Microfinance in the 21stcentury: How New Lending Methodologies May Influence Who We Reach and the Impact That We Have On the Poor

This paper addresses the fact that, although much has been made of successes in the microfinance industry (largely attributed to the joint liability and peer monitoring that result from group lending methodology) as individual lending becomes more common there is a need to revisit the reasons for these successes. The paper thus seeks to:

• Address a few reasons ignored so far in the literature;
• Discuss how common practices of MFIs and the insistence of donor agencies on financial self-sufficiency may unnecessarily harm the poor which these programs aim to reach.

In this context the author provides a dynamic model in which:

• Endogenously determined repayment incentives serve to discourage strategic default, or failure to repay a loan once a positive outcome is realised;
• The MFI is constrained to be fully self-sufficient, following "best practice" guidelines of the industry;
• A negative and unanticipated economic shock is introduced disrupting the microentrepreneur's ability to repay the loan.

The model presented suggests that:

• It is not necessary for MFIs to engage in group lending to induce repayment of loans;
• Dynamic incentives, or the promise of future loans after successful repayment is sufficient to discourage strategic default when borrowers are homogeneous and face negative and unanticipated economic shocks;
• The traditional policy of denying loans forever to a microentrepreneur who defaults may be too harsh in the presence of negative demand shocks;
• Given sufficiently low risk and lending costs, microenterprises that are able to return a high enough profit margin, and a sufficiently high discount rate, a borrowing equilibrium in which repayment incentives are based on a T period "renegotiation phase" after a borrower defaults can be devised, while allowing the microfinance institution to be sustainable.

In addition, this model provides insight into the interest rate setting practices of microfinance institutions throughout the world:

• In areas where markets are thicker and microentrepreneurs are more profitable microfinance can easily become a sustainable development alternative;
• By cutting interest subsidies to microfinance institutions that cater to the least profitable, the rural microenterprises, or operate in areas most prone to adverse economic shocks, donor agencies may be forcing MFIs out of business;
• Sustainability is not possible under all circumstances.

Finally, the author suggests the need for a closer examination of the ways outcomes are affected when borrowers are not homogeneous-when risk is not identical across borrowers or borrowers differ in the profits that they can make from a particular microenterprise.