EXAMINING CLIENT EXIT IN MICROFINANCE: THEORETICAL AND EMPIRICAL PERSPECTIVES DISSERTATION Presented in Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy in the Graduate School of The Ohio State University By Maria E. Pagura, M.A. * * * * * The Ohio State University 2003 Dissertation Committee: Approved by: Professor Douglas H. Graham, Adviser Professor Claudio Gonzalez-Vega ________________________ Adviser Professor Priyadarshi Banerjee Depar tment of Agricultural, Environmental, and Professor Mario Miranda Development Economics ©Copyright by Maria E. Pagura 2003 ABSTRACT Repeat borrowing is critical for the long-term viability of microfinance organizations (MFOs), which provide invaluable financial services to low-income households in developing countries. Repeat borrowers reduce MFO administrative costs , lower risks, and increase organizational productivity. In practice, however, several MFOs worldwide are experiencing high borrower exit, i.e. , termination of the lender-client relationship, which hamper organizational and financial sustainability. This dissertation sets out to determine and analyze the factors that influence borrower/client exit. A choice theoretic dynamic model and duration methods are developed and used to accomplish this goal. In the choice theoretic dynamic model, a firm wants to maximize profits over her life cycle by investing in her business on an on-going basis. To do this she strives to establish a long-term relationship with a formal bank; however, she lacks the necessary physical collateral required by the bank to obtain loans. Instead, she engages in a sub-optimal strategy of group-lending in which she is jointly liable for her own repayment as well as her co-members’ payments in the event they cannot repay their loan shares. However, if the group demonstrates good repayment behavior, i.e. , never defaults, after n loan cycles, then the members are rewarded with an admission into an individual loan program. ii There are two types of firms in this economy, high and low ability. Her rewards are greater if she picks a high ability type partner than if she chooses a low ability type since high types succeed more often than low types. Due to uncertainty about fellow partner ability type, i.e., high or low, the optimizing firm forms a belief about her partner’s type and uses Bayes’ Rule to update this belief each period based on business outcomes that she observes. Each period the firm has an option to stay in the borrowing relationship with her partner or exit, i.e. , terminate the relationship and use self-financing. An optimizing agent chooses an optimal stay/exit policy for the life of the contract. The outcomes of this model are as follows. Each period there exists a critical probability value that her partner is of high ability. If her subjective belief is greater than that value, she remains in the contract, otherwise she exits. In the beginning of the contract, this critical value is low, demonstrating the optimizing agent’s willingness to remain in and learn about her partner. However, this critical probability value increases with time, reflecting an unwillingness of the optimizing agent to remain in the contract in the later periods since new information has little additional value. In addition, critical probability values are affected by the terms of the contract, risk aversion, and loan return. Namely, the critical probability value is an increasing function of loan size, interest rate, and relative risk, and a decreasing function in loan return. When end rewards are explicitly accounted for in this model, the optimizing agent’s behaviors change. In other words, reward scheme prompt an iii optimizing agent to stay in the borrowing contract when she would not have done in the absence of the scheme. A duration model is used to empirically examine the factors that affect the borrowing relationship length. Two field surveys conducted on 260 microfinance clients from one MFO in Bamako, Mali make up the data set. It is found that loan return, income shocks, and borrower’s dependency ratio decrease client exit rates. Group member repayment behaviors, education, and excessive MFO growth increase client exit in this setting. iv To Gary, Adam, and Ellen v ACKNOWLEDGMENTS Graduate school has been a long and challenging journey. There are several people who have made this journey an amazingly rich and rewarding experience. I would like to acknowledge and thank them here. First, I wish like to thank my adviser, Douglas H. Graham, for his invaluable mentoring and constant support throughout this process. At all times I felt that he had only my best interests at heart. His intellectual curiosity, professionalism, and generosity have left indelible impressions on my life. I wish to thank Professor Claudio Gonzalez-Vega for encouraging me to further explore the theoretical dimensions of this research. Because of this effort I produced a better dissertation. His intellectual rigor is admirable. I also wish to thank Professor Priyo Banerjee for spending hours exploring several possible theoretical dimensions of my research problem. His patience and kindness in working with me and answering my questions will never be forgotten. I wish to thank Professor Mario Miranda for the constant guidance and availability during the theoretical modeling exercise of this dissertation. His unique gift of explaining often very complex dynamic concepts in a manner that I could easily grasp was invaluable. I am also grateful to Professor Tim Haab for his econometric support. His approachability is something that should be replicated by all in the teaching profession. I vi wish to thank Professor Dave Kraybill for his feedback and support on earlier drafts of this dissertation. His knowledge on firm dynamics was very useful to me This research effort would not have been possible without the cooperation of the microfinance clients and staff of Piyeli who willingly gave of their time to respond to all of my questions during two field studies in Bamako. In addition, I am grateful to World Education and The Ohio State University for their financial support of my work. I wish to thank several friends and colleagues. Alka Gandhi for her invaluable feedback on my work and unwavering support through it all. Roisin O’Sullivan, Peter Kower, and Rob Dietz for critical advice on earlier versions of my work. Mike Taylor for his practical feedback throughout this process. Mehnaz Safavian for her sound council and constant support through it all. I wish to thank my family, especially my mom and dad for the love and support that they have given so freely to me. I wish thank my sister, Michele, for her selfless help with my children during this process. Without her assistance I truly could not have accomplished this goal. I also wish to thank Annie, Karen, Susan, and Jennifer for their support and always helping out in times of need, especially during the critical periods of this process. I wish to thank the most important person in my life, Gary, for his constant love and encouragement throughout this process. His unwavering support gives me the courage and strength to strive for great things. vii VITA June 30, 1966……………………… Born – Columbus, Ohio 1989………………………………. B.S. Business Administration and French, The Ohio State University 1999……………………………….. M.A. Economics, The Ohio State University 1990-1992…………………………. Volunteer, Small Enterprise Development Division U.S. Peace Corps-Mali 1993………………………………. Trainer, Small Enterprise Development Division U.S. Peace Corps – Mali and Uzbekistan 1993-1994………………………… Interim Director, Small Enterprise Development Division, U.S. Peace Corps-Mali 1994-1996………………………… Manager, Women’s Microenterprise Program, World Education, Inc. 1996-present…………………….. Graduate Teaching and Research Associate, The Ohio State University FIELDS OF STUDY Major Field: Agricultural, Environmental, and Development Economics Minor Field: Rural Finance viii TABLE OF CONTENTS Abstract……………………………………………………………………………….. ii Dedication…………………………………………………………………………….. v Acknowledgements…………………………………………………………………… vi Vita…………………………………………………………………………………….viii List of Tables…………………………………………………………………………. xii List of Figures…………………………………………………………………………xiv Chapters : Page CHAPTER 1: INTRODUCTION 1 1.1 Problem Statement 1 1.2 Client Exit and the Virtues of Group-Lending 4 1.3 Client Exit and the Relevant Literature 5 1.4 Research Objectives and Key Hypotheses 8 1.5 Research Contributions 10 CHAPTER 2: STYLIZED FACTS ON CLIENT EXIT 13 2.1 Introduction 13 2.2 Client Exit versus Client Retention 14 ix 2.3 Regional and Lending Technology Biases 17 2.4 Classifying Stylized Facts on Client Exit 19 2.4.1 A Taxonomic Framework 19 2.4.2 Client Exit Issues Worldwide 22 2.5 Client Exit: A Case Study of PIYELI 26 2.5.1 Exit Reasons 26 2.5.2 Speed of Exit 29 2.6 Conclusions of Stylized Facts on Client Exit 30 CHAPTER 3: A DYNAMIC CLIENT EXIT MODEL IN GROUP LENDING 32 3.1 Introduction 32 3.2 Dynamic Economic Models 35 3.3 General Model Framework 37 3.4 Numerical Methods and Solutions 43 3.5 Model Simulations and Survival Paths 56 CHAPTER 4: GROUP LENDING IN MALI 63 4.1 Physical, Social, and Economic Environment in Mali 64 4.1.1 National Level 64 4.1.2 Local Level 72 4.2 Organizational Design 76 4.2.1 Promotion Strategies 76 4.2.2 Solidarity Groups 78 4.2.3 Savings Products 82 4.2.4 Loan Products 84 4.3 Institutional Growth and Performance 87 4.3.1 Growth 88 x 4.3.2 Performance 89 4.4 Comparative Analysis of Client Groups 94 4.5