Micro-Credit and Group Lending: The Collateral Effect

This paper analyzes the collateral effect due to group lending methodologies. It considers a model with two types of entrepreneurs (high-risk and low-risk) and a competitive banking system.

The paper lists several advantages with the group-lending setup:

• Peer screening effect: Credit-evaluation done by the borrowers (rather than the bank) thereby reducing transaction costs;
• Peer monitoring effect: Each group member induced to use loans for productive purposes thereby increasing the probability of success and repayment;
• Social relations effect: Borrowers induced to spend extra effort to secure timely payment;
• Collateral effect: Successful entrepreneurs within each group covering part of the losses, thus reducing losses due to unsuccessful projects, generating group collateral.

Further, the paper complements the theoretical analysis by a comparison of the performance of Bolivia's BancoSol, which practices group-lending, with the other private Bolivian banks, which lend on an individual basis.

Finally, the paper demonstrates theoretically that:

• Banks face lower risk when lending to joint-limited-liability groups;
• Lower risk allows the bank to reduce the interest rate;
• Lower interest rate attracts less risky loan applicants, further reducing the banks' overall risk;
• An additional reduction in interest rates allows more customers to be served.