Since the 1950s, governments recognized the fact that a large number of individuals did not have any other option but to be under the dominance of those monopolists. Consequently, there were implementations of programs where the governments subsidized the provision of credit to small-scale farmers in most developing nations (Parmar, 2003). Institutions of development finance and international donors did the delivery of inexpensive credit to the poor farmers. The difficulty in the examination of the application of the credit, the reliance on the donors, the wrong decisions on investment and low rates of repayment rendered the projects unsustainable.
During the late 1970s, a new concept for the private program stared becoming significant. The savings of the customers contribute only less than a third of the money needed for loans. The approach demands much of the time of staff as well as that of customers, which can always be very expensive (Yunus and Weber, 2007). Such a financial institution does not apply any penalties on a group of people that take a loan if any of the members is either not in a position or not just willing to pay their share, and that the financial institution does not decide to exploit the group’s potential as a way of enforcing the liability on the group.
In this view, some organizations’ contribution to the movement of microfinance start to show, for example, that the experience of the establishment of small loans could replace the physical security that the poor people are not able to afford by social security via the borrowers’ joint liability; for instance, by the joint duty of loan repayment concede to any group member (Parmar, 2003).
This is an effort of reducing the costs of screening by the use of local insider information regarding the borrowers’ creditworthiness, and concerning the actual use of the credit, to avoid serious selection and problems of moral hazard. The serious selection problem happens because it is not easy to know exactly the amount of effort every member of the group will make in paying back the loan and hence the financial institution cannot differentiate between potential defaulters and good borrowers (Yunus and Weber, 2007).
The methods of self-selection implies that this information, not known to the financial institution, is not provided via the formation of group, since none of the members will select a partner who will apparently default on the paying back of their loans. The problem of moral hazard happens when it is not probable, or even too costly to examine the activity for which a loan is being used by a borrower.
Abed, F. H 2000, “Microcredit, poverty and development : the case of Bangladesh”. In Behind the Headlines. Vol. 57, No. 2/3 (pp. 12-19).
Association for Social Advancement (ASA) 1997, A Study on the constraints to reaching the hardcore poor with microcredit. Dhaka : ASA.
Hashemi, S. M 1997, “Those Left Behind : A Note on Targeting the Hard-core Poor.” In Wood G. D. and Sharif I. A., (eds.) Who Needs Credit? Poverty and Finance in Bangladesh. Dhaka. The University Press Ltd.
Parmar, A 2003, "Micro-credit, Empowerment, and Agency: re-Evaluating the Discourse". Canadian Journal of Development Studies XXIV (3): 461–476.
Yunus. M and Weber. K 2007, Creating a World Without Poverty: Social Business and the Future of Capitalism. PublicAffairs, New York.