Lending Methodology Module

The Russia Microfinance Project Document No.53

A U.S. Department of State/NISCUP Funded Partnership among the University of Washington-Evans

School of Public Affairs, The Siberian Academy of Public Administration, and the Irkutsk State University

Lending Methodology Module

Laura Brandt, Natalya Epifanova, and Tatiana Klepikova

1. What This Module Covers

This module will provide an outline of the diverse program structures and operational methodologies employed by microlending institutions today. There are several distinct models of popular microlending methodology. Among them, the Grameen Bank model may be the most well known. This module will introduce the reader to other models of microlending that have been formulated and applied in different parts of the world and will outline the most important differences between models.

2. History of Microlending Methodology

The practice of microlending is not new. Credit cooperatives and charities making loans to young entrepreneurs have been documented from 18th century Europe. A notable example is the fund created by 18th century novelist Jonathan Swift. Swift donated £500 of his own wealth for lending to “poor industrius tradesmen in small sums of five, and ten pounds, to be repaid weekly, at two or four shillings, without interest.” Another interesting historical example of microlending is the Irish Reproductive Loan Fund Institution, which came into existence following the famine in 1822. This fund, which received donations from charities in London, was established to make small loans (under £10) to individuals in small towns for “relief of the distressed Irish”.

German credit cooperatives in the late nineteenth century provide an example of historic group microlending. These cooperatives were often located in rural areas where individuals knew each other well. The cooperatives provided credit services, and importantly, many had a policy of unlimited liability. That is, if the cooperative failed, any member could be sued for the entire amount owed by the cooperative. Interestingly, these credit cooperatives were the inspiration for the credit union movement in the United States.

Microcredit became an important tool in the world of development finance starting in the 1970s. Over the past three decades, older microlending methodologies have been tested and new methodologies developed. Operations in diverse economic, political, social, and legal environments have inspired new creativity in microlending methodology. It has become clear to practitioners that there is not one correct microlending model, or even one correct model in a given operating environment.

3. Current Popular Microlending Methodology

A specific microlending methodology is chosen to fit the needs of the target client group, conditions in the local environment (economic, social, political, and legal), and goals of the program. As a result, there are no two completely identical approaches to microlending. However, nearly all microlending programs can be classified as belonging to one of a limited number of microlending models. The purpose of this section is to introduce the reader to the methodological variation that exists in the field.

All microlending programs can be divided into two general categories: individual lending programs and group (or peer) lending programs.

3.1 Individual Lending Programs

Loans are given to individual borrowers. The bank performs a thorough analysis of every potentially funded business venture. Borrowers receive loans based on past performance, credit histories, viability of business propositions, and references. To encourage repayment, borrowers provide collateral and co-signers. Credit officers for close long-term relationships with clients.

The individual approach is most commonly associated with commercial banks. Successful individual microlending programs are usually highly modified variants of systems employed by commercial banks. Individual lending has been applied most successfully to urban clientele.

3.2 Group (or Peer) Lending Programs

Just as individual lending programs disburse loans to individuals, group lending programs disburse loans via groups. In this case, group members guarantee the repayment of each other’s loans. Collateral and co-signers are generally not used, peer pressure and collective responsibilities generated by the group take their place. In addition, functions typically performed by the bank staff are delegated to the borrower group: peers screen clients, determining who to accept into their group; loan analysis by the lending institution is minimal, depending instead on peer assessments of each other’s businesses.

3.3 Operational Structure of Group and Individual Methodologies

Individual and group methodologies require different structures of operational and financial organization. It is important for the most appropriate structure to be selected based on organizational goals, profitability objectives, and risk tolerance.

Individual lending and group lending have different cost structures. Individual lending requires careful analysis on behalf of the lending institution prior to fund disbursement. Evaluating the loan proposal and defining the terms for each particular client, which may take several weeks, is costly to the lending body. In contrast, group lending is less time consuming, and hence less costly, prior to fund disbursement. However, managing groups requires additional and greater costs after closing.

Operational costs for group lending tend to be higher than those of individual lending, largely due to the additional time required for managing groups. In addition, because the bank holds no collateral, group lending is considered riskier than individual lending. High operational costs to the bank combined with relatively high risk require high revenues if the lending institution is to be sustainable. As a result, group loans are usually more expensive and have higher rates of interest than individual loans.

In summary, interest rates on group loans tend to be higher than interest rates on individual loans. Group lending has lower closing costs but higher maintenance costs and higher overall costs than individual lending. It is important for a microlending organization to evaluate these tradeoffs when deciding on a methodology.

4. Approaches to Group Lending

Unlike individual lending programs, which tend to generally follow the same approach, there is wide methodological variation among group lending programs (as shown in Scheme 2.1).

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