2.2 The Problem of Asymmetric Information in Credit Markets
2.2.8 Multi-period Contracts and Borrower Reputation
Borrowers thus need to evaluate the effect that current actions will have on their contract performance and thus their reputation. Repaying the loan in arrears would imply a repeated contract with less favourable terms and conditions as described by Webb (1991), while default would result in the termination of the lender-borrower relationship altogether. The effectiveness of borrower reputation within a multi-period framework is reduced where the long-term relationship between the borrower and the lender cannot be properly established (Lambert, 1985). Rodriguez-Meza (2000) shows that the extent to which borrowers are credit constrained and the ease with which these credit constraints are overcome impact on the success of borrower reputation to reduce incentive effects. The incentive to repay a loan in a multi-period framework may diminish as the wealth levels of initially credit-constrained borrowers improve. In such a case, the value that the borrower derives from the lender- borrower relationship is critical to maintain the incentive. Such a value is derived from service quality and other benefits such as access to savings and transmission facilities.
A similar situation emerges with group loans. Credit-constrained borrowers have a better incentive to repay, since access to future credit has greater value. Once the credit constraint is reduced over time, the incentive effect is diminished. Easy access to alternative credit sources can also negatively impact on the value of borrower reputation as an incentive mechanism. This is particularly the case in a competitive environment where information sharing between lenders is limited as switching between lenders is less costly for borrowers (Lambert, 1985; Gonzalez-Vega, 1998).
Given the costly information acquisition and monitoring processes in many developing country microfmance markets, and the lack of formal collateral, MFOs have strongly
emphasised borrower reputation and sequencing of loan terms and conditions in their contract design (Rodriguez-Meza, 2000). However, this enforcement mechanism is under threat where markets are becoming increasingly competitive and where borrower wealth levels are
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2.2.9 Concluding Comments
A number of practical issues arise out of the potential problems encountered by lenders when designing suitable loan contracts. Firstly, how well informed are lenders about the production technologies and riskiness of their potential clients? Does the credit delivery system employed by lenders allow for cost-effective provision of financial services? Can lenders effectively monitor their clients without incurring excessive costs?Ifnot, can lenders make use of suitable incentive devices such as collateral to encourage loan repayment? Is ex post contract enforcement possible given the nature of the collateral and the legal and institutional environment in which the lender operates?
To the extent that these issues differ across lenders, some may be able to more profitably service individuals in rural financial markets. Informal lenders may have distinct informational advantages, since information is a by-product of living in the communities in which they operate (Chaves and Gonzalez-Vega, 1996). They are able to cost-effectively monitor their clients because of their close proximity, while also making use of interlinked credit contracts and 'strong arm' tactics, relying less on formal collateral types, to increase the cost of default (Carter, 1988). Their credit delivery systems are simple and inexpensive making credit easily accessible to potential borrowers. In addition, they are not subject to the administrative requirements, interest regulations and reserve requirements of formal lenders
which allows more flexible and timeous provision of credit to the rural poor (Larson et aI., 1994; Llanto, 1990). Thus, the credit market characterised by a degree of symmetric information appears more relevant to informal lenders.
Formal lenders may face considerable information asymmetries, enforcement and incentive problems when operating in rural financial markets. As shown by Stiglitz and Weiss (1981) and Carter (1988), lenders may not be able, given asymmetric information, to write individual-specific credit contracts to account for borrower risk, resulting in non-price credit rationing. While government interventions in the form of subsidised interest rates have been criticised as being counterproductive, free market credit policies may have a similar outcome in rural financial markets in the presence of asymmetric information (Carter, 1988).
Successful extension of formal credit to small borrowers in rural fmancial markets requires institutions that can economically resolve the information problem (Gonzalez-Vega, 1998;
Rodriguez-Meza, 2000). The financial technologies of formal lenders may necessarily be complex and costly and result in a systematic bias against small borrowers in rural fmancial markets (Barham et al., 1996). The design of suitable financial technologies that reduce both borrower and lender transaction costs is necessary to promote ready access by rural borrowers to formal financial intermediaries, and to allow lenders to provide these fmancial services on a cost effective basis. Excessive administrative work, extensive travel distances and long loan approval times may be obstacles that formal fmancial intermediaries will have to overcome in order to provide low-cost financial services to low income individuals.
The provision of the necessary incentive devices and proper loan contract enforcement are also imperative for successful credit provision in rural and urban microfinance markets. To
the extent that limited collateral is available to formal lenders and monitoring is costly, alternate strategies have to be developed to encourage borrowers to repay their loans while the institutional environment must be conducive to contract enforcement. The next section highlights how successful MFOs have adapted their fmancial technologies to reduce information asymmetries and transaction costs to successfully operate in rural and urban microfinance markets.
2.3 Financial Technologies used by Successful Microf'mance Organisations to Reduce Agency Problems
Microfinance credit markets are characterised by three principle features, that distinguish them from other credit markets - the absence of suitable collateral, underdeveloped complementary institutions (absence of credible legal system, insecure and non-transferable property rights, and under-developed infrastructure such as roads and telecommunications) and high covariant risks (rural residents in the same geographic area are all subject to income shocks). In addition, high illiteracy amongst the poor has resulted in formal financial technologies imposing high transaction costs on borrowers. Poorly-developed communication systems and geographic dispersion of people in rural areas makes information difficult and costly to come by, while high covariant risks increase borrower susceptibility to income shocks (Llanto, 1990; Besley, 1994).
This section explores the financial technologies employed by MFOs who have successfully provided rural fmancial services, where success is measured in terms of the ability to reach a large number of rural poor (outreach) with viable fmancial services free of any subsidy (self- sustainability) (Yaron, 1992). The types of contracts used by MFOs are complex and consist of a plethora of implicit and explicit terms and conditions that have been refined over time
through a process of experimentation and learning. One aspect that stands out is the use of innovative collateral substitutes which can be included ex ante into loan contracts to reduce ex post costs. Collateral substitutes are non-physical assets with or without market value, or physical assets that have qualities other than collateral to enforce loan repayment (Nagarajan and Meyer, 1995). Several of the collateral substitutes used by 'best practice' MFOs are discussed below.