Microfinance and the Mechanics of Solidarity Lending: Improving Access to Credit Through Innovations in Contract Structure

One of the most intractable economic problems for poor countries has been the high price or outright unavailability of credit in rural communities. One of the few concepts that have succeeded in expanding the availability of credit has been "microfinance," a practice that involves the provision of small loans (generally of a few hundred dollars or so) to borrowers without conventional collateral. The success of microlending has been especially striking because its benefits have accrued primarily to groups ignored by traditional development assistance--the poorest segments of poor countries' populations--and to women in particular. This paper explains how a large part of microfinance institutions' success can be traced to their practice of bundling loans together through a system known as "solidarity lending." Under this system, would-be borrowers form groups (usually of between three and six), within which each member agrees to guarantee the loans of the others in the group. If any one individual member defaults on his or her loan, the other members of the group are required to cover the shortfall. This paper reviews insights of the informational economics literature that explain the link between information asymmetries and credit market failure, and then shows why solidarity lending dramatically decreases the costs of information, particularly where institutional infrastructure is weak and borrowers' projects are small. Microfinance has revolutionized the way in which credit is provided to the rural poor; this paper explains why it has succeeded.