Assortative Matching, Adverse Selection, and Group Lending
This note reviews a theoretical analysis to explain the success of group lending programs in least developed countries. Ghatak (1999) and van Tassel (1999) have claimed that if groups are allowed to form themselves, risky and safe borrowers will sort themselves into relatively homogenous groups, provided that they can make side payments between themselves. This positive assortative matching can be exploited by lenders to solve the adverse selection problem that would otherwise undermine the effectiveness of lending programs. The present note shows that:
- Positive assortative matching can be reversed in the presence of dynamic incentives, specifically, the threat of not being refinanced if the group defaults;
- Positive assortative matching would prevail in the absence of side-payments;
- Safe as well as risky borrowers prefer safe borrowers as peers;
- Without side-payments, safe borrowers would choose to form groups together, leaving the risky borrowers to form groups among themselves.
Finally, the paper emphasizes that contrary to the arguments of Ghatak (1999) and van Tassel (1999), positive assortative matching is more certain when side-payments between borrowers are not feasible.
