Collateral and risk sharing in group lending: evidence from an urban microcredit program

Abstract

Empirical research on group lending is extensive, but without allowance for collateral to mitigate strategic default. Indeed, lack of credit access has motivated microcredit in rural areas of developing countries, where agents with collateral are very rare. As rural communities have tight-knit hierarchical structures information about borrowers is accessible and enforcement of social sanctions makes collateral superfluous. First, we illustrate in a model how collateral mitigates group default. Second, we study a group lending program in Cotonou, the largest city in Benin with 1.1 million inhabitants. Results show diversification within groups facilitating risk pooling but also increasing expected default costs for safe borrowers. Risky borrowers offset group-default negative spillovers default with collateral, and facilitate credit access to safe borrowers. We find joint liability to be a mechanism for risk sharing in a setting where poor households lack resources for collateral and insurance markets are missing.

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