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Why Are Default Rates Not High in Microcredit Schemes?

The people whom microcredit schemes lend to do not have collateral and have very little financial flexibility, so normal banks regard them as too high of a credit risk. Yet default rates for microcredit schemes can be low. A 1997 United Nations investigation concluded that the default rates in microcredit schemes in developing countries are comparable to or lower than the rates for traditional banks.

Here are some possible reasons why the default rate can be low.

First, a nonreason: It is implausible that poor people are inherently more trustworthy than other people.

The fact that microcredit organizations operate within local communities and that they were less successful when tried in areas with low-population density suggests that the social interaction of a local community with a relatively stable population is an important factor in promoting dependability. In such an environment, actions can have long-term social consequences (positive or negative), and social pressure is possible. Moreover, knowledge and resources can pooled.

This pooling, on a level involving a smaller number of people but a greater intensity of involvement, is what takes place between the groups of five businesses with a Grameen Bank loan, the groups of neighbors consulted by the bank about the creditworthiness of one of them, and the groups of borrowers who meet together. These can lead to greater financial elasticity, sharing of useful knowledge, a more efficient use of resources, and social pressure not to default. The financial and organizational structure encourages the construction and use of collective social assets.

The administrators of microcredit schemes tend to live locally, and successful microcredit organizations tend to encourage participation in organizational decisions. This leads to long-term social obligations and helps with transparency of operations. It also can stimulate the individual creativity, participatory planning skills, and initiative of the borrowers.

The "stepped" credit facilities reduce the microcredit scheme's exposure to unreliable borrowers because borrowers defaulting on an introductory loan do not get any subsequent larger loans. It also means that borrowers have smaller obligations until they have had some practice at repaying loans, which gives them some opportunity to learn from experience and perhaps iron out initial imperfections in their business before taking on a higher level of debt.

A final reason may be that microcredit organizations do not have much competition. The entrepreneurs that microcredit organizations lend to have access to few credit sources, and those sources that they do have access to tend to charge much higher interest than a microcredit organization. A microcredit organization, therefore, is likely to lend to a good number of the successful entrepreneurs in a poor area. In contrast, banks who lend to entrepreneurs with collateral compete with other credit sources to lend money to successful (nondefaulting) local entrepreneurs, and this may result in greater default rates for banks, even if microcredit organizations accept a large proportion of the loan applications made to them.

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