According to the Federal Deposit Insurance Corporation, nearly one-third of those residing in the United States skip the use of banks in the course of transacting their financial business. Approximately one-quarter do not have a credit score, but few of these households have an asset-to-liability ratio of zero or less. The credit gap is even greater in countries outside of the US.
Although the requirement for financial services in these sectors is high, their invisibility to mainstream banking entities presents problems when attempting to access credit for business or personal ventures. Financing for educational or business startups, and automobile or home purchases often fall prey to unsavoury lending practices, leading financially underserved enterprises to fail, just as their financial futures begin to show promise.
These statistics indicate that financially underserved populations represent a viable customer base for financial institutions who can develop strategies to solve credit scoring issues. One such innovative approach for credit scoring of largely unbanked populations is the “lending circle” concept.
Savvy bankers took their cue from low-income communities themselves, whose members have solved the lending portion of the equation by creating social circles within the community to pool financial assets for the purpose of lending to motivated community members. However, entrepreneurs and upwardly mobile families are still underserved by these informal lending scenarios, since they provide financing, but cannot build a credit history or provide for other financial service needs.
The goal of lending circles is to bridge the gap between the underserved and the mainstream financial entities. This is accomplished by organisations who pull together funding, providing it to credit-worthy individuals with signed promissory notes. Typical lending circle sponsors are non-profit organisations or banking entities, who have the capacity to organise individuals who are capable of lending small amounts, but also need to borrow. Organising entities formalise the process, whereby borrowers access a money pool that each member has contributed to, on a rotating basis. Organisers must also guarantee against the potential for loss, if members of the circle drop out. The final step is to report loan payments to credit-tracking agencies.
According to FDIC research, the lending circle concept is not only an effective tool for providing much-needed funding for low-income populations, but also for establishing credit scoring and decreasing debt levels. Banking providers who participate in lending circles can keep fees and interest rates low, since they are rewarded with new customers, who show their appreciation with low default rates. Developing financial literacy, rather than focusing on accountability, is a key aspect of these programs which require loan recipients to open bank accounts for the purpose of direct deposit of loaned funds.