Collusion and Group Lending with Adverse Selection

This paper characterizes optimal lending contracts when banks face adverse selections and borrowers have limited liability. It addresses two main questions:

• What is the relative power of group lending in the class of possible lending mechanisms?
• What are the optima collusion proof lending mechanisms and how do group lending contracts perform from the point of collusion?

The main findings, with regard to group lending, presented in the paper are:

• The contracts makes limited discrimination amongst members;
• It is dominated by contracts which vary payments as a function of the announcements of the agents. These contracts are not collusion-proof if agents can collude when they make announcements;
• The contracts are a particular way of practicing a subtle type of discrimination;
• These contracts are not optimal instruments. They are interesting and instruments for extracting payments when collusion is possible.