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AN ASSIGNMENT ON

Bank-Moneylender Credit Linkages:


Theory and Practice

Financial Management

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

2. Bank-Moneylender Linkages: Theory


For sustainable linkages, not only moneylenders but also banks must willingly
participate. The linkages can be divided into two broad categories: explicit and implicit. In
the explicit linkages, banks hire moneylenders. In the implicit linkages, banks alter their
own loan contract, aware of the presence of moneylenders. We will review four models of
linkages.

2.1. Moral Hazard (MH): Moneylenders Monitor Borrowers


The bank cannot explicitly observe how the borrower runs her project because it is
too costly to observe it. The borrower will choose to undertake the good action (diligence)
as long as the returns are greater than the bad (non-diligence). If the borrower is non-
diligent, then she receives a private benefit which is an increasing function of the loan size.
As in standard moral hazard models, an asymmetry rises. In case of non-diligence,
borrowers share their lower expected returns with banks but can capture the full value of
the private benefit.

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The bank does not extract the full amount in case of high income and leaves a
surplus (referred to as the enforcement rent) which depends upon the amount of the
borrower’s private benefit. In order to obtain positive profits, the bank would set a bound on
the loan size, which would in turn limit the private benefit. The bank could increase its
profits by hiring a moneylender. Assume that the moneylender has access to a linear
monitoring technology which determines whether the borrower chooses a good or bad
action. Now monitoring decreases the private benefit the borrower obtains.
Now, in contrast to lending on its own, the bank can extract a higher repayment
amount through the increased monitoring and leave a lower enforcement rent. However the
bank needs to hire the moneylender and pays wages. The compensation differential
directly relates to the monitoring costs and inversely relates to the diligence probabilities
(4P). When the difference (4P) is large, the bank need not have to compensate the
moneylender as much to ensure that the borrower chose diligence.
Advantage: The bank pays lower wages when moneylenders do not provide a valuable
monitoring role and consequently, banks need not employ moneylenders. It calls for a
flexible credit policy across regions depending on moneylenders’ opportunity costs and
borrowers’ diligence probabilities. If the incremental gain through monitoring is greater than
the monitoring costs, banks can increase their profits by linking with moneylenders.

2.2. Enforcement (E): Moneylenders Enforce Repayments


In the most commonly observed and suggested linkage, assume that banks on their
own cannot enforce repayment and need to hire moneylenders. This linkage shares many
features with the (MH) linkage, sometimes denoted as ex-post moral hazard. The smaller
the differential probabilities, then a lower responsiveness of moneylender’s high wage to
the repayment probabilities. In this case, the moneylender’s value added is small. The bank
induces the moneylender to work harder by increasing his wages and may choose not to
hire the moneylender. The linkage also reveals a self-equilibrating character: banks will not
hire moneylenders when their value is less. In contrast to explicitly hiring money-lenders,
banks “free ride” from the information of moneylenders. The following linkages address this
option.

2.3. Adverse Selection (AS): Moneylenders Screen Borrowers


The bank cannot differentiate between good and bad borrowers. Moneylenders, with
better information, lend only to the good types. Good borrowers have a higher probability of
high output than bad. The bank can first offer a pooling contract in which both types obtain
the same loan. In order to attract the good borrowers it must provide the same terms as
moneylenders. Notice that the banks’ repayments now take into account the presence of
money-lenders by tieing their repayments to the moneylender’s cost of funds. Banks can
distinguish between good and bad borrowers by using the additional information that the

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good borrowers have access to moneylenders and that all borrowers rely on a critical
minimum amount. The bank separates by deliberately under-financing the good, using the
implicit knowledge that the good will resort to moneylenders for the rest of the funds. The
bad will not obtain any funds from the banks & they cannot obtain the remaining funds from
moneylenders. In other words, the bank offers two contracts: one with higher repayments
and no financing (the bad will choose), the other with lower repayments and under
financing (the good will choose). The bank lowers the good’s required repayments by the
loan amount it obtains from moneylenders. The bank’s profits now from good types only
since the bad now do not have access to bank loans.

2.4. Costly State Verification (CSV): Moneylenders Verify Output


Since the bank now cannot observe if the incomes of borrowers are high or low,
borrowers would always claim they suffered bad times and the bank will never lend.
However, banks can separate good (high income) and bad (low income) borrowers again
based on what they can observe, i.e. repayments. As in the (AS) linkage, repayments are
not sufficient but banks can now employ an additional instrument, the threat not to lend
anew. Only if borrowers repay, they will obtain more loans. The threat of termination
provides good borrowers an incentive to repay. The bank thus requests repayments that
will cover next period’s expected income. Moneylenders recognize this opportunity, the
banks do not. Moneylenders with their superior information serve as linking agents by
providing loans to excluded borrowers who can then repay banks and enjoy continued
access.
Advantage: Banks need not rely on the threat of termination to separate the good from the
bad since the bad can now borrow from moneylenders. In a reversal of the (AS) linkage,
the bad and not the good borrowers are active in both markets. Now the bank needs to
induce the moneylender to participate.
The bank’s repayments now relate inversely to the moneylender’s cost of capital. As
in the previous linkages, this equation reveals a self-equilibrating character. With a higher
cost to induce the moneylender to participate, banks require lower repayments from the
borrowers.

3. Formal-Informal Linkages: Practice


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

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

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

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

4. Linkages vs. Joint Liability Lending


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

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

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

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

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