Optimal (Partial) Group Liability in Micronance Lending

This paper develops a model of group borrowing that incorporates partial group liability, where borrowers are penalized if their group members default but are not held responsible for the entirety of the failed loan. The model implies that greater group liability encourages greater intra-group transfers, but if group liability is too large, it induces borrowers to strategically default.The model predicts the existence of an optimal partial liability that maximizes transfers between group members while avoiding strategic default. The paper extends the model to incorporate household structure and group size in order to estimate the prevalence of strategic default in the presence of correlated returns to borrowing. It uses administrative data from a large MFI in Mexico. Findings include:

• Structural estimates suggest correlated returns across borrowers and substantial incidence of strategic default;
• Exploiting variation across loan officers in de facto group liability, empirical results reveal a U-shaped relationship between group liability and default rates, as predicted by the model;
• Moving to 50% liability could reduce the incidence of default by about 14%, resulting in an increase in welfare of about 5%.