Credit Cooperatives

Among local financial institutions that reach beyond a small group of persons, credit cooperatives (credit unions) are the most widespread type, apart from small-scale, donor-supported lending organizations. The structure

97. These names and more in other countries are found in The World Bank, 1989, p. 114.

98. G. Nagarajan, R. L. Meyer and D. H. Graham, 'Institutional Design for Financial Intermediation by NGOs: Implications for Indigenous Self-Help Village Groups in The Gambia', in R. Rose, C. Tanner and M. A. Bellamy (Eds), 1997, p. 274.

of credit co-operatives is fundamentally different from that of banks. Depositor-borrowers are owners of credit co-operatives, and many of the co-operatives do not have a base of capital. In addition, except in cases in which they are federated, they do not have recourse to borrowing from other financial institutions to tide them over liquidity shortages. Banks, in contrast, have owners who contribute share capital, and their more formal structure allows the access to them interbank loan market.

One of the advantages of credit co-operatives is the ease of forming them, as they do not have to comply with the minimum capital requirements and other regulations that pertain to banks. (The disadvantage of this situation is that they are not subject to prudential regulation, as banks are.) Another advantage is that the cost of their administration can be very low; sometimes they even rely on volunteer labor from their members. As a result of the heightened participation of members, credit co-operatives tend to be more 'user-friendly' than many banks, and the cost of their services generally is low. However, banks increasingly are emphasizing improvements in the quality of their services.

More formally, the reasons for the success of credit co-operatives lie in the facts that (a) they have a long-term interaction with their members, which fosters a sense of identification with the institution and responsibility on the part of the latter, and (b) even in larger co-operatives, loan monitoring is carried out by peers who often are members of the same community.99

In practice, the record of credit co-operatives has been uneven and their performance in many countries has been disappointing, often characterized by a high rate of failure. 'Developing-country credit unions have shown a strong tendency toward disruptive boom-and-bust instability. In more than a few poor countries, the majority of all credit unions are insolvent - that is, unable to pay off all depositors'.100 Ledgerwood has made a similar observation: 'many [credit union] systems do not function as well as their basic philosophy would lead one to expect. At the same time, they are very difficult partners for foreign institutions'.101 This outcome can be traced directly to their institutional structure (as Feibig also observed in the comments cited above):

. .. credit cooperatives have not performed well even in countries where they belong to the formal financial structure (i.e. are regulated) because their governance rules and ownership structure are inconsistent with their financial health. Credit cooperatives can only lend to their owners which for all practical purposes means that credit cooperatives have no capital. In case of bankruptcy, owners can capture their equity investment by defaulting on their loans. In the absence of capital, financial intermediaries are unconcerned about risk. Moreover, credit cooperatives can be easily controlled by individuals with negligible investments in them. These governance rules and property rights are perverse because individuals in control of these organizations are residual claimants only of their profits but not of their losses (i.e. borrower domination). . .. Examples of.. . practices adopted by borrower-dominated intermediaries are weak collection of loans and low interest rates.102

In a comprehensive study of the experience of credit unions in the developing world, John H. Magill summarized some of their major weaknesses and constraints as follows:

99. Abhijit V. Banerjee, Timothy Besley and Timothy Guinnane, 'Thy Neighbor's Keeper: The Design of a Credit Cooperative with Theory and a Test', The Quarterly Journal of Economics, 1994, 109(2), pp. 491515.

102. The World Bank, Latin America and the Caribbean Region, Central America Department, Sector Leadership Group, El Salvador Rural Development Study, Yellow Cover Draft, Report No. 1625ES, Washington, DC, January 23, 1997, p. 14.

Credit unions tend to be small. . .. [and hence they] could not assume the risk involved in developing or implementing specialized programs designed to reach large numbers of small-scale enterprises.

Because of basic inadequacies in credit union financial and interest rate policies in most countries - particularly the precedence of credit over savings - credit unions are not generating capital rapidly enough to meet member demand. .. .

Increased credit union participation in enterprise lending is also limited by the fact that most are conservative, highly traditional organizations that do not have a modern growth- and service-oriented philosophy. .. .

Internal credit union policies and operating procedures need modernizing if credit unions are to significantly expand their role in small-scale enterprise lending. In particular, poor delinquency control and weak portfolio management capabilities limit the ability of many credit unions to expand loan portfolios or add new services. Management, operational systems, and even basic accounting systems need improvement, particularly in smaller credit

unions.103

Substitute 'farm' for 'enterprise' in this passage and the problems of relying on credit unions for agricultural finance, in their present state of development, can be seen clearly.

The problems of credit co-operatives can be compounded, rather than lessened, by financial support from the government:

In many developing countries cooperatives operate under a government department that supports them with funds, technical assistance, and policy guidance. Government support is attractive to the cooperatives' managers because it allows lending to expand quickly, but it weakens the incentives of cooperative members to provide their own finance. When loans are made according to government directive, lenders may find it difficult to collect. Such loans are often seen as grants and hence as resources that can be spent on consumption . . .

Moreover, the goals of government and cooperatives can differ greatly: governments often view cooperatives as instruments for the conduct of broader policy. In Africa, for example, a ministry wished to use the cooperative credit system to channel low-interest funds from foreign donors to targeted programs. When the ministry's plan was presented to the cooperative, the director declined because he felt that the funds would never be recouped by his institution. The director was told to reconsider or resign. The plan went into effect, repayment rates were extremely low, and other cooperative lending programs were undermined. .. .

Similarly, the support of foreign donors can be a mixed blessing. Cooperatives may seem a suitable channel for development funds, but they often end up with heavy liabilities and a bad collection record. . . .104

Nevertheless, under appropriate institutional designs and an appropriate policy environment, some experiences of credit co-operatives have been successful. The opportunities afforded by credit co-operatives and insights into approaches which can make them function well were presented by the World Bank in reviewing the experience of Togo:

Despite the difficulties, cooperatives are a good way of increasing access to financial services. Their costs are often low because they use volunteer labor and because they can reduce risk through group accountability and local sanction. Where governments have been more concerned with the viability of cooperatives than with social objectives - and where interest rate

103. John H. Magill, 'Credit Unions: A Formal-Sector Alternative for Financing Microenterprise Development', in M. Otero and E. Rhyne (Eds), 1994, p. 149.

Both typical weaknesses and potential strengths of credit co-operatives are illustrated by the experience of the World Council of Credit Unions in reforming credit co-operatives in Guatemala:

Before 1988. . . their main purpose was to provide cheap rural credit. [They] were financed by subsidized external credit and by compulsory, zero-interest share deposits from members. Because loans were issued at below-market interest rates, members were in effect penalized for saving and rewarded for borrowing. The credit unions had serious operational problems (management information systems were underdeveloped, the credit unions carried a large volume of nonearn-ing assets, the loan delinquency rate was about 20 percent, and loan loss reserves were underestimated by more than 50 percent). Liquidity reserves were so low (about 3 percent) that the credit unions could not always honor cash withdrawals from members. . . .

The World Council for Credit Unions, funded by the US Agency for International Development, implemented an institutional development program for the credit unions between 1987 and

1994. ... By 1994. . . deposits had grown from 24 percent of assets... to 55 percent. . . . The loan delinquency rate had decreased to 8 percent of the loan portfolio. . . . Several factors contributed to this turnaround:

• .. . use of a business plan that incorporated institutional development, financial stabilization, savings mobilization, and credit administration. Firm financial targets were set and an effective management information system was put in place. Interest rates on deposits and loans were increased.

• . . . An agreement of participation was signed by all parties to demonstrate their commitment.

• .. . financial assistance for the stabilization process was provided to the credit unions in the form of non-interest bearing one-year loans. The loan principal was placed in high-yielding Guatemalan investments, and the interest earned went to the credit unions to offset non-performing assets

( from J. Yaron, M. P. Benjamin and G. L. Piprek, 1997, p. 74).

restrictions have been relatively modest - cooperatives have flourished and the supply of financial services has broadened. In Togo, for example, savings in the credit union system grew by 25 percent a year and loans by 33 percent a year during 1977-1986. Members elect a board of directors, which decides on interest rates, dividends on shares, and lending policies. The credit unions are federated, and they jointly manage a central fund, invest in low-risk financial instruments, and mediate transfers between member unions with surplus funds and those with deficits. . . . they have access to broader financial markets through their federated structure.105

Magill feels that if the credit union movement overcomes the weaknesses he describes, they can play a stronger role in financing development:

Credit unions throughout the developing world, and particularly in countries facing high inflation rates, have begun to modernize their savings services. Regular savings accounts and deposits are being offered in addition to the traditional share savings accounts. Credit unions are paying interest. . . closer to market rates on these new savings instruments. .. . These changes will make credit unions more viable financial institutions. . . .

Modernization of credit unions also should focus on improving their financial products:

• Developing a broader range of savings services, including long-term savings instruments, with different interest rates and maturities.

• Developing an expanded range of loan services designed to meet the needs of a wider variety of members.

105. The World Bank, 1989, p. 118 [emphasis added].

• Pushing aggressively forward to offer quasi-transaction loan and share draft accounts to meet the transaction needs of their members.106

In summary, the credit co-operative model can be made more viable through improved financial management and policies that offset some of their structural weaknesses in the areas of governance and ownership: a realistic interest rate policy, creation of a federation of credit unions which includes a central fund, and a policy by governments and donors of abstaining from directing subsidized credit through the co-operatives. It also is important to subject credit co-operatives to adequate supervision, which they frequently do not have, and, as indicated above, this requires separating the supervisory authority from the entity that provides technical assistance for the development of the co-operatives. Regulations need to be implemented to prevent the institutions' directors from having special access to loans without passing through the normal process of application and qualification. Many credit unions have shipwrecked on the shoals of struggles by influential individuals over access to funds.

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