PAPER WRAP-UP: Group Lending and the Role of the Group Leader: Theory and Evidence from Eritrea, by Remco van Eijkel, Niels Hermes and Robert Lensink

By Remco van Eijkel, Niels Hermes and Robert Lensink, published by University of Groningen, The Netherlands, 2007, 26 pages, available on the Microfinance Gateway at http://www.microfinancegateway.org/content/article/detail/43084

The paper by Remco van Eijkel, Niels Hermes and Robert Lensink explores the monitoring behaviors of entrepreneurial borrowers in a group lending environment. The paper presents a model to explain differences in monitoring behaviors and to explore the impact of group leaders on overall monitoring efforts. The authors use empirical data from Eritrea, a small country in East Africa, to prove their theoretical models. Previous research on group lending has explored whether group lending mitigates moral hazard behavior or improved repayment performance but this paper builds on that previous research by specifically analyzing why someone chooses to become a group leader and how monitoring efforts are distributed across group members.

The paper contains ten sections. The first section introduces microfinance and explains the paper’s purpose of exploring the group leader’s role in group lending. The paper’s primary purpose is to answer the question, “why does someone volunteer to be a leader even though being a leader is costly and typically brings no direct financial benefit?” The paper contains a theoretical model to explain why. In section two, the authors describe the main characteristics of existing models on joint liability lending. Section three contains a description of a basic group lending model with three asymmetric borrowers. In section four, the authors show moral hazard is present if no peer monitoring exists. Section five contains details on monitoring methods and technology for both group leaders and group members. The authors introduce their benchmark case in section six, a group without a leader. In section seven, the authors introduce a group leader and then derive two baseline models. The first model contains a leader who has the most profitable venture and the second model has a leader who is the second most profitable in the group. Section eight explores a mathematical explanation for group leader selection. Section nine includes empirical evidence from group lending programs in Eritrea. In section ten, the authors provide their conclusions.

The authors conclude that monitoring efforts of borrowers in a group at equilibrium will differ from each other due to the asymmetry in loan benefits, particularly when one borrower stands to gain more from the use of a loan than other borrower. In a group, the borrower with the business or project that will generate the highest profit will put in the highest amount of monitoring effort to ensure the continuation of the lending opportunity. The authors also note that if one member begins to contribute more to monitoring efforts, other members may reduce their efforts. If a leader is added to the group, it is likely the leader will supply more monitoring effort due to the leader’s reduced per member monitoring costs. Consequently, non-leaders are likely to reduce their efforts. However, although per member monitoring costs are lower for a leader, the leader’s total monitoring costs increase. The authors point out that it is beneficial for the most profitable entrepreneur to be the group leader because the probability that the least profitable borrower is monitored effectively is higher than if another member became the leader. Moreover, if the group leader is the most profitable group member, the probability that the least profitable borrower puts in a high effort is maximized.

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