Bank-Moneylender Credit Linkages: Theory and Practice∗

Adel Varghese

The Bush School of Government and Public Service,Texas A&M University

August 2004

Bush School Working Paper # 415

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Bank-Moneylender Credit Linkages: Theory and

Practice∗

Adel Varghese

Bush School of Government and Public Service

Texas A & M University

4220 TAMU

College Station, TX 77843-4220

E-mail: avarghese@bushschool.tamu.edu

Phone: (979) 458-8015

Fax: (979) 845-4155

August 2004

∗I would like to thank Jonathan Conning and especially Mark Schreiner for helpful comments.All errors remain my own.

Bank-Moneylender Credit Linkages: Theory and Practice

Abstract — This paper critically reviews proposals for banks and moneylen-

ders to link together in disbursing credit to rural areas of developing countries.

The linkages suggest that banks should compensate moneylenders according to

the moneylenders’ opportunity costs and information contribution. These mech-

anisms’ appeal lie in their self-equilibrating and self-sustaining character. With

these attractive features, bank-moneylender linkages can emerge as a serious al-

ternative to group lending-based microfinance. The paper also provides evidence

primarily from Indonesia on incentives similar to those suggested by the theoreti-

cal models. It concludes that with the appropriate regulation of informal lenders

and with incentives provided to commercial banks, linkages provide an unexplored

potential.

2

1. Introduction

In meeting the credit demand of farmers, governments in developing countries

have sponsored formal institutions in environments where private banks reluc-

tantly enter on their own. These institutions have performed poorly.1 Many of

their failures can be traced to the difficulties associated with disbursing and col-

lecting credit in risky agricultural environments. Informal private lenders such as

moneylenders, friends, relatives, and landlords can overcome some of the lending

constraints. By residing close to villagers and free of the bureaucratic layers of

formal creditors, these private lenders can meet demand in a quick and flexible

manner. Private lenders are still limited by the size of the market. Formal lenders

can rely on nationwide funds from savings mobilization and re-financing support

from governments.

With comparative advantages in different areas, linking the formal and infor-

mal sectors can improve the disbursal of credit to farmers. Linkages fall under

two categories: explicit or implicit. Under the former, formal lenders actually hire

other lenders. Under the latter, formal lenders recognize that borrowers resort

to toher lenders as well and incorporate that information in their lending deci-

1For example see the evidence in Adams, et al. (1984).

3

sions. In creating linkages, formal lenders must structure incentives for informal

lenders to cooperate and not collude with borrowers. Thus, lenders face a mech-

anism design problem and the recent development of principal-agent models aid

in formalizing these incentives. In this respect, the presented models differ from

previous literature in that banks act as active profit maximizing participants.2

Linkages would exploit the advantages of each sector. For example, banks could

issue large production loans and request moneylenders to monitor and enforce that

loan. In monitoring the loan, moneylenders adapt their own flexible practices to

the “bank” loan. In this manner, banks access borrowers to whom they would

otherwise not lend and borrowers access loans that would otherwise be beyond

their reach.

Surprisingly, the rural credit markets literature does not systematically address

the linkages potential. Morduch addresses this lacuna in a review of alternative

mechanisms to microfinance and states that, “Unfortunately, for now policymakers

have little to go on beyond a handful of small-scale case studies and ... theoretical

2Hoff and Stiglitz (1998) provide a model with passive formal lenders. Their model andsimilar types will not be covered here. They do not address the issue of interaction becausethey do not explicitly model the formal lender’s behavior but treat it as fixed. By isolatingthe economic profitability of bank lending, the approach in this paper is also more relevant tofinancial liberalization efforts (for example in India, see RBI (1998)). Currently, banks in manydeveloping countries face a soft constraint in that they rely on refinancing their deposits fromgovernments but non-profitable banks do not usually obtain continuing funding

4

examples and counter-examples.”3 In all fairness, the literature mentions linkages

but in disparate areas and has not discussed its potential rigorously.4 For example,

consider the following suggestion: “Better linkages would enable banks to benefit

from the outreach and local knowledge of informal lenders, ... improving the

overall efficiency of the financial system.”5

This suggestion begs the following questions: how should policymakers con-

struct linkages ? Under which circumstances will banks willingly participate in

linkages ? What are some constraints that prevent these linkages from being con-

structed ? This paper will provide theoretical and empirical support to answer

these questions. The search for effective linkages forms part of a wider program in

the microeconomics of development. This new line of research recognizes that in-

stitutions arise to exploit their relative advantages and respond to the constraints

around them. Linkages can help bridge the persistent dualism in many developing

countries by providing a step in the development process.

Consider a formal lender in rural credit markets. As outlined by others, for-

mal lenders face the following problems : at loan disbursal, they face difficulty in

3Morduch (1999), p. 1575.4Mahabel (1954) is an early qualitative discussion of linkages. Linkages are mentioned only

in passing in Hulme and Mosley’s (1996ab) two volume study of rural finance for the poor.Linkages do appear in a separate subsection in Ray’s 1998 textbook, Development Economics.

5Steel, Aryeety, Hettige, and Nissanke (1997), p. 827.

5

differentiating between good and bad borrowers (adverse selection).6 While bor-

rowers use the loan, lenders cannot verify borrowers’ dedication to their projects

since they may divert the production funds (moral hazard). Ex-post, lenders face

difficulties observing and verifying output to a third party (costly state verifica-

tion) and extracting repayments (enforcement). A comparative analysis of four

proposed linkages in the literature reveals that a well structured incentive system

can potentially overcome these four problems. The linkages suggest that formal

lenders should compensate informal lenders according to the informal lender’s

opportunity costs and information contribution.

Linkages provide an alternative to the more popular solution to credit dis-

bursal, joint-liability lending or group lending (hereafter JLL). Most microfinance

organizations adopt JLL as opposed to individual lending policies. The survey by

Ghatak and Guinnane (hereafter G-G) denote this practice as a primary reason

for their success. This paper follows a similar structure to G-G but focuses on

aspects of lending other than JLL, which has been exhaustively covered in the

two major surveys by both G-G and Morduch. As Conning and Fuentes (2000)

note, even JLL institutions require a staff member to monitor and oversee the

group. This paper then also serves in evaluating contracts where a microfinance

6For example, see Besley (1994), Ghatak-Guinnane (1999), and Ray (1990).

6

institution hires officers that have greater information and enforcement powers.

Thus, this paper both complements previous work and provides an alternative to

JLL.

Some limits of the scope of the paper follow. As the title indicates, the paper

will limit itself to banks and moneylenders. Cooperatives, the other major formal

financial institution in many developing countries, are generally poorly run with

their economic motives weak. Moneylenders are individuals who lend at an interest

either full or part time. This paper will also not focus on linkages through savings

such as ROSCAS.7 Furthermore, on the credit side it will discuss the pure lending

aspects of trader-lenders and not their inter-linked aspects. It does not include

lenders such as friends and relatives who help out in times of need. Friends and

relatives may serve as linking agents but since they do not participate as profit

maximizing agents, the economic incentives are difficult to discern.

This paper first identifies the relative advantages of banks and moneylenders.

It then incorporates these advantages in reviewing proposed theoretical models

of linkages. The paper then finds several successful cases in Indonesia which

incorporate some of the incentives suggested by the theory. In contrast to JLL,

it finds that linkages provide additional attractive features. It concludes that for

7Nagarajan-Meyer (1996) provide an example of this type of linkage.

7

viable linkages, banks need additional “carrots” to enter while informal lenders

need “sticks” in regulation.

2. Bank-Moneylender Linkages: Theory

In this section, we first outline the models and address how moneylenders can help

overcome information and enforcement constraints. We explore the models in a

unifying manner through simple equations. Throughout, we will use the following

structure: borrower’s output Y has two values: high (Yh) and low (Yl) where

Yh > Yl = 0. The probability of high (low) output is P (1− P ). Each borrower

requires a loan amount L and needs to repay amounts Rh and Rl for high and

low output, respectively. Assume that all projects are socially profitable, i.e. that

PYh+(1−P )Yl = Y > L. Assume that borrowers face limited liability constraints

and lenders can extract only what borrowers declare. Then, it follows thatRl = 0.

Normalize the borrowers’ alternative from borrowing to zero. Denote the bank’s

and moneylender’s cost of funds respectively as γ and ρ, where following the

literature, γ ≤ ρ.8

In order to focus on the pure problems of information, assume that banks and

8Moneylenders must rely on their own funds. Commercial banks,with nationwide branchesand re-financing access from governments, face a lower cost of funds.

8

moneylenders are risk-neutral. All the linkages share similar assumptions on infor-

mation available to lenders. Banks cannot observe the borrowers’ actions (moral

hazard), types (adverse selection), and/or verify incomes (enforcement and costly

state verification). In evaluating when banks would link, we first note that banks

can lend on their own. We focus on the incentive constraint that banks employ

to induce borrowers to “truth tell.” To simplify the technical details, we will

assume that these constraints bind which can be formally proven in a more com-

plete model. For sustainable linkages, not only moneylenders but also banks must

willingly participate. We then add the moneylender as a linkage agent. In con-

trast to banks, moneylenders have superior information (or enforcement powers).

We then compare the bank’s profits on their own (denoted πB) to those with the

linkage (with moneylenders) (denoted πL) in evaluating when banks would link.

The linkages can be divided into two broad categories: explicit and implicit. In

the explicit linkages, banks hire moneylenders. In the implicit linkages, banks

alter their own loan contract, aware of the presence of moneylenders.

2.1. Moral Hazard (MH): Moneylenders Monitor Borrowers

With moral hazard, the bank cannot explicitly observe how the borrower runs her

project because it finds it too costly to observe the borrower’s actions (Conning

9

(1999, 2002)). Borrowers can choose a good or bad action (diligence or non-

diligence), where the probability of a high output is greater for a good action

than a bad action, i.e. Pg > Pb.9 If the borrower is non-diligent, then she receives

a private benefit which is an increasing function of the loan size, B(L). As in

standard moral hazard models, an asymmetry rises. In case of non-diligence,

borrowers share their lower expected returns with banks but can capture the full

value of the private benefit.

The borrower will choose to undertake the good action as long as the returns

are greater than the bad,

Pg(Yh −Rh) ≥ Pb(Yh −Rh) +B(L)

which, assuming that it binds, simplifies to the following:10

Rh = Yh −B(L)

4P (2.1)

where 4P = Pg − Pb. The bank does not extract the full amount in case of high

income and leaves a surplus (referred to as the enforcement rent, see Conning

9We can equivalently model the moral hazard as high and low effort with a disutility inchoosing high effort.10Following the tie-breaker rule, assume that the borrower will choose the good action.

10

(1999)) which depends upon the amount of the borrower’s private benefit and

the sensitivity of 4P . If 4P were large, then diligence probability is high and

the bank requires lower repayments. After substituting the binding condition

(in which the borrower chooses the good action), the bank profits simplify to the

following:

πB = (Pg)(Yh −B(L)

4P )− γL (2.2)

From above, in order to obtain positive profits, the bank would set a bound on

the loan size, which would in turn limit the private benefit.11 The bank could

increase its profits by hiring a moneylender.

Assume that the moneylender has access to a linear monitoring technology

c which determines whether the borrower chooses a good or bad action. Now

monitoring decreases the private benefit the borrower obtains and results in a

benefit function B(c, L). The binding incentive compatibility constraint (Equation

2.1) from before now alters to the following:

Rh = Yh −B(c, L)

4P11Here the bank would want to optimally set L = 0 but that would affect Yh in a fully specified

model.

11

Now, in contrast to lending on its own (Equation (2.1)), the bank can extract

a higher repayment amount through the increased monitoring and leave a lower

enforcement rent. However the bank needs to hire the moneylender and pays

wages wh and wl, respectively, for high and low output.12 For the moneylender

the participation constraint follows:

Pgwh + (1− Pg)wl − c ≥ Pbwh + (1− Pb)wl

The above, assuming that it binds, simplifies to the following:

4w = c

4P (2.3)

where 4w = wh − wl. The left hand side (4w) indicates the compensation

differential the bank would pay the moneylender. The compensation differential

(4w) directly relates to the monitoring costs and inversely relates to the diligence

probabilities (4P ). When the difference (4P ) is large, the bank need not have

to compensate the moneylender as much to ensure that the borrower chose dili-

gence. This linkage provides a convenient advantage: the bank pays lower wages

when moneylenders do not provide a valuable monitoring role and consequently,

12For now, allow for the possibility of wl 6= 0.

12

banks need not employ moneylenders. It calls for a flexible credit policy across

regions depending on moneylenders’ opportunity costs and borrowers’ diligence

probabilities.

After substituting the repayments and the moneylender’s wages, the bank’s

profits then yield (here, WLOG set wl = 0):

πL = (Pg)(Yh −(B(c, L) + c)

4P )− γL (2.4)

Comparing πB to πM , banks will hire moneylenders as long asB(L)−B(c, L) >

c. In other words, if the incremental lowered diversion through monitoring is

greater than the monitoring costs, banks can increase their profits by linking with

moneylenders.13

2.2. Enforcement (E): Moneylenders Enforce Repayments

In the most commonly observed and suggested linkage, assume that banks on their

own cannot enforce repayment and need to hire moneylenders (Fuentes (1996)).14

This linkage shares many features with the (MH) linkage, sometimes denoted as

13Note that surprisingly this decision does not depend upon 4P , the differential gain betweengood and bad actions since the moneylender’s wages absorbs the gains14In this static case and no collateral, banks will not lend on their own and trivially, πB = 0.

With dynamics, as will be seen later, banks can exclude borrowers from future credit access

13

ex-post moral hazard. Similar to the (MH) linkage, the moneylender may choose

diligence (eg) or non-diligence (eb), where eg > eb represents the moneylender’s

effort in recovering a bank loan.15 This linkage differs from (MH) in that the

probability (P ) is now of borrower repaying rather than action choice.

The above discussion indicates that the wages paid to the moneylender will

have a similar structure to Equation (2.3) where now 4e = (eg − eb) substitutes

for the monitoring costs c in the previous equation. The 4P now corresponds to

the incremental increased probability the borrower repays if the moneylender puts

in high effort. Again focussing on the binding condition, we obtain in a similar

fashion:

4w = 4e4P (2.5)

The smaller the differential probabilities (i.e. 4P is small), then a lower re-

sponsiveness of moneylender’s high wage to the repayment probabilities. In this

case, the moneylender’s value added is small. The bank induces the moneylender

to work harder by increasing his wages and may choose not to hire the money-

lender. The linkage also reveals a self-equilibrating character: banks will not

hire moneylenders when their value is less. In contrast to explicitly hiring money-

15Usually, these effort levels are referred to as “high” and “low.” But to be consistent withthe previous notation, we refer to them as “good” and “bad,” from the bank’s perspective.

14

lenders, banks “free ride” from the information of moneylenders. The following

linkages address this option.

2.3. Adverse Selection (AS): Moneylenders Screen Borrowers

The bank cannot differentiate between good and bad borrowers (Jain (1999)).

Moneylenders, with better information, lend only to the good types at the lenders’

cost of funds ρ. Good borrowers (g) have a higher probability of high output than

bad (b): Pg > Pb. Denote as λ (1− λ) the proportion of good (bad) borrowers.

The bank can first offer a pooling contract in which both types obtain the

same loan. Here, we allow borrowers the option to borrow from moneylenders.

Thus, in order to attract the good borrowers it must provide the same terms as

moneylenders, where R denotes the pooling repayments:

Pg(Yh −R) ≥ PgYh − ρL

Simplifying and assuming that the above binds,

R =ρL

Pg

Notice that the banks’ repayments now take into account the presence of money-

15

lenders by tieing their repayments to the moneylender’s cost of funds. The profits

under the pooling contract yield:

πB = λρL+ (1− λ)PbρL

Pg− γL (2.6)

Banks can extract the moneylender’s information in the following manner. Banks

can distinguish between good and bad borrowers by using the additional informa-

tion that the good borrowers have access to moneylenders and that all borrowers

rely on a critical minimum amount. The bank separates by deliberately under-

financing the good, using the implicit knowledge that the good will resort to

moneylenders for the rest of the funds.16 The bad will not obtain any funds from

the banks but will not mimic the good’s contract since they cannot obtain the

remaining funds from moneylenders.17 In other words, the bank offers two con-

tracts: one with higher repayments and no financing (the bad will choose), the

other with lower repayments and underfinancing (the good will choose).

Since the bank cannot observe the riskiness of the borrower, it offers loans

16Note that this implicit linkage can incorporate the (MH) case as well where now moneylen-ders would only lend to borrowers who choose good projects. The bank, again knowing thatmoneylenders engage in this type of lending, would then cofinance these borrowers.17For certain parameter values, Jain finds that the bad will obtain full financing from the

bank as well. In this knife-edge result of either obtaining full or no funding, for the purposesof the paper we will ignore the uninteresting result of full funding.

16

contingent upon what it can observe: repayments.18 The bank must still provide

the good with the alternative of borrowing directly from the moneylender so that

(where M now represents the partial loan from the moneylender):

Pg(Yh −Rg)− ρM = PgYh − ρL

Solving for Rg, we obtain:

Rg =ρ(L−M)

Pg

Thus the bank lowers the good’s required repayments by the loan amount it

obtains from moneylenders. The bank’s profits now from good types only since

the bad now do not have access to bank loans follow:

πL = λ(ρ− γ)(L−M) (2.7)

Comparing πB to πL, the higher the proportion of bad borrowers (1− λ), the

higher 4P , and the lower the cost difference (ρ − γ), the more likely the bank

will link.

18For the bad borrower, the incentive compatibility constraint yields the following: Pb(Yh −Rb) ≥ Pb(Yh − Rg) − ρM . Assuming that the above binds, the constraint simplifies to thefollowing: Pb(Rb−Rg) = ρM . The differential gain from repaying for a bad borrower is exactlyoffset by access to moneylenders (ρM).

17

2.4. Costly State Verification (CSV): Moneylenders Verify Output

The bank now cannot observe if the incomes of borrowers are high or low (Bolton-

Scharfstein (1990),Varghese (2004)). Since the bank cannot observe the two states,

borrowers would always claim they suffered bad times and the bank will never lend

since 0 < L. However, with an additional period, the dynamics of the lending

sustain a solution.

Banks can separate good (high income) and bad (low income) borrowers again

based on what they can observe, i.e. repayments. As in the (AS) linkage, repay-

ments are not sufficient but banks can now employ an additional instrument, the

threat not to lend anew (denote βi the probability of obtaining a loan conditional

on output i = h, l). Only if borrowers repay, they will obtain more loans (thus,

we set βh = 1).19 The threat of termination provides good borrowers an incentive

to repay. The incentive compatibility constraint for the good borrowers follows:

Yh −Rh + PYh ≥ Yh −Rl + βl(PYh) (2.8)

Since Rl = 0, then βl = 0 since that would relax the above constraint. Assuming

19This result can be proven in a full model,see Varghese (2004).

18

that the constraint binds, then the repayments for high income yield:

Rh = PYh

The bank thus requests repayments that will cover next period’s expected income.

Bad borrowers cannot mimic good borrowers since repayments for good borrowers

(Rh) are too high (PYh). In other words, the bank offers two contracts: Rh > Rl

but with the additional stipulation that the good will receive loans and the bad

will not. The bank’s profits under this separating contract would yield:

πB = P (PYh − γ2L)− γL (2.9)

The separation comes at a cost since Y = PYh > L for all borrowers in the

next period and the bank does not seize the socially efficient opportunity.

Moneylenders recognize this opportunity. Moneylenders with their superior

information serve as linking agents by providing loans to excluded borrowers who

can then repay banks and enjoy continued access. An advantage of this linkage is

that banks need not rely on the threat of termination to separate the good from

the bad since the bad can now borrow from moneylenders. In a reversal of the

19

(AS) linkage, the bad and not the good borrowers are active in both markets.

Now the bank needs to induce the moneylender to participate, where R refers to

the pooling repayments, RM refers to the moneylender’s repayments:

−R+ PRMρ≥ 0

Assuming that the moneylender will extract the full amount in the good state

and competition among moneylenders forces the above constraint to bind, we

obtain:

R =PYhρ

(2.10)

The bank’s repayments now relate inversely to the moneylender’s cost of capi-

tal. As in the previous linkages, this equation reveals a self-equilibrating character.

With a higher cost to induce the moneylender to participate, banks require lower

repayments from the borrowers. Now the bank profits yield:

πL =PYhρ− γ2L− γL

Comparing πB to πL, the bank opts to link when P and ρ are low. One can

also show without normalizing Yl = 0, that when the dispersion between incomes

20

(Yh−Yl) is high, the bank prefers linking with moneylenders. In these situations,

banks find it more difficult to differentiate between income types and would rely

on the moneylender.

2.5. Summary and Discussion

We have reviewed four models of linkages. The theoretical linkages precisely

outline the mechanisms of bank-moneylender linkages. The models indicate that

banks and moneylenders complement each other, increasing the available lending

opportunities.20 While the (AS) and (MH) linkages focus on the ex ante screening

aspects, the (E) and (CSV) are concerned with loan recovery.

Banks need not always link with moneylenders. A theoretical analysis of

the linkages reveals that banks will link when the information value added (∆P )

is high, the monitoring costs or effort of the moneylender (c) are low and the

differential cost of funds (ρ−γ) is low. With complete data, an empirical exercise

could map these values onto observable variables. The information value added

(∆P ) can be captured with proxy variables which measure banks’ knowledge of

borrowers. These include trustworthiness, access to collateral, access to credit

20With overwhelming qualitative evidence,the ADB study essentially comes to the same con-clusion and as eloquently stated by Jain, the interaction between the two sectors creates a“symbiosis.”

21

information, legal recourse, or when idiosyncratic shocks form a major component

of the output. The monitoring costs c would be higher when lenders engage in

higher marginal activities. Finally, the differential cost of funds (ρ− γ) is related

to the costs c above with the larger spread for less well developed and integrated

the financial markets.

The theory also reveals that wages should be contingent on repayments, which

are observable. The linkages are also self-equilibrating in that payments to money-

lenders adjust according to their contribution and costs. The above linkages are

not purely theoretical, policymakers have implemented these in a number of de-

veloping countries. The practical execution of the linkages must overcome some

issues which are absent in the theoretical models.

3. Formal-Informal Linkages: Practice

Many of the attempted linkages draw from Indonesia, “the world’s laboratory of

rural financial markets.”21 Two general surveys on rural credit by Hulme and

Mosley (1996ab) and Ghate, (1992, sponsored by the Asian Development Bank,

hereafter referred to as ADB) delineate the adopted practices. We will first

explore the pay structures of the bank officers in the (MH) and (E) linkages. In

21Gonzalez-Vega and Chavez, quoted in Hulme and Mosley (1996b), p.32.

22

these linkages, banks explicitly hire officers to monitor repayments and are the

most prevalent. The pay structure reflects lenders’ efforts at overcoming incentive

problems.

In Indonesia, regional development banks established KURKs, village units

which disburse loans at weekly mobile bank offices. In order to monitor at this

level, the KURKs actually hire ex-moneylenders as commission agents (Hulme and

Mosley (1996b)). The lenders receive four percent of collected loan installments.

The whole system builds a web of incentives, with other participants such as the

village headman (who provides some of the (AS) linkage advantage) screening

borrowers and receiving one and a half percent of pre-tax profits. One of the

KURKs’ successes was to minimize the guaranteed element in a bank worker’s

pay.

Another Indonesian bank (BUPB) offers field officers minimum guarantees plus

two percent of fully repaid loans seven and a half percent of savings (which thus

includes a link through savings) (Fuentes (1996)). The evidence stretches beyond

Indonesia to Sri Lanka where banks use informal lenders termed PNNs. These

14,000 PNNs lend bank loans to borrowers with no documentation but have to

follow bank regulated interest rates and loan amounts (ADB).

In eight other financial intermediaries in Indonesia, village agents (but not

23

necessarily moneylenders) screen and collect loans (Chaves and Gonzalez-Vega

(1996)). The agents’ wages depend on observable variables such as collected re-

payments, loan installments, and primarily adjusted profits. Profits are adjusted

since some events go beyond the control of lenders. This flexible system varies in

its implementation across villages in that wages are village specific and incorporate

the variables outlined in the theoretical section.

The term “on-lending” refers to an implicit version of the above when lenders

typically work as traders, i.e. inter-linked credit. In this case, banks aware of the

moneylenders’ presence deliberately increase credit so that moneylenders may lend

the increased loans without following bank regulations. Moneylenders would then

lend on their own. The Philippines has a long history of deliberately increasing

credit (Floro-Ray).22

In the NAP Program of 1984, end-users and input suppliers received cheap

credit if they extended credit to farmers. In particular, a senior official of one

of the largest commercial banks claimed that “some of the informal lenders are,

in effect, conduits of bank funds.”23 Credit-layering, an extreme version of on-

22Conning (2002) provides more direct evidence of the (MH) linkage. He observes that inChile contract farming firms establish contracts with farmers by signing letters of credit. Thesenotes are technically legally binding, but difficult to enforce. The firm then shows the lettersto the bank and requests the bank to cofinance these projects. The bank agrees as long as thefirm invests a certain fraction of the money itself.23Quoted in Floro-Ray, p.40.

24

lending, is a cascading series of transactions where banks lend to informal lenders

who lend to others and so on. On-lending is widespread even when banks do not

deliberately increase credit. Frequently, borrowers from banks re-lend at higher

interest rates: with examples fromThailand (Coleman (1999)), the Grameen Bank

(Rahman (1999)), Malaysia and Pakistan (ADB). The above sources indicate that

the percentage of loans that lenders on-lend range from twenty to upwards of

eighty percent.

With regard to the implementation, linkages (MH) and (E) have strong promise

but a number of countries have not fully implemented them. This possibility does

not seem to arise from the reluctance of moneylenders. As Karmakar (1999) ex-

plains, in informal talks with moneylenders in India, many have offered to act as

agents as long as they can lend with an agency commission to meet their operating

costs. Policymakers’ attitude towards informal lenders vary in a number of coun-

tries. As mentioned in the Philippines, the government has actively intervened to

incorporate the informal sector into the overall strategy of agricultural develop-

ment (Floro-Ray (1997)). In sharp contrast, in India historically the government

has actively excluded the informal sector. In the 1980s though, the Indian gov-

ernment as in many other countries has reversed its philosophy. By launching

a program where commercial banks participated with informal lenders, linkages

25

have become more viable in India. (reference: RBI)

In the (AS) linkage, banks screen borrowers with the complicity of moneylen-

ders. Though not the same implicit structure as the (AS) linkage, the aforemen-

tioned Indonesian banks engage in explicit screening mechanisms. In particular,

within the discussed KURKs, village heads screen borrowers. Robinson (?) re-

ports on a similar scheme also in Indonesia (PSP-Kupedes) with traders recom-

mending borrowers. Customers with good banking records recommend members

from their business networks as borrowers. The head of the network has his name

and preferential treatment at stake which explains the low amount of defaults.

For now, the (AS) linkage may be a case where theory is ahead of practice.

Practically, banks can implement the (AS) linkage in the following manner.

Suppose a bank operates in an area with active informal lenders. If banks know

the required loan size of the project, they can deliberately underfinance borrowers

knowing that low risk borrowers can always resort to moneylenders. The bank’s

information requirement is high in this linkage. The bank must not only know the

critical minimum amount required by the borrower but also their other financing

sources with information such as borrowers’ liquid wealth and access to other

lenders.

Varghese (2002) provides evidence on the (CSV) linkage, where moneylenders

26

provide loans to borrowers who can then repay banks. Using ICRISAT data from

Indian villages, he finds that in general repayments to banks fluctuate with income.

However for households that obtain loans from moneylenders, banks’ repayments

do not fluctuate with income. Thus, borrowers can use moneylenders to smooth

cash flows so as to meet bank obligations better. In another interpretation of this

linkage, banks provide production loans and moneylenders provide bridge loans

in order to ensure access. In a similar but slightly different set-up in Bangladesh,

Sen reports that “recovery agents” help borrowers roll over bank loans for a fee

(ADB). Borrowers then obtain a new formal loan and found that even after

paying the fee, found the loans worthwhile. Karmakar provides another twist on

this linkage from moneylenders in India who provide bridge loans for borrowers

who are waiting to receive sanctioned bank loans.

In microfinance the above is known as informal “bicycling” which occurs when

borrowers who repay a microfinance institution on time obtain immediate access to

another larger loan. Informal lenders, aware of this situation, provide bridge loans

to borrowers who are short of cash to pay the microfinance lender. A number of

studies focus on another aspect uncovered by the (CSV) linkage: the consequences

of denying future loan access by formal lenders. For example, as the Masagna-

99 formal credit programs expanded in the Philippines, repayments deteriorated

27

under the formal sector, borrowers were excluded and the lending shifted back to

informal lenders. This same phenomenon occurred in rural Thailand when the

BAAC attempted to expand credit (ADB). From these case studies, policymakers

can follow a more inclusive approach to informal lenders in the launching of new

credit programs. Informal lenders can serve an invaluable role in the incipient

stages by enabling borrowers to enjoy continuing access to formal sector loans.24

As seen above, the evidence mainly from the largely successful Indonesian

experiments serve as lessons for other countries. The question remains on the

replicability of the Indonesian experiments. For example, Hulme and Mosley ar-

gue that the Indonesian system works because of a clear system of control (the

village head) which may not work in all places. Similarly, compensation to money-

lenders reflects the opportunities foregone and these vary with respect to Indone-

sia. Finally, in some regions moneylenders are not prevalent so that linkages must

be attempted with other agents (see Steel, et al. on the continent of Africa and

Robinson).

These studies and others do not provide evaluation on neither the effectiveness

of particular linkages nor whether formal lenders actually hired moneylenders

24An important caveat is the anecdote told by Coleman inThailand. He found that the villagebank recorded a 100 % repayment rate to the NGO but that 67 % of borrowers borrowed frommoneylenders to repay the village bank. Later, borrowers repaid the moneylenders with theloan from the village bank, creating a “vicious debt cycle.”

28

as agents. As mentioned before, in not all the cases the hired agents were ex-

moneylenders. One would still expect moneylenders with the learned practice of

lending to be the most adept at continuing this tradition. Alternatively, banks

lend to NGOs, where NGOs guarantee and assist in loan recovery as in Sri Lanka or

Bangladesh (ADB and Fuentes). No study provides independent evaluation on the

effectiveness of moneylenders with respect to non-moneylenders. Hulme-Mosley

state that training costs of staff represent a significant portion of microfinance

institutions’ costs. In hiring moneylenders, banks need not expend resources on

training since moneylenders have already incurred these costs. Furthermore,

the implicit linkages have the added advantage of banks not needing to directly

interact with moneylenders.

The evidence squares with the theory with its emphasis on bank worker in-

centives and its flexibility. Not surprisingly, the Indonesian experiment was built

on the work of foreign consultants who were adept at creating incentive based

systems. The review of the actual practices also points towards other dimensions

not covered in the theory which should be considered for the success of linkages.

One research point we can begin to address are the advantages of linkages over

other mechanisms such as group lending.

29

4. Linkages vs Joint Liability Lending

In this section, we compare and contrast linkages to joint liability lending. Group

lending or JLL circumvents the problems banks face by issuing joint liability

contracts: members of a group are liable for one another. Formally, joint liability

consists of the following for a two person group: if a borrower will repay her

loan but her partner will not repay the loan, then the borrower must repay an

additional c to the bank. This incentive constraint replaces the moneylender’s

participation constraint in the linkages. Previous literature has not evaluated the

advantages of joint liability lending (JLL or group lending) over linkages or any

other alternative credit delivery mechanisms. For example, in Ghatak-Guinnane’s

(hereafter G-G) survey of JLL, the alternative to group lending is individual bank

lending.

We will formally only analyze the effects of group lending on the (MH) contract

(Conning (1999)). Now we need to account for four possible outcomes (with

four corresponding repayments): Yhh, Yhl, Ylh, Yll where the first subscript denotes

the borrower’s outcome and the second the partner’s outcome. In the optimal

contract, the bank rewards the successful borrower but penalizes the unsuccessful

30

borrower.25 The only relevant constraint is for a successful borrower to truth-tell

and monitor the partner in Nash Equilibrium:

PgPg(Yhh −Rhh)− c ≥ PgPb(Yhh −Rhh) +B(c, L)− c

Thus, one constraint captures the production and monitoring problem. The

above, assuming that it binds, simplifies to the following:

Rhh = Yhh −B(c, L)

Pg4P

Again substituting the above in bank profits yields the following (denote this

πG):

πG = (PgPg)(Yhh −B(c, L)

Pg4P)− γL

Comparing the above to Equation (2.4), assuming that Yhh = Yh,note that

πG > πB if c > 4P (1− Pg)Yh. For large monitoring costs and high probability

of a good outcome, group lending dominates linkages. The advantage of group

lending is that it absorbs the monitoring costs c within the group but requires a

25See Conning (1999) for a more thorough discussion of a model with collateral.

31

higher likelihood of a good outcome for success.

For brevity, for the other problems we will limit ourselves to the G-G informal

explanations (please refer to their article for formal derivations). In the (AS)

version. the safe will associate with the safe and the risky are left with the risky

resulting in positive assortative matching. Banks offer two contracts: one with

high interest rates and low joint liability (the risky will choose) and one with

low interest and high joint liability (the safe will choose). In the (E) case, if one

member will not pay back but the other pays both her own and her partner’s JLL

dominates individual liability. Also, if the community imposes social sanctions on

a member who does not pay her partner’s then JLL becomes more attractive. For

the (CSV) case, now the bank has to induce the borrower to report the truth for

high borrower’s returns and low partner’s returns. G-G argue that the partner has

an incentive to audit the borrower due to partial liability. So now the bank need

only audit when the whole group announces its inability to repay (which occurs

with a lower probability). Group lending still introduces further constraints as

borrowers are prone to collude with each other. To avoid this possibility, we need

to introduce a non-collusion constraint. With this constraint, for large monitoring

costs borrowers will not reveal the truth about each other. Due to this limitation,

many borrowers would graduate from group loans to linkages or individual lending

32

to reach larger scales.

To address greater problems that arise in group lending we limit our analysis

to an informal analysis. The lending solution proposed by JLL creates its own

problems since the solution relies on interdependence among borrowers. The

incentive constraint imposed in JLL is not as innocuous as the participation con-

straint imposed in linkages since it introduces interdependence. Practically, in

close knit village communities, borrowers reluctantly sanction delinquent borrow-

ers (see G-G on Ireland and Burkina Faso). Wydick also finds that with Accion in

Guatemala friends do not make reliable group members since members are often

softer on friends. Sometimes social ties among possible borrowers are too weak

to support feelings of group solidarity as demonstrated in the failed transplant

in Arkansas (Ghatak-Guinnane). On a theoretical level, interdependence creates

the following: bad borrowers create negative externalities on good ones. The

group-lending structure may be less flexible than individual lending for borrowers

in growing businesses and those that outstrip the pace of their peers (Morduch).

Due to the interdependence, the JLL enjoys more success in areas of high

population density and steady and frequent income streams (Conning-Fuentes).

Thus, less successful in agricultural environments where the nature of produc-

tion requires balloon repayments (Hulme-Mosley). Furthermore, the obsession

33

with the repayments record leads to some undesirable consequences such as vio-

lence against women (Rahman (1999) on the Grameen Bank). ADEMI in the

Dominican Republic switched to individual lending because it felt that credit ad-

visors relied too much on peer pressure for loan repayments and did not develop a

significant relationship with clients (Conning-Fuentes). Finally, some finer points

include whether group lending leads to excessive monitoring, pressure to undertake

“safe” projects, and the costs of weekly meetings and staff training (Morduch).

This latter point cannot be overemphasized as Hulme and Mosley indicate that

training costs form a large component of JLL programs. For example, with the

Grameen bank, salary and personnel costs accounted for half of Grameen’s total

costs. Over half of female trainees and a third of male trainees dropped out before

taking first positions at Grameen (Morduch).

Until recently, the profitability of JLL justified some of the negative conse-

quences. Morduch’s re-evaluation (1999) finds that most programs are subsidized

with soft loans from donors, with $26-30 m for the Grameen bank. Morduch also

reports that some donors believe only five percent of all programs today will be

financially sustainable ever. These difficulties of microlending leads one in search

of a self-sustaining solution.

This search leads one back to the solution proposed here: linkages, a not fully

34

exploited solution with potential. The relative advantages over JLL are many:

self-sustainability, no excessive bureaucratic layer, no pressure on neighbors, and

the use of the specific capital of moneylenders. Linkages build on villagers who

would not engender the suspicion of neighbors. Individuals who traditionally

have been lenders, i.e. moneylenders, would continue as lenders. Linkages could

potentially achieve Hulme and Mosley’s three main conditions for successful credit

programs: intensive loan collection, incentive to repay, and provision for voluntary

saving. Linkages would bring the bank worker (moneylender) to the customer,

within a self-interested and decentralized decision making process.

5. Conclusion

This paper has reviewed potential linkages and provided available evidence of

linkages in rural credit markets. Theoretically and empirically, linkages are at an

inchoate stage. In exploring why linkages are not prevalent in developing countries,

one can uncover some stumbling blocks that remain. An immediate response is

that ideas such as mechanism design, institutions, and incentives are relatively

new topics. Furthermore, historically policymakers have viewed informal lenders

such as moneylenders as exploitative. The ADB study reviews many cases and

concludes that these views may be out-dated. enforcement, political economy

35

This paper provides an alternative role for moneylenders. For linkages to be

effective, banks are needed alongside moneylenders. In certain cases, banks may

not find it worthwhile to enter both on theoretical and practical grounds. The

theory is based on knowledge spillovers since one bank would provide another bank

with borrower training and management skills gratis. Second, banks may not enter

for the same information and enforcement issues raised throughout this paper.

Due to these reasons, commercial banks would still need additional “carrots” to

enter rural areas.

Since the linkages program is at an incipient stage, a myriad of topics remain

to be explored. Future research can investigate savings linkages, the advantages

of moneylenders over others as linking agents, the relative advantages of one link-

age over another, or finally combining linkages, as linkages within linkages. In

the future, in light of the new revisionist views of microcredit, policymakers can

explore linkages more fully as an alternative credit delivery mechanism.

36

Appendix: ExtensionsWe now extend the discussed linkages to incorporate the following: relax-

ing limited liability constraints on borrowers (i.e. allowing for collateral) and

moneylenders, introducing risk aversion for moneylenders, and allowing bank-

moneylender competition. We will only briefly discuss the extensions.

Extension I: Collateral for borrowers

First, suppose in the (MH) linkage banks can employ collateralized loans in

which monitoring is unnecessary. Borrowers with high levels of collateral will then

choose to borrow these cheaper loans from banks For medium levels of collateral,

borrowers choose the linkage (Conning (2002)). For the (AS) model, as Besanko-

Thakor (1987) and others show, collateral allows banks to screen good and bad

borrowers, where the good borrowers now opt for the contract with collateral. The

collateral allows banks to overcome the problems in the (CSV) and (E) models

if the collateral amount would cover bank profits. In sum, the discussion above

indicates that the introduction of collateral allows for less reliance on linkages.

However, this assumes away one of the main problems in developing countries

where limited wealth and limited legal systems do not allow the use of collateral.

In fact, researchers now directly focus on the effects of collateral substitutes (for

example, Bond-Rai (2002)). As countries develop into more collateral-based

37

economies, the collateral constraint would lessen.

Extension II: Relax limited liability for moneylenders

Instead of relaxing the limited liability constraint on borrowers, we can relax

the moneylender’s constraint. In the moneylender’s case, a low wage of wl = 0

may not provide enough of an incentive for him to participate. This normalization

is harmless for the effects of the contract. Again, in the (MH) and (E) linkages,

in the Equation (2.3), set wl = wMin, the minimum accepted wage. Then the

equation modifies to the following:

wh = wMin +c

4P

The above now comprises a guaranteed component (wMin) and a bonus element

which varies as before ( c4P ).

26 For the other linkages, a similar normalization now

with respect to the bank’s repayments would yield similar results, with a greater

surplus provided to moneylenders and less to banks.

Extension III: Risk aversion for moneylenders

In introducing risk aversion with moneylenders, banks would need to part with

a greater surplus. Risk aversion is more justifiable for moneylenders than banks as

26Conning and Fuentes (2002) further discuss this extension.

38

they cannot diversify income since they are subject to aggregate shocks within the

village economy. Risk-aversion in the (MH) and (E) models introduces concavity

in the wage function so that Equation (2.3) would change to the following where

U(·) refers to this function:

U(wh)− U(wl) =c

4P

Now since 4U > 4w for small w, an even greater difference in utility is

needed to compensate the moneylender for a small 4P .27 Consequently, with

risk-aversion we have the well-known trade-off between risk-aversion and incen-

tives, i.e. the larger the guaranteed element in wages, the smaller the incentive

for the moneylender to follow up on the repayments. Introducing risk-aversion

in the other two linkages would also induce banks to lower its repayments so

that moneylenders would participate and the linking option would become less

attractive.

Extension IV: Introducing Competition

Jain-Ghasari Instead of providing linkages, competition between banks and

moneylenders could potentially transfer surplus from lenders to borrowers. In ad-

27More precisely, for a concave function, U(wh)−U(wl) < U 0(wl)(wh−wl), and since U 0 > 0and U 00 < 0, for small wl, U(wh)− U(wl) > (wh − wl).

39

dition, competition would not entail the inefficient layering required in linkages.

Formally, banks face a zero profit condition in addition to the incentive compatibil-

ity condition. Moneylenders would not face the incentive compatibility condition

but incur a higher cost of funds. In different models, both Mc-Intosh-Wydick

(2002) and Hoff-Stiglitz (1998) show that competition in information markets

crease some unintended consequences. These problems arise because of the in-

creased indebtedness of borrowers and concomitant lack of information sharing

among lenders so that all participants may be worse off. Varghese (2002), in

a similar model to the (CSV) linkage above, shows that under competition the

surplus flows to the good borrowers but poorer borrowers still would not obtain

further loans. As the above papers indicate, banks still face constraints with in-

formation or collateral and these would be alleviated only with great difficulty.

Introducing a guarantee for moneylenders means less incentives and practice might

provide directions into the actual mix between guarantee and incentive.

40

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