- 12 Sep 2012
- Working Paper Summaries
Liability Structure in Small-Scale Finance: Evidence from a Natural Experiment
Executive Summary — Microfinance has exploded in popularity and coverage in recent years, particularly in meeting the large unmet demand for finance. But what is the optimal loan contract structure? This paper examines the relative merits of joint and individual liability contracts by analyzing the effect of contract structure on a group of borrowers who are willing to borrow with either individual or group liability. Findings show that group liability structure significantly improves repayment rates. Overall, these results provide the first credible evidence that group liability contracts improve upon individual liability, particularly in ensuring repayment and increasing savings discipline among clients. Key concepts include:
- While most microfinance organizations use group liability, not all do so.
- The lending model matters. For the same borrower, required monthly loan installments are 11 percent less likely to be missed under the group liability setting, relative to individual liability.
- Compulsory savings deposits are 20 percent less likely to be missed under group liability contracts.
- Results suggest a cautionary tale: Many microfinance institutions have been moving away from joint to individual liability, but even so, this transition is not supported by strong empirical evidence.
Microfinance, the provision of small individual and business loans, has witnessed dramatic growth, reaching over 150 million borrowers worldwide. Much of its success has been attributed to overcoming the challenges of information asymmetries in uncollateralized lending. Yet, very little is known about the optimal contract structure of such loans-there is substantial variation across lenders, even within a particular setting. This paper exploits a plausibly exogenous change in the liability structure offered by a microfinance program in India, which shifted from individual to group liability lending. We find evidence that the lending model matters: for the same borrower, required monthly loan installments are 11 percent less likely to be missed under the group liability setting, relative to individual liability. In addition, compulsory savings deposits are 20 percent less likely to be missed under group liability contracts.