (1=yes, 0=no) Group was formed by the Village headman (1=yes, 0=no) Members have joint enterprises (1=have joint enterprises) Percentage of group members not knowing group composition Percentage of member not knowing loan characteristics An index of wealth heterogeneity(1=Group is homogenous) Number of villages fromwhich members come At least one member is fromthe family of a village headman (1=yes) Number of members fromthe clan of a politician Number of members fromthe family of club chair person Whethergender composition of the group is mixed (1=yes, 0=no) Whethergroup exerted pressure before due date (1=yes) Number of members that were excluded fromgroup (sanctions)

3.17 4.72 0.439 0.46 0.241 0.12 0.6 0.066

1.471 1.533 0.490 0.499 0.428 0.321 0.533 0.147

Dynamic Incentives CONTRIBPAY Whetherwould be willing to pay fullcost of defaulters loan (1=yes, 0=no) 0.46 PAYPENATY Would only be willing to pay ten percent penalty 0.37 PAST SACA Incentive Match NEWMMBAVG LONCYCLE Control Variables GPSIZE CREDLIMIT MAIZE COTTON NON-FARM Number of members at the startof the season in a credit group in a group per individual Average Credit limit Dummy formaize creditgroup (1=maize, O=otherwise) Dummy forcotton creditgroup (1=maize,0=otherwise) Dummy fornon-farmcreditgroup (1=maize O=otherwise) 16.84 4642.38 0.19 0.042 0.30 Number of new members in the group The loan cycle forwhich loan was received (1-5) 1.41 2.74 At least one member was frompast failed credit programs (1=yes, 0=no) 0.78

3822.1 +

Source: RDD/IFPRI1999 RuralFinance Survey

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AFRICAN REVIEWOF MONEY, FINANCE AND BANKING- 2006

a) Factors Following model. The relative and capture

of production Ahlin intuition and Townsend we include factors of production in the (2003) increases the payoff of safe projects higher productivity This leads to the softening of the moral hazard problem more effective. For this study we use two variables to namely, years the land of education for all the to decline of group members in acres holding of the group members (EDUCA related variables. Thus, productivity with the increase in the level of pro are loan more and likely to get payoffs that of any defaulting

is that

to risky projects. it makes monitoring group

(AVGLAND), We TION). we expect ductivity.

productivity, and the average a negative expect hazard critical is because

moral This the

sign incidence

than higher members.

highly productive groups values to repay both their

In concurrence hazard payoffs penalty. enough which loan and

with this

shows observability, such that the incentive In less returns productive (above induce other

line of thinking, that default for moral value who

in his paper on moral (1979) with the increase decrease in penalties hazard also with a decline decreases in

Holmstrom

groups, the critical members

it is more

will

members will not get likely that some for repayment to occur) to pay their loan, have returns to avoid their enough paying

too

(strategic

default).

b) Screening The SCREEN that there place capture shows variables were considered as proxies for the following is a variable which measures whether or not there are are when rejected by the group three variables that capture formation a group selection to join they wanted the extent to which variable the self extent some of screening: non-members

were

Ghatak by the members. (1999b) can be solved problems through group lending schemes that provide incentives for similar to group self types together through selection. Peer selection is thus seen as key to improving We expect that repayment. the likelihood of incidence of moral hazard will be low among that are self groups how adverse formed.

the group during whether or not

The process. was self-formed

In addition, group. selection is taking PEERSELECT is used to

a number ideal

However, the implementation group lending with joint liabilitycan be affected by


of institutional requires and social cultural values in the self communities. selection process, While the situation group formation through the it may

24

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F. SIMTOWE, M. ZELLER, A. PHIRI - MORAL HAZARD IN MICROFINANCE

In this survey, for example, less than a not be possible under certain conditions. were formed residents or peer third of the groups (self-selection by ordinary village either by the village chiefs or by the agricultur while the rest were formed selection), to cap In this regard we include two extra variables al officers and credit assistants. ture the extent formation screening impact on of groups variables the of screening by the are as follows: FASCREEN workers and and the VHSCREEN capturing the extension of moral village selection All chief, respectively. to have a negative of the two other and of screening

We expect peer hazard. the impact However, variables is undetermined as it depends on the quality screening the influence that leaders have on the group. dummies. incidence c) Peer monitoring

of peer monitoring variables in the moral hazard who notes indicators monitoring following Diagne (1998) substitute to the lender's own toring to be an effective members engage dence must: in peer of moral 1) have better access used to relevant to enforce two monitoring hazard. The activities survey

icance

Following Stiglitz (1990), Conning (1999) and Aghion de (1999) we test the signif
model. We construct that in order for peer peer moni

activities, monitoring group information and 2) be willing to loan use or report any inci proper to obtain evidence of the two

methods

components. First, specify centage we capture the proportion of members and loan responding characteristic "I don't know how The to

on questions of members loan and

group from

composition each group is taken of information

variables."

and group information As members tion to loan interest

characteristics the quality above

that indicating as a measure flow within

they lack knowledge of poor access to respectively.

per of the

relevant

groups, measures

described

the

variable

GCOMPDNI

not knowing of group members characteristics

expect in a group

of the loan. With regard the knowledge of sizes, duration and captured to be good rates. Both variables are assumed indicators of monitoring. We to increase with the proportion of individuals the likelihood of moral hazard the variable reporting that they don't know their group composition and loan char

while GLONCDNI group composition, that don't know the characteristics

the percent of group measures the propor

acteristics.
Second,

the

whether they owned joint enterprise at group level (PMJOINTENT). This is a dummy

survey

captured

the

extent

of monitoring

by

asking

members

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AFRICAN REVIEWOF MONEY, FINANCE AND BANKING- 2006

variable

and

enterprises moral hazard monitoring

within

it is equal the will be

1 when

and group, lower in groups

it is reported that 0, otherwise. that have joint

at least We

some

members that due the

have incidence

expect

joint of

enterprises

the effect

of peer

d) Social ties and social capital


Coleman trol. (1993) In concurrence rule observes with that this social capital Olomola functions as a source that of social con

notion

homogeneity, enhance social control) groups

and trust can enforcement, observes that the Olomola capital. in groups where members are socially

notes (2000) be reinforced, capacity

social through both of which will rules is higher (social in than

to enforce

to presumption with membership The that heterogeneity. in terms of wealth, social status or kinship should that are homogenous groups lower default rates than heterogeneous Flora and Yotopolous have groups. (1991) show how the success of group can be attributed to its ability to harness lending social ties between that more that people borrowers that are sumption and are reason This is based to improve loan repayment. close in terms of social ties know each on the other pre better

homogenous leads proposition

group ture the

It is for this to harming each other through default. likely to be averse institutions will encourage most joint liability lending homogenous to cap in terms of social status and wealth. We use six variables formation

COWEALTHHOMO is a of social ties within a borrowing magnitude group. It is equal of the group. 1 if the group is homogenous proxy for wealth homogeneity The incidence of moral hazard should be in terms of wealth, and zero, otherwise. that are homogenous in terms of wealth. VILLAGENUMBER meas lower in groups ures ber from which members come. The larger the num the number of villages group ties. This variable of villages relative to the group sizes the smaller the social of the ease of monitoring. of members also be a measure Groups composed same are village members coming variable The likely to know each from many villages. to have come other better and much easier to mon

can

from the itor than This ence group. loans loan

of some because

is expected members that

chief in the group or indeed his/her relative will have significant effects on the quality
of interactions within the group. Considering the potential influence of the village

have chiefs village of the MRFC for their signatures requirements to club officials. are delivered The presence, packages

a positive measures the pres sign. PMFAMVG from the clan or family of a village headman in a considerable influence on the operations of seasonal before therefore, the fertilizer of a village

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F. SIMTOWE, M. ZELLER, A. PHIRI - MORAL HAZARD IN MICROFINANCE

chief the

on the chief

to default extent

behaviour of group we expect members, is honest, and high if the chief is dishonest when they see that the chief has defaulted. by the village chief. As such the

that as

moral

hazard members we don't

will be would

low want

if

other

However, expected

of honest

sign

for this

the capture variable is

undetermined. in a group of members measures the presence that are from the of a politician. Political leaders in Malawi have a significant on the impact are perceived and this can have a significant way loans by the borrowers impact on moral hazard behavior and hence The collapse in 1994 of a gov repayment. POLITCLAN clan administered credit the Smallholder Credit Admin program, Agricultural was attributed to the political influence. Politicians were (SACA) mainly blamed for sending to the borrowers their political conflicting messages during such that most borrowers believed that the loans were donations campaigns, from government. some on groups influence that We, therefore, expect political have social ties with politicians, we don't have a predetermined although expec istration tation as the type of influence will depend on the honesty of the politician in con sideration. CHAIRFAMILY the number of group members that belong to the fam represents chair person. the strength of influence that the chairper ily of a group Considering son has on group members we expect that such influence could have implications on moral hazard. the expected effect on moral hazard is undetermined Nevertheless, because it depends on the character and values of the chairperson. variable GENDERHOMO is a dummy It is equal one where the gender group. erwise. We expect that gender homogeneity hazard. in the e) Peer The pressure and sanctions The the homogeneity of gender capturing of the group is mixed, and zero oth will reduce the incidence of moral ernment

of peer pressure was leaders whether captured by asking group in a group ever exerted on their peers before and after the due pressure was said to exist when date for the loan repayment. Active members peer pressure authorities or threatened to take punitive action to the village complained against defaulters. The way the question was that peer pressure phrased implies may only members be captured predicts (1998) in groups that had that peer pressure default should problems. be relevant A theoretical only in groups paper that by are Diagne hetero

existence

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AFRICANREVIEWOF MONEY, FINANCE AND BANKING- 2006

incentive of the dynamic incentive constraints of its compatibility in groups that are heterogeneous in risk. However, in only occurs that bias we only focus order to reduce on peer pressure before the due date of the We expect to have a negative of the loan (PRESUDUEDATE). peer pressure impact incidence of moral hazard in the group. geneous members. This In addition, called excluded the the group. f) Dynamic Dynamic opposed resulting and peer counting repaying. asking from incentives incentives to the pressure. benefits However, the following are actual joint and are further based on access stated expect incentives access to credit to credit and preferences the dynamic willingness incentive peer to pay as constraints monitoring by dis from used not by the presence LEFEXCMG. from the of sanctions This variable in the group behaviour. sanctions hazard in the captures was as an group captured the number of members extra that

in the

variable were default on that the

or non-cooperative extent to which likelihood

of moral

loan as a result of loan previous cycle We assume that this provides a picture are implemented We expect among groups. will decline with the evidence of sanctions in

behaviour.

We

liability to create The value of future future access survey, in the IFPRI

for peer selection, to credit can best be and comparing preference with

from

captured benefits

a revealed

approach

was

question:

If you repaid required choose? 1. 2. 3.

your

in a group where some members have defaulted but you have fully in addition and to loosing 15 percent asked, you were you to choose the following three options, which one will you deposit, among loan,

Contribute where the Pay another excluded Accept ers are

to repay defaulters 10% loan

in full the are penalty size excluded and next

loans be time

of defaulters, of a new be

and group

be

part

of a new defaulters

group are

part and

where group

the

a lower excluded

part of a new

where

the default

The firstoption is directly related to the fulljoint liabilityprinciple (no loans to non
defaulters until all loans are

alternative liabilityoptions (limited liability)which would maintain the same incentives

paid).

The

two

other

options

were

aimed

at exploring

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F. SIMTOWE, M. ZELLER, A. PHIRI - MORAL HAZARD IN MICROFINANCE

for peer

mitigation the three two

both of which have direct relevance to the pressure, et al (2000) notes that the key difference between Diagne is that in the first one the penalty is dependent on the total amount options of defaulted loans while it is not in the two other ones. The rationale behind these monitoring of moral peer hazard. to the is that they should lead to fewer strategic defaults options compared first option. the first option should lead to higher penalties Therefore, among non-defaulters in a group where there are more defaulters. the first Groups choosing are likely to attach value of the future access to credit. The second option higher the third option, higher they as value would such be those willing a much in which to future choosing to access to accept alternative

and

than is assumed to be more costly option the second are assumed to attach option credit than those the third option choosing a lower value of the loan.

of the options of the We expect that the choice of either is a good indicator attaches to future access or value that the group to credit. The inclu importance in our model us to explore sion of these variables also the potential of lim helps ard. the

ited liability contracts (as substitutes to full joint liability) in mitigating moral haz
The two first option An extra access who the are options is chosen entered and as PAY dummy is equal variables. CONTRIB second 1 when the option is equal 1 when is chosen.

variable to credit.

is included PASTACA

future

a group, therefore

was from the past was discontinued. program should increase the probability of moral the same value to credit access from

incentives and the value of dynamic the presence of at least one member in captures failed credit program where defaulted and people The the hazard of such presence in the group as current institution accepted were never with that members they may in a group not attach

to capture

in a failed It is generally experience program. enced former failed programs in which loans might gram be little incentive 1996). for them to comply (Buckley

their past following if clients have experi there collected, rigorously in the new credit pro

contracts

g) Mismatching
In order the model. retically, in a group we to capture incentive match we include a measure of the age of the is negatively associated the age of a credit group First of the group increases introduce two variables Theo Paxton in

group (LONCYCLE). with repayment.

notes that as the age (1996) different skills in their areas divergent credit requirements.

members are acquiring group of entrepreneurship, such that they start developing The matching arise when the demand and problems

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AFRICAN REVIEWOF MONEY, FINANCE AND BANKING- 2006

supply default most with loan

which could lead to members can no longer match, among group In is not incentive members whose of credit compatible. supply by some with rates. this declines starts cases However, lending high repayment group with the likelihood of moral hazard to increase we expect time. Therefore, for credit

cycle. of new members among borrowers in

that captures the presence we include a variable Second, at the beginning of the loan a group cycle. (NEWMMBAVG) to exclude as group members continue is continuous groups this could also with safe ones. and them However, replace sighted by problem terms and conditions repeated Paxton, problem several Paxton (1996). The matching problem for each

Screening bad risk lead arises to

a matching when credit

member as credit is are no longer appropriate in the same context as mentioned not necessarily by Though again. in a group introduces the same of new members the presence potentially have after their colleagues since already developed they enter the group We their credit skills that also requirements. change entrepreneurship of a matching problem in a group will increase the likeli

that the presence expect hazard. hood of moral h) Control In addition, maize variables we included

for the

dummies control variables that are program and non-farm income (COTTON), gener group in of members size (GPSIZE) is the number (NONFARM ). Group ating activity group can size on loan repayment de Aghion the effect of group a group. (1999) Following we in the literature review effects. As indicated with opposing be multifaceted as follows: behaviour in 4 ways that group size will affect moral hazard 1) the expect in the model cotton group (MAIZE), effect and the com effect, 3) cost sharing hazard is undeter for group size on moral amount of credit a group can of the maximum limit (CREDLIMIT), as a control variable. Its

effect, 2) the joint responsibility free-riding mitment effect. Thus, the expected sign mined. access impact We also include the value as the credit at any time, known is ambiguous. on moral hazard

5. Empirical The are

results

and

discussion probit estimates of the above moral hazard equation

maximum

likelihood 6.

presented

in Table

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F. SIMTOWE, M. ZELLER, A. PHIRI - MORAL HAZARD IN MICROFINANCE

Table

6: Determinants

of Moral

Hazard-Maximum

Likelihood Measure

Probit

Estimates Coeff. -0.215 -0.201 -0.042 -0.319 -0.838* -0.311 -0.608* 3.266* -1.828 0.377*** -0.251 -0.046 -1.025" 0.279 -1.311" -0.265 1.200** Z-statistic -1.54 -1.31 -0.11 -0.63 -1.66 -0.5 -1.87 1.77 -1.07 3.39 -0.58 -0.77 -2.02 1.3 -2.36 -0.5 2.25

Variable Productivity Screening PRODARABLE PRODLEVELSCH SCREEN SCRFA PEERSELECT SCRVGHEAD Peer monitoring PMJOINTENT GCOMPDNI GLONCDNI Social ties VILLAGENUM-R PMFAMVG CHAIRFAMILY Peer pressure Dynamic incentives PRESUDUEDATE LEFEXCMG CONTRIBPAY PAYPENATY PASTSACA Matching problem (incentive match) NEWMMBAVG LCYCLE Control GPSIZE MAXIDLMG MAIZE COTTON NONFARM Constant Total observations Observation withdependent =0 % Correctlypredicted Wald chi2(23) Prob > chi2 Pseudo R2 Log pseudo-likelihood

Number of hectares Years of education Dummy Dummy Dummy Dummy Dummy % of total members % of total members Number of villages Dummy Number of people Dummy Number sanctioned Dummy Dummy Dummy

Number of members Number of cycles Number of members Amount in MK Dummy Dummy Dummy 99 58 72.73 44.72 0.009 0.3315 45.64

0.306*** 0.478** 0.025 0.001" -0.694 -0.654 0.211 -1.436

3.23 2.51 0.68 2.0 -1.08 -1 0.44 -1.28

Source: Own calculationfrom RDD/IFPRI1999 RuralFinance Survey Note: * P<0.10; " P<0.05; "* P<0.01

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AFRICAN REVIEWOF MONEY, FINANCE AND BANKING- 2006

selection

In line with a priori expectations, results indicate This have a lower incidence of moral hazard. observation observes which can

to screen This groups risky borrowers. selection. Ghatak ry of adverse (1999a) of a pool of safe borrowers emergence moral hazard. Both peer the a priori expectations. not know the composition nifies the non-occurrence moral less each hazard. the incidence

that groups formed peer through enables implies that peer selection is in concurrence with Ghatak's theo to a reduction leads to the process in the likelihood of

that self selection lead

are significant variables and their signs conform to monitoring of group First the proportion members reporting that they do of the group has a positive and significant coefficient. This sig of monitoring in some which increases the likelihood of groups, a reducing that moral effect on hazard is

with joint enterprises The presence of individuals has This conforms to a priori expectations of moral hazard. are

with joint enterprises because members likely in groups other's investment decisions and the levels of output.

more

likely to monitor

Only one of the variables members from which group this implies variable, spatial

levels of social ties, the number measuring come is significant, with an a priori expected that groups with members from villages that

of villages sign. As a are further

in peer monitoring. the members from different villages apart face difficulties Secondly, that they may not know are less likely to exhibit strong social ties, such pre-existing each other well which would lead to the inclusion of risky borrowers within the group. The dence presence of moral of peer pressure has a significant and negative on the inci impact hazard. This is in conformity with our a priori expectation. This find conforms to the finding in which he observes that the by Wydick (1999), a significant effect on reducing moral hazard The presence of social sanctions returned

ing also to apply has willingness peer pressure from Guatemala. within borrowing groups

a conflicting sign but it is insignificant.


The dynamic incentives captured

is negative loans, which is also a measure of the willingness to accept fulljoint liability and significant.The implication is that the fulljoint liabilityclause is a key mechanism
which through the preference the incidence of moral hazard can be minimized. only The variable to pay for limited

by the willingness

to pay

a full value

of defaulted

The findings are consistent with a prioriexpectations in that full penalty is insignificant. joint liability strengthens togetherness in the group which makes it less likelythat individ
uals would want to harm each that loans

liability where

individuals

are

required

capturing 10 percent

failed programs in a group has a significantand positive coefficient.This conforms to a


priori expectations where programs members that have ever were not rigorously collected in previously participated have a tendency to take failed credit risky actions

other through

default.

The

presence

of members

from past

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F. SIMTOWE, M. ZELLER, A. PHIRI - MORAL HAZARD IN MICROFINANCE

that have es the

In the same discuss context, impact on repayment. Buckley (1996) of offers in joint liability lending notes that a programs. Buckley arises with JLLIs in that the institution sometimes keeps the group but abandons problem the joint liability which is the pillar of group lending. likens the situation to the Buckley a negative abandonment

abandonment of joint liability in Smallholder Agricultural Credit Administration (SACA) in Malawi. He notes that at first SACA lent to individuals under joint liability and the repay
ment had was good. in 1992 SACA a policy of allowing that However, adopted any individual further credit even if one or more of the borrow repaid his or her own loan to access rates. ers in his/her group was in default. This led to a severe drop in repayment conform Both variable to a priori expectations capturing mismatching problems by coefficients. of new members in a and significant First, the presence returning positive as the loan demand a matching for new members problem group is likely to introduce those of old members due to differences in the levels of business may not match

skills. ment repay. moral Paxton loan.

This

in turn makes a diverse

it difficult for the lending

institutions

to meet create

the loan the

demand

for such

among Second, hazard. (1996).

of individuals group some members whose the variable that Again this is related In the first meeting as members at different levels. As

to an erosion leading loan supply does not the age

of incentives

for repay incentive to effect on

measures

to the matching every one agrees to receive leads members hazard. hazard, to the This

of a group has in loan problem to the terms

a positive

cycles proposed by and conditions of the

However, skills develop which it among

continue

in turn makes

it difficult for the lender more of moral available to moral

from a lending institution; they to a diversity in their loan requirements to match the demand and supply of cred become Both although group productivity the incentive for unsatisfied, variables had no signif they returned expected signs. the likelihood of moral

loans

repayment icant impact The observed than the

members. group declines leading on the incidence loan size

maximum that the

increases

hazard. This is consistent with theoretical proposition by Stiglitz (1990) in which it is


expected that relative of a safe such as project. attractiveness group size increases faster in loaned funds utility of risky projects This assumes that an increase in the loan size increases to moral were hazard. Other control insignificant. of risky projects leading and program dummies

variables

6. Conclusions

and Policy Implications

Joint Liability Lending (JLL) is celebrated as an innovation that has made previ
ously insolvent individuals solvent by creating 'social collateral1 to replace the miss

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AFRICAN REVIEWOF MONEY, FINANCE AND BANKING- 2006

collateral ing physical finance. Nevertheless, access poor are given cannot be limited

that the

excluded

them

from

access

to more

traditional

forms

of

joint liability lending programs has produced mixed results. In addition, empirical
studies that its occurrence The investigate in such the extent to which rare. therefore, analyze propositions to examine the determinants of Ghatak by testing the the extent of the and to which likelihood moral moral hazard occurs and determinants programs are

punished to take While theorists have can induce borrowers liability risky actions. conditions under which can be self to propose joint liability contracts attempted that moral hazard would be minimized, the performance of to the extent enforcing of

with joint liability lending is that the problem programs and in the event of default, to credit without collateral, they a mere denial of future access to credit. This form of beyond

of the study was, objective occurs in credit groups and Guided occurrence. by theoretical hazard

of its (1999),

Guinnane to which incentives hazard.

Diagne (1998),
attempt selection, matching Results

Paxton (1996),
to moral

and Ahlin and Townsend


literature ties, peer-pressure, the incidence

(2003), the study is an


extent peer and

to contribute

hazard

peer-monitoring, can be problems indicate that

social used

to explain

dynamic of moral

potential to moral moral hazard, mitigating that they experienced either a misuse of funds or a mis of the credit groups reported members. Our analysis further of their group of an investment by some management is lower in groups that were of occurrence of moral hazard that the likelihood shows Peer monitoring formed through peer selection. through rules that encour endogenously age existing as well

the high in Malawi, despite the mechanism is still prone

of joint liability lending in hazard. About 40 percent

theoretical propositions by Ghatak and Guinnane (1999), and Diagne (1998).


new new Indicating members members the significance in a group and of the matching problem, the number of loan cycles results lead show

the incidence of moral hazard. The degree of pre reduces ownership joint enterprise of villages from which group members come social ties captured by the number of peer pressure, before the due date of the loan as the existence particularly, of moral hazard. These offer support to of the incidence reduce the likelihood findings

that the number

of of

to a rise in the incidence

moral hazard. This findingis consistent withthe proposition by Paxton (1996). Normally,
either some are excluded from the old members join the group because or they left willfully. In microfinance of for non-compliance, literature, the number is a strong indicator of whether or not the financial services from the program dropouts the problem of high dropouts which are being met. To reduce needs for the beneficiaries microfinance institutions constant leads to replacements require by new members, group appraisals of their activities to ensure that they address the needs of their clientele.

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F. SIMTOWE, M. ZELLER, A. PHIRI - MORAL HAZARD IN MICROFINANCE

With regard to dynamic results show that the full joint liability as captured incentives, in the willingness to pay a full amount of defaulter's loan has great of group members that can be used to minimize the incidence of moral haz as lending technology potential by those that are only willing to pay a 10 percent penalty in that it increases the incidence of moral hazard. against repayment incentives incentives can be used The results on the role of dynamic imply that dynamic for borrowers that want to take risky actions and that through the as a discipline device in an honest borrowers will be persuaded to behave man creation of proper incentives limited for default works ner. The has would reduces tution, microfinance of several emergence for bad borrowers created alternatives borrow from another such credit the value members institutions, such some that defaulters with conflicting objectives, in one credit program ard. The liability, chosen

when they particularly the establishment policy initiative that supports for potential borrowers can be accessed must

without facing any sanctions. This seriously program credit from a particular insti may attach to accessing know that they can still borrow from other institutions. A of credit be

burros from which past records This would promoted. stop bad bor such a policy must be supported rowers from accessing further funds. Nevertheless, by that introduces Other policies that a legislature mandatory identity cards for all citizens. and enhance would reduce incentives relate to the mismatching problems dynamic nance institutions. This will require MFIs to relax their rule on joint liability by allowing with dynamic and growing investments who make use of group loans at the to switch to individual credit offers when they are in need of higher loans. on peer formation selection or the have creation important policy of associations implications. for purposes are groupings The Policies that of improving

introductionof combined offersthat include both joint and individual liability by microfi
borrowers beginning The

findings group to credit

advocate access

self-formed will facilitate mation ening

ascertain that such by the poor should with minimum intervention from credit officers.

group associations ble adverse continue and in so

of potentially bad borrowers and thus screening with strong pre-existing social ties which are important of groups for strength the interdependency between which is needed for strong intra group members insurance. The current government the formation of credit policy of promoting and unless selection. relying doing on introducing for defaulters is unlikely penalties tougher formation group process supported by a proper The findings on the effect of peer monitoring, peer social cohesion in order to reduce the incidence to yield tangi that reduces pressure and hazard

endogenously self-selection process would the for enhance

results

social ties in mitigating moral hazard imply that joint liabilitylending institutionsmust
of moral

ited impact and lack of financial self sustainability, all of which are key pillars of the
Trianale of Microfinance (Zeller and Mever. 2002).

they

will be simultaneously

addressing

problems

of low

outreach,

lim

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AFRICAN REVIEWOF MONEY, FINANCE AND BANKING- 2006

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AFRICAN REVIEWOF MONEY, FINANCE AND BANKING- 2006

APPENDIX

Abstract Moral ly arising group hazard is widely from information reported as a problem in credit and insurance main markets, to explain how

with joint moral hazard lending the poor, empirical studies are rare and sometimes among give mixed results. In Malawi, with joint liability has been practiced for nearly four for example, although group lending loans remains the single the unwillingness to repay cause of default. decades, major This paper examines the extent of occurrence of moral hazard and investigates its deter minants level data of occurrence from 99 joint liability lending among programs farm and non-farm credit groups. Results pressure, explain incentives dynamic most of the variation and dynamic and reveal from Malawi, using group that peer selection,

asymmetry. liability can

theorists have attempted Although be an important tool for mitigating

peer monitoring, peer of matching problems tinue

variables the extent capturing in the incidence of moral hazard as a means impact group to enhancing their and sustainability. lending, Malawi.

among credit groups. The implications are thatjoint liability lending institutionswill con
to rely on social cohesion which has a direct moral hazard, joint incentives implication liability, on their outreach, incentives,

performance Keywords:

dynamic

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