Fair Microfinance Loan Rates

• Author: Philip Protter,Robert Jarrow
• Date: 01 December 2019
• DOI: http://doi.org/10.1111/irfi.12195
• Published date: 01 December 2019

Fair Microfinance Loan Rates*

ROBERT JARROW

†,‡

AND PHILIP PROTTER

§

†

Samuel Curtis Johnson Graduate School of Management, Cornell University,

Ithaca, NY

‡

Kamakura Corporation, Honolulu, HI and

§

Statistics Department, Columbia University, New York, NY

ABSTRACT

This paper uses a reduced form credit risk model to determine fair lending

rates for microfinance loans. A fair lending rate is defined to be that rate

which makes the loan have a net present value of zero to the lender, after

the inclusion of the lender’s costs of issuing and monitoring the loan.

Accepted: 12 April 2018

I. INTRODUCTION

Microfinance 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 first 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., five members compose a

group) for a fixed period of time (often less than a year). The “group”element 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 financing.

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 Protter’s 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. 909–918

DOI: 10.1111/irfi.12195