DP8197 | Repayment incentives and the distribution of gains from group lending

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Group loans with joint liability have been a distinguishing feature of many microfinance programs. While such lending has benefitted millions of borrowers, major lending institutions have acknowledged their limited impact among the very poor and have recently favored individual contracts. This paper attempts to understand these empirical patterns using a model in which there is a single investment project and access to credit is limited by weak repayment incentives. We show that in the absence of large social sanctions, the poorest borrowers are offered individual and not group contracts. When both types of contracts are feasible, the relative gains from group loans are shown to be decreasing in loan size. We compare the role of bank enforcement with social sanctions and find that bank enforcement is more effective in increasing outreach while social sanctions raise the welfare of infra-marginal borrowers. Finally, we explore the welfare effects of group size and find that those requiring small loans are better served by larger groups but group size effects are, in general, ambiguous.