Small Money Big Impact

CHAPTER 6Lending Methodologies

The entire bank is built on trust.

Muhammad Yunus¹

Lending in microfinance is based on trust.

Group loans, mutual monitoring and a progressive loan structure inspire trust among borrowers themselves on the one hand, and borrowers and MFIs on the other. Borrowers are prepared to redeem their loans to be able to have continuous access to capital.

Socio‐economic factors such as location and gender also have an impact on the success of a micro entrepreneur's business activity.

6.1 TRADITIONAL CREDIT THEORY AND MICROFINANCE

Traditional credit theory is based on Stiglitz and Weiss's model of credit rationing.² They examined credit rationing in markets with imperfect information. Generally, high‐risk borrowers pay higher interest rates and must provide higher collateral as their probability of default is higher than in low‐risk borrowers. Credit rationing thus occurs when borrowers with a low degree of creditworthiness are willing to pay interest that is above the equilibrium interest rate at which banks issue loans. These borrowers, however, remain unserved because despite the elevated interest rate, the bank will refuse to take the higher risk of probability of default. Interest rate and collateral are in this case used as a means of selection to counteract issues with moral hazard, adverse selection and asymmetrical information. This issue is known ...