Our experimental results highlight several new insights about joint-liability lending contracts. First, theory has posited that joint-liability lending is able to mitigate problems of adverse selection through its ability to screen high-risk borrowers from the lending pool. Our research does not contradict this hypothesis because our experiment is not intended to measure the impact of borrower screening. But using the results from an artefactual experiment, we observe a strong tendency for borrowers with risky projects to prefer joint-liability loan contracts. Whether the positive effects or negative effects of joint liability contracts on adverse selection dominate in practice remains an empirical question that likely depends on the context of microlending.
Second, our experimental results suggest that the principal determinant in choosing to undertake risky investments is a low level of risk aversion, where we measure risk aversion by the Holt and Laury risk-aversion protocol. We find no significant evidence for the effect of social capital on project selection.
Third, we find evidence that the preference among borrowers with risky projects for joint-liability contracts appears to be driven by free-riding rather than a desire to diversify risk. As risky projects may offer a higher expected individual payoff to borrowers, they impose a negative externality on a borrowing group while shielding the borrower from the added risk. We find that the pool of borrowers who switch to joint liability contracts when projects move from safe to risky is disproportionally made up of the pool of borrowers who switch from safe to risky projects as lending moves from individual to joint liability.
The policy implications of these findings do little to contradict what previous research has suggested about factors driving joint-liability lending repayment rates (e.g. Ghatak, 1999; Wydick, 1999; Giné and Karlan, 2010). Our results both support and contrast with those of Gine et al. (2010) and Fischer (2010), supporting in the sense that each of these three papers finds that joint liability is associated with increased risk-taking, but contrasting in the sense that we model risky projects as detrimental to the interest of the lender, and where joint liability induces problems of adverse selection. In addition, our experimental results point to the pitfalls of
joint-liability contracts if these mechanisms designed to mitigate asymmetric information problems in credit contracts should fail. Joint-liability lending without high levels of borrower screening is likely to attract risky loans. Peer-based screening of credit groups ex-ante to group formation should be encouraged and incentivized by microfinance institutions to mitigate adverse selection among joint-liability borrowers. Where these mechanisms are absent, joint-liability lending may induce more problems related to asymmetric information in credit markets than it solves.
We believe our experimental results give some insight into why microfinance borrowers appear to display a preference for individual loans and group loans without joint-liability. With competition in the microfinance industry intensifying and microfinance institutions being forced to offer credit contracts that are increasingly appealing to borrowers, market forces have begun to steer microfinance away from joint-liability loan contracts. We would expect joint-liability contracts to remain in place chiefly where social capital and social networks between microfinance borrowers are sufficiently strong that the adverse selection problems associated with joint-liability lending are outweighed by the ability of these social factors to mitigate them.
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