Group Lending, Local Information and Peer Selection

The paper analyses how group lending programs use joint liability to utilize local information that the borrowers have about each other's projects through self-selection of group members in the group formation stage. These schemes are shown to lead to positive assortative matching in group formation. Faced with the sane contract, this makes the effective cost of borrowing lower to safer borrowers: because they have safer partners, conditional on success their expected dues to the lender are lower than that of riskier borrowers. The resulting improvement in the pool of borrowers is shown to increase repayment rates and welfare.

The paper provides a theory based on two contractual features of group lending programs to explain why they can potentially achieve high repayment rates despite the fact that borrowers are not required to put in any collateral: the existence of joint liability and the selection of group members by borrowers themselves.

The paper focuses on group lending programs under which borrowers who cannot offer any collateral are asked to form small groups. Group members are held jointly liable for the debts of each other. Formally speaking, what joint liability does is to make any single borrower's terns of repayment conditional on the repayment performance of other borrowers in a pre-specified and self selected group of borrowers.

The paper concludes that risky borrowers who will end up with risky partners will be less willing to accept an increase in the extent of joint liability than safe borrowers for the same reduction in the interest rates. This implies that the degree of joint liability can be used as a screening instrument to induce borrowers to self-select loans that differ in terms of individual and joint liability.