Paper: A Little Skin in the Game: Reducing Moral Hazard in Joint Liability Lending through a Mandatory Collateral Requirement

Both collateralized individual loans and joint liability group loans have received much attention in the microfinance literature. Yet, each has important limitations. Collateralized individual loans exclude those who lack the requisite collateral assets, or are unwilling to put them at risk. On the other hand, joint liability loans are subject to moral hazard and freeriding, especially by those with little social reputation at risk.

This paper asks whether a hybrid contract, which combines joint liability with an individual collateral requirement, could resolve these tradeoffs. It shows theoretically that adding an individual collateral requirement to joint liability unambiguously reduces moral hazard through both carrot and stick effects. Some positive level of collateral is optimal for many, but not all borrower types. Some may exit the credit market in the face of a collateral requirement, although this selection is advantageous or lenders.

To gain empirical purchase on these issues, the study employs a framed field experiment with credit group members in Tanzania. A modest (20%) collateral requirement reduces moral hazard, and defaults falls by 15-20% depending on the level of social connectedness. Moreover, while the fraction of the population willing to borrow decreases by 7% overall, it increases for group members who are highly socially connected.