Banks and other financial institutions hesitate to lend to borrowers who cannot provide adequate collateral. The reason is simple: the collateral represents the penalty for default, which, if sufficiently high in value, discourages people with low repayment potential to apply for loans. But collateral requirements also cause credit to be inaccessible to people who are poor. This tends to perpetuate poverty and underdevelopment in societies where economic backwardness and low productivity are a consequence of the scarcity of capital.

In sharp contrast with the conventional lending practice of banks, microfinance organizations specialize in providing small loans, with little or no collateral requirements, to poor borrowers in economically depressed regions. The dramatic success story here is that of the Grameen Bank of Bangladesh, which, since its inception in 1976, has steadily increased its clientele (its loans, mostly to poor women from rural areas, exceeded 2 million in 1999) while maintaining an exceptionally high rate of recovery of its loans (between 92 - 98%).

Why has the Grameen Bank been successful in ensuring that its borrowers make productive use of their loans and are able to pay back their debts? The answer lies in the lending practices adopted by its founder, Professor Mohammad Yunus. The Grameen Bank does not require any collateral, but it deals with groups, instead of individual borrowers. To qualify for a loan, a person has to belong to a small group of loan applicants, all of whom must be from the same village. While each person in a group receives a separate loan, the whole group is jointly liable in case of default by any of its members. What this means is that borrowers whose projects are successful may have to pay additional amounts, over and above their own dues, if any member of their group is unable to repay his loan. Thus, even though there is no collateral, default imposes a penalty, although this is exacted from the rest of the group rather than from the individual responsible.

It is this feature of joint liability that performs the function of screening high-risk borrowers from the pool of loan applicants. Groups are formed on the basis of self-selection by borrowers who live in the same community, and who are well acquainted with each other. In traditional societies, residents of the same village usually know of each other's productive capabilities. A person regarded as a high-risk borrower by others will not be included in a group since he is more likely to default and impose a financial burden on the rest. The terms of joint liability, appropriately determined, provides incentive to borrowers to utilize their personal information on each other to ensure membership quality.

Besides excluding bad borrowers, group formation encourages "peer-monitoring" activities. Members of a group are likely to monitor the performance of each other, offer help and advise, and apply pressure on those that tend to be lazy or delinquent, in order to minimize the incidence of default, and the consequent burden of joint liability. In this manner, the Grameen Bank uses intra-group incentives to circumvent the dangers of providing loans without collateral, and makes it possible to finance productive activities among the poor.