Rural credit and microfinance

Credit is a promise to repay in the future. Whether the promise is kept depends on things the lender cannot easily see, and two problems follow.

• Adverse selection. Before the loan, the lender cannot observe how risky each borrower is (JNU 2016). If the lender raises the interest rate to cover the risk, careful borrowers with safe projects drop out, and those who stay are the riskier ones, so the average risk rises with the rate. George Akerlof’s market for “lemons” (1970) is the general argument.
• Moral hazard. After the loan, the borrower may take actions that do not lead to the best outcome for the lender and a high risk of default, and the lender cannot observe them (JNU 2021): a riskier project, less effort, or a diversion of funds. A higher rate makes the borrower, who now has to earn more to repay, take on riskier projects.

Joseph Stiglitz and Andrew Weiss (1981) showed that with both problems the lender’s expected return can fall when the rate is raised beyond a point, so that it is better to ration credit, refusing loans to some applicants who are willing to pay the going rate, than to raise the rate until demand equals supply. The poor suffer most because they have no collateral to pledge, which is the usual device for reducing both problems, and because a small loan costs nearly as much to assess as a large one.

In colonial India, the system of agricultural credit was dominated by indigenous moneylenders (CUET 2026), and informal lenders, who include moneylenders, traders and landlords, still lend to many poor households. They lend to the poor more than banks do because, relative to commercial banks, they can more easily circumvent the information problems (JNU 2020): they live in the village, know each borrower’s character and land, and can link the loan to the borrower’s other dealings with them (Lesson 12). They are not necessarily less risk averse, and they do not charge lower rates.

Their rates are high, and the break-even calculation shows why this need not reflect monopoly power. A lender who lends one rupee, pays a cost of funds ρ, spends c on screening and collecting, and loses a share d of loans entirely must charge at least

since only the share 1 − d of loans repays the principal and interest. With default of 10 per cent, a cost of 5 per cent and a cost of funds of 7 per cent, the break-even rate is 24.4 per cent, and nearly half of that is the cost of loans that are not repaid and of screening and collecting. Aleem (1990), who studied lenders in a village market in Pakistan, found that the high rates largely reflected the cost of screening and monitoring borrowers and of default, so that the lenders’ profit was small relative to the rate. High rates can thus be an outcome of costly information, and not only of market power.

Muhammad Yunus began lending small sums to poor women in the village of Jobra in Bangladesh in 1976; the Grameen Bank, founded on that experience, was given its own legal form in 1983. Yunus and the Grameen Bank received the Nobel Peace Prize in 2006 (UGC NET 2024 pairs the name of Yunus with microfinance). The model lends without collateral to small groups of borrowers, who are jointly liable for each other’s loans: if a member does not repay, the others must cover her, or the group loses access to future loans. According to the World Bank view quoted in UOH 2017, a major cause of poverty is the lack of access to credit markets for want of collateral, and the microfinance model is said to overcome the limitation by implementing joint liability on the group.

Why it can work: group members know one another, so they pick partners they trust (screening, which reduces adverse selection); they see how the loan is used and can pressure each other (monitoring, which reduces moral hazard); and they can enforce repayment through the social ties (social collateral). The theory is in Stiglitz (1990), Besley and Coate (1995) and Ghatak and Guinnane (1999); Besley and Coate also show a catch, that a group may let a member who could repay default, because the others are willing to pay, so joint liability can in some cases lower repayment.

The second chart of the calculator shows the arithmetic of one simple case. Two borrowers each succeed with probability p, independently, and a successful borrower can cover both repayments. The lender is repaid unless both fail:

With p = 0.8, the pair repays with probability 0.96, against 0.8 for each borrower alone. The model leaves out what makes real groups work or fail: the willingness of the successful member to pay, and the cost to her of doing so.

The questions in this area ask for names and years. The main points:

• Cooperative credit began with the Co-operative Credit Societies Act of 1904 and was meant to replace the moneylender.
• Bank nationalisation (14 banks in 1969 and 6 in 1980) and rural branch expansion brought banks to the countryside. Branch expansion by banks proved critical in the spread of the high-yielding seed technology (UOH 2017, Lesson 14).
• Regional Rural Banks were set up on the recommendation of the Narasimham Working Group (1975) as small banks for small and marginal farmers. The Centre holds 50 per cent of the equity, the sponsor bank 35 and the state government 15 per cent (UOH 2013); they receive refinance from NABARD, which also coordinates their activities, and they are not lead banks. UGC NET 2024 keeps the statements about the Narasimham group and about NABARD’s coordination and refinance, and rejects those that give the sponsor bank the largest equity share and make RRBs lead banks.
• NABARD, the apex institution for agricultural and rural credit (CUET 2019), was set up on 12 July 1982 on the Shivaraman Committee’s recommendation (JAM 2022).
• Kisan Credit Card: started in 1998 (CUET 2022), a revolving credit limit for crop needs.
• Rural Infrastructure Development Fund: set up in 1995–96 at NABARD with a corpus of Rs 2,000 crore, funded by the shortfall of commercial banks in priority-sector lending, and lending to state governments and state corporations for rural infrastructure. It has not been merged with the Kisan Credit Card (UGC NET 2025).
• Priority sector lending requires banks to lend part of their credit to named sectors, which include renewable energy, education, housing and social infrastructure, with agriculture and small enterprises (JNU 2019).

Microfinance was widely expected to lift households out of poverty. Randomised evaluations gave a more modest result. Banerjee, Duflo, Glennerster and Kinnan (2015) offered microcredit through a lender in Hyderabad to randomly chosen neighbourhoods and followed households: they found no significant effect on average household spending, health, education or women’s decision-making, though more households started businesses and bought durable goods. Access to credit seems to help some borrowers and not to transform the average. The case for microfinance is therefore as a way to smooth consumption and to help small businesses, and not as a quick fix for poverty; a lender that charges interest near the break-even rate is also not earning a monopoly return.

Questions on credit market failures, informal lending, microfinance and Indian rural credit institutions. Banking and monetary policy more generally are covered in the Indian economy pages; tenant credit is in Lesson 12.