Fair Microfinance Loan Rates

AuthorPhilip Protter,Robert Jarrow
Date01 December 2019
Published date01 December 2019
Fair Micronance Loan Rates*
Samuel Curtis Johnson Graduate School of Management, Cornell University,
Ithaca, NY
Kamakura Corporation, Honolulu, HI and
Statistics Department, Columbia University, New York, NY
This paper uses a reduced form credit risk model to determine fair lending
rates for micronance loans. A fair lending rate is dened to be that rate
which makes the loan have a net present value of zero to the lender, after
the inclusion of the lenders costs of issuing and monitoring the loan.
Accepted: 12 April 2018
Micronance studies lending mechanisms to low-income borrowers who have
little or no collateral. The lending mechanism most often analyzed in the litera-
ture is that rst used by the Grameen bank in Bangledesh (see Schreiner 2003 for
a detailed description). This lending mechanism is called group lending. In group
lending, loans are made to all members in a group (e.g., ve members compose a
group) for a xed period of time (often less than a year). The groupelement is
that if any member of the group defaults, no member in the group can obtain
future loans. The loss of future loans to a group member is a severe penalty. This
component of the mechanism is called contingent renewal. The group lending
mechanism is intended to induce: (i) peer selection of members in a group since
members are better informed about other potential borrowers, (ii) peer monitor-
ing to ensure continued performance on the loan, and (iii) peer pressure to help
enforce payments by other members in the group, perhaps even to induce group
members to cover missed payments by others. For a group, the loans are often
staggered (perhaps by a month) and issued in a sequence to ensure that early bor-
rowers in the group make interest payments before additional loans are issued to
subsequent members within the group. This aspect of the group lending mecha-
nism is called sequential nancing.
The existing academic literature primarily focuses on understanding why the
group lending mechanism is successful in reducing defaults. Both static and
dynamic models have been analyzed (see Stiglitz 1990; Varian 1990; Conlin
* Professor Protters research has been supported in part by National Science foundation (NSF)
grant DMS-1612758.
© 2018 International Review of Finance Ltd. 2018
International Review of Finance, 19:4, 2019: pp. 909918
DOI: 10.1111/ir.12195

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