Monday, September 21, 2009

SHG membership as a signalling mechanism

In the last two decades, Self Help Groups (SHGs) and the micro-finance movement have emerged as one of the most important, if not the dominant, platform for addressing the challenge of eradicating poverty in many developing countries. The penetration of SHGs have been especially strong in many parts of India. However, there is a growing danger that these SHGs are becoming an end in themselves, rather than be instruments in fighting the scourge of poverty. I have blogged about this in an earlier post here.

These groups which started out as a means of empowering and inculcating thrift among women continue to remain stuck with the same paradigm and objectives. At best, the existing sets of policies have helped these groups start and expand on small, livelihood-based business activity. However, even in the specific activity of accessing formal sources of financing (for various purposes), the SHGs have not gone beyond traditional bank-loan driven group borrowings.

This post will seek to make a case in favor of a signalling role for SHGs in helping their individual members (and not as a group) access the broad spectrum financing options in the market. I will flag off one dimension - accessing all available formal financial/financing markets - in which SHGs, especially those with adequate capacity, can be invaluable in spurring more macro-level economic activity.

Now, a large number of these groups have gathered substantial capacity to deliver on outcomes beyond those intially envisaged. With some assistance and a different set of policy tools, many of them are capable of leveraging their capacity and built-up strengths in moving up into a higher trajectory of growth. More specifically, those SHGs can enable the transition of the SHG and micro-finance movement from addressing poverty alleviation to promoting vibrant entrepreneurship and economic development.

One of the most important dimensions of the utility of SHGs is in their role as an effective signalling mechanism. The poorer borrowers suffer from an especially acute risk aversion among lenders arising from the greater probability of adverse selection. The peer-pressure driven compulsion among SHG members to repay bank loans has become an effective credit guarantee for banks in making group loans to the SHGs. A logical extension of this argument would be to use the same credit-worthiness signal arising from SHG membership (atleast in the case of the stronger groups) to leverage loans for individual group members.

This would enable individuals to use their group membership to access/draw individual loans from banks for specific productive investments like business expansion or starting new businesses, constructing homes, purchasing consumer durables and automobiles, loans for education and health care, and so on. Presently, individual group members who want to make these purchases or investments access credit through the group loans, and then use it to incur their expenditures, thereby causing considerable transaction costs and duplication of activities.

Further, group loans generally involve equal distribution of the loan amounts among all group members. However, within a group, different members have varying levels of credit thresholds. Members use these loans for different purposes, move along varying growth trajectories, and have non-uniform credit needs and repayment abilities. In the circumstances, it becomes likely that those members who are more enterprising and have higher credit appetite gets constrained (in access to more credit) by their laggard compatriots. All these only highlight the importance of enabling individuals to access loans at their terms.

Here are a few examples of how this would work. Retailers (or their partner financing institutions) selling consumer durables on EMI can lend directly to poor customers, without the standard collateral requirements, by banking on the implicit guarantee provided by the individual's group membership. Typically, in the rural areas and smaller towns, there are likely to be only a handful (even only two or three) of retailers in the local market selling consumer durables or automobiles. It is easier and more efficient for them to administer these EMI sales of consumer durables and automobiles to the small numbers of local customers.

Poor people, looking to construct their homes, face numerous problems in accessing home loans in the regular financial markets. Given the large demand for home loans and the massive government spending on providing housing to the poor, it is natural that it offers ample mutually beneficial opportunities for both banks and the poor customers. The regular government housing programs for the economically weaker sections can be dove-tailed with direct bank lending to individual members of good SHGs, either by government providing the interest subvention subsidy (soft loans to beneficiaries) directly to the bank or the individual leveraging bank loan to top up the government assistance and construct a larger house with an additional loan.

Similarly, individual members should be able to access education loans by leveraging their membership of the SHGs, especially for higher education in professional courses. Here too, the regular government interest subsidies can be transferred directly to banks, thereby minimizing transaction costs and effectively addressing the targeting problem.

By encouraging the banks to lend directly to individuals using the signalling platform of SHG membership, and then transferring the interest subsidy directly to these banks, the government can reduce the considerable transaction costs and other numerous distortions associated with government subsidies.

It is true that there is nothing that prevents bankers today from providing loans to credit worthy individuals who are members of SHGs. But a formal recognition of provision of individual loans to the members of SHGs with good track record on the back of an implicit (not explicit) guarantee as a component of priority sector lending of banks, would go a long way in boosting the demand for such loans. It would encourage bankers to lend and borrowers to access formal financial institutions to meet their financial requirements. Bankers do not bear much additional substantive risks. Afterall, loans provided to SHGs were done so without any collateral backing and have borne impressive returns till date.

In the absence of credible signalling mechanism about the credit-worthiness of these individuals, such transactions would not have materialized. The banks benefit by increasing their loan portfolio without a disproportionate increase in the risk assumed, while the poor consumer gains access to the formal sources of credit provisioning, and government becomes able to more effectively target and deliver its assistance. We have a clear Pareto improvement, brought about by the signal emanating from membership of a credit-worthy SHG.

In order to avoid any moral hazard arising from this, it may be prudent to limit such lending to only those groups which have availed of and repaid atleast one or two tranches of loans in the recent period. The lending should be done strictly only after a resolution has been passed by all the members of the group permitting the specific individual to access the loan. Further, such lending can start off with small loans and the credit limits can be progressively loosened, both among group members and specific individuals availing of the loans. Also, the initial rounds of such loans can be limited to specific categories of expenditures like purchases of consumer durables, automobiles, student education loans etc.

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