Q & A with Seed Grant Recipient Emmanuel Maliti

How Indirect and Direct Punishments Affect Repayments
March 5, 2013


Q. How do you describe your research project and the questions you’re seeking to answer to non-economists?

A. My research project focused on the informal savings and credit groups located in Dar es Salaam, the business city of Tanzania. The principal motive was to investigate the ways in which these groups enforce repayment behavior, to answer the question: how effective are punishments—both direct and indirect—on repayment performance. Direct punishments are those related to defaulting on a loan; while indirect punishments are those used to enforce non-defaulting related rules, such as not attending compulsory weekly meetings.

Research on social institutions and their punishments is of tremendous importance given the informal nature of collective groups, such as those engaging in financial intermediation(i.e., collecting savings and issuing credit). These groups do not rely on the coercive apparatus of the state in enforcing collective agreements, loan repayment being one of them. They are informal in that have their own ways of managing defaulters or late repayments of loans, as opposed to relying on police and/or local government offices in case members do not uphold their agreements.

Q. What do you hope to contribute to the understanding of financial systems and poverty with your project?

A. There are many contributions emerging out of this research project. It extensively elaborates on the way in which these groups function. Furthermore, the research provides both anecdotal and empirical evidence on whether punishments have any effects in changing behavior (i.e., improving adherence to group norm of repaying loans on time). The value of this research to the existing literature is that it separates the effects of the two categories of punishments (direct and indirect punishment). Plenty of literature exists on the role of direct punishment on defaulters while scant evidence exists on the effects of indirect punishment. This is the novel contribution to the existing knowledge.


Q. What interested you in this line of research?

A. Economic activities in developing countries that directly impact livelihoods are mostly informal. This means that any intention to alleviate poverty needs to be well informed by the ways in which both formal and informal activities of the poor affect their livelihood—and to what extent. This is one of the inspirational aspects of this research. Nonetheless, these savings and credit groups, which have been mostly spearheaded by development agencies, have spread so extensively that it is common to come across members meeting in public. Plenty of program-based literature exists without any scientific research on what is transpiring within these groups.  


Q. Your initial findings suggest that those who have had indirect punishments are more likely to repay their loans on time than those who have never experienced punishments. How do you account for this?

A. This is an empirical finding, the key contribution of this research. In essence, the probability of repaying loans on schedule for those who have experienced indirect punishments is higher than those who have never experienced indirect punishments. We can then, with confidence, say that one of the possible explanations for such outcomes is that the perceived certainty of punishment on defaulting comes from the past experience of borrowers in encountering punishments for rule violations; there is a relationship between past wrongdoing and the perceived probability of being punished in the future for violating rules, such as defaulting on loans.


Q. Your study also shows that indirect punishments are more effective in repayment of loans than direct punishments? Why do you think this is?

A. Though the difference is not very large, it is, however, true that the effects are higher for the case of indirect punishment relative to the effects of direct punishment. I am referring to this as the “zero tolerance effect.” The difference in effects might be caused by the way these groups are structured. After a group is formed, members accumulate savings for 11 consecutive weeks. No loans are issued during this period, so only indirect punishments take place during this period. As a result, in these 11 weeks agents build up perceptions on the probability of being punished for defaulting when lending starts in the 12th week. Therefore the spillover effects materialize; those who have experienced other punishments will perceive a high risk of being punished again if they dare to default (i.e., fear is created when other punishments are administered prior to the issuance of loans). In this way, indirect punishment works indirectly, by increasing the credibility of direct punishment.


Q. Why are there more people in Tanzania involved with informal savings groups than there are those who have a bank account?

A. A recent survey of access to financial services in Tanzania (Finscope, 2009) shows that around 12 percent of the adult population has access to a bank account; while 27 percent engages in the informal financial markets. There are plenty of explanations behind this situation. Traditional banks are formal institutions and there is bureaucracy involved in not only opening and managing saving accounts but also in accessing other financial services, such as loans. Documentation barriers were listed as one of the reasons Tanzanians preferred not to use formal banks in the survey. 

Everyone knows that banks demand collateral for a loan, making economic barriers one of the key obstacles to banking services. This is different from the informal saving groups where you only need social rather than physical collateral during the loan application. By social collateral, I am referring to first, being a member in these groups; members are closely associated and often have been living in the same area for a number of years. Secondly, you just need a few guarantors for your loan application. My research found that even this rule is not strictly enforced, often being a member with a good reputation and active in making weekly contributions is sufficient to access credit. Also, banks are far away—both in distance and in societal access—which is different from these informal lending groups, which usually meet on a weekly basis in the same neighborhood. They also have less bureaucracy; it usually only takes a few minutes to apply and obtain loans, which is very different from the formal banking sector.


Q. What draws Tanzanians to become involved in such informal savings groups? Is it social or financial?

A. It is both social and financial. It is social in the sense that people are used to cooperating in a number of social activities, such as weddings, funerals, etc. Therefore, these groups are an extension of social environments. That is, people have taken advantage of their social capital by venturing into the economic activities of saving and credit transactions. That’s why these financial groups are composed of people with similar social status who have known each other for a number of years. It doesn’t mean that by joining these financial groups, members have abandoned their social responsibilities. Not at all. They have structured their groups in such a way to accommodate social cooperation, for example, by establishing a social fund when a member experiences social calamity or when a member has a death in the family. Other groups have gone further by establishing rules and even specific rates of contributions to support members in such adverse situations, on top of what the social fund provides.


Q. What can members do if someone defaults? Can they seek remedy through the courts?

A. It is difficult to access state coercive bodies, such as courts, because of several factors including distance and availability. However, it is also true that even if they are accessible, people have less trust in these institutions; several surveys (and even political leaders) have expressed concerns about the behaviors of state authorities. People usually make a cost-benefit analysis when making financial decisions. As a result, it is more likely that they find the costs of using formal apparatuses higher than using the informal means to enforce good behavior. So, in essence, they end up applying informal social sanctions, such as punishments, to address the repayment challenge I elaborated on earlier. We should be aware that punishments are not the sole mechanism that address repayment behaviors in an informal environment; these people have known each other for a number of years and, in most cases, they collaborate in outside group activities. Hence, the presence of these types of social interactions in one way or another, “force” members to behave prudently when it comes to agreeable group norms, such as repaying a loan. Otherwise they risk their reputation not only inside the group but also outside, to the larger community. This is what the literature refers to as “reputational effects.”


Q. What are the direct punishments for defaulting on a loan?

A.  Direct punishments for defaulting on loans are financial penalties. They can include a higher interest rate for the remaining loan balance or deducting the defaulted amount from the savings of the guarantors. However, we should understand that before applying any penalties, members usually investigate reasons behind defaults or late repayments. They can contact the partner—wife or husband—of the defaulter and, in some cases, pressure the partner to repay on behalf of his or her spouse. In some cases, they can go to the defaulter’s house and confiscate household items, such as televisions, sofas, to be auctioned for loan recovery. However, there are very few cases of such measures being applied.  


Q. Can you give examples of the most common indirect punishments?

A. Indirect punishments are also financial penalties. For instance a penalty for missing a weekly meeting can be the equivalent of 40 cents U.S.; a phone ringing during a meeting can be equivalent to 20 cents U.S.; showing up late to a weekly meeting can garner a fine of 20 cents U.S.; sleeping during a meeting is 30 cents U.S. These rates vary across groups. The key issue is that while both direct and indirect punishments are financial penalties, they differ in terms of the offence they are intended to address.


Q. Where is the informal savings group’s monies stored?

A. These groups maintain a metal cash box with three locks on three sides of the box. This box not only stores the group’s savings but also the group’s main stationery and stamp. Keys for the three locks are kept by three different members; therefore, no one can open the box on his or her own; you need three key holders for that to happen. The box is usually kept at the home of one of the leaders who is not among the three key holders; and it is opened and closed only during the weekly meetings (i.e., in the presence of group members). I found that because of the high demand for loans the box usually ended up storing very little cash, and this minimized the risk associated with such a seemingly insecure way of storing cash.


Q. What is the standard interest on a loan from an informal savings group?

A. It varies across groups ranging between 5 to 10 percent. This rate is set by consensus of all members. The interest revenue usually goes back to members at the end of each financial term as a dividend. This makes the operation of these groups similar to the normal profit making corporate entities. When members make weekly savings/contributions to the groups, they are actually buying shares and, therefore, at the end of the financial year the group profit is divided based on the number of shares (amount of savings) each members has purchased (made) over time.


Q. How did the quality of group leadership contribute to the repayments of loans?

A. Quality of leadership is imperative in enforcing good behaviors. Apart from the traditional leadership post, such as a chairperson, secretary etc., there is a disciplinary officer whose main task is to ensure that each member fulfills his or her obligation and does not break any collective rules. The establishment of this position by itself shows how important leadership is perceived to be in these groups. Interviews with those who provide training to these groups revealed that groups with good leaders perform better than those with weak leadership (e.g., lenient leaders result in group underperformance when it comes to loan repayment.)


Q. Why does having a large number of female members increase punishments?

A. First of all I should mention that the majority of the surveyed groups have a female-dominated membership. I couldn’t find an all-male group; however, it was common to encounter an all-female group. Furthermore, because the interviews were carried out during weekly meetings, I had an opportunity to observe members’ interaction during the weekly meetings. Women-dominated groups appeared to be more interactive that male-dominated groups. I have found statistically that social ties positively correlate with repayment behavior as well as with punishments. It was further found that women have higher social ties (measured by number of friends) than men. 


Q. How do you think the U.S. market, still recovering from the foreclosure crisis, could implement indirect punishments that would be effective in lessening defaults?

A. The U.S. legal process of auctioning mortgaged properties because of delinquent payments (foreclosure) is similar to the direct punishment of savings groups: When a member defaults, his or her savings and those of his or her guarantors are liquidated. The general lesson is that whether it is mortgages or any other financial product, it is important that all rules are enforced by establishing and applying penalties—whether they are directly related to the core transactions (e.g., mortgage) or indirectly related. Through this, indirect punishments will be sending a credible signal that the lender is serious about applying the ultimate penalty (e.g., foreclosure in the case defaulting materializes).


Q. What other findings from your study do you think are significant?

A. Direct punishments and indirect punishments are necessary to address repayment challenges. That is punishment of trivial misbehaviors affects compliance on more relevant issues (i.e., loan repayment). Other findings, which do not differ much from the existing literature, include the results that preferences on saving and credits, compulsory savings, social ties and economic inequality are found to be significantly associated with variation in repayment behavior.