A Different Kind of Credit Crunch

In India today, there is a plentiful supply of up-and-coming entrepreneurs. With the advent of microfinance, less privileged communities throughout the world are given opportunities to start businesses in conditions that would otherwise be impossible. So, what is microfinance? Microfinance is the practice of making credit available to individuals in the form of small loans, who would otherwise not have the required income or collateral. The loans generally require in-depth involvement by both the lender and other community members.

Over the last ten years, microfinance has helped many people to avoid high-interest loans and enabled them to start new ventures. Because of the success of these loans, they have grown in many countries, including India. Recently a study was performed addressing trends surrounding credit in rural communities in India. Interestingly enough, the growth of microloans has been matched or exceeded by the growth of traditional, high-interest loans. One would assume that the availability of lower-cost loans would drive down the demand for higher-cost loans – Right? Wrong. 

The requirements of microfinance loans are relatively stringent and, most importantly, require borrowers to be part of a small cohort of other borrowers.  If one member of the cohort is unable to make a weekly payment, none of the members can take out more loans.  It is argued that because of the social pressure associated with this practice, borrowers will resort to high-interest lenders to pay back microfinance loans.  Although cohort members avoid the pressure from their peers, the advantage obtained by using the cheaper option is immediately destroyed when high-interest loans are utilized.

What is the solution?
Given that the objective of microfinance is to help underprivileged communities to break out of poverty, the incentive to take advantage of these loans must remain in place.  Driving the increase in traditional, high-interest loans is the stipulation that individual borrowers must always make on-time payments. If an on-time payment is not made by one member, all others are punished.

Microfinancers must first take into account the cultural impact of the policies they enact. In this case, the cohort practice is good because it enables new businesspeople to share success stories and seek advice to problems. However, the burden of punishment must only be carried by each individual. This will quickly discourage the use of high-interest loans, while also allowing communities to prosper when true success is achieved. In the case where borrowers cannot make a payment, individual counseling should be provided by the lender to quickly improve business performance.