Peer Group Formation in an Adverse Selection Model

Abstract

This paper develops an adverse selection model where peer group systems are shown to trigger lower interest rates and remove credit rationing in the case where borrowers are uninformed about their potential partners and ex post state verification (or auditing) by banks is costly. Peer group formation reduces interest rates due to a 'collateral effect', namely, cross subsidisation amongst borrowers acts as collateral behind a loan. By uncovering such a collateral effect, this paper shows that peer group systems can be viewed as an effective risk pooling mechanism, and thus enhance efficiency, notjust in the full information set up. A well-known family of adverse selection models in the Stiglitz and Weiss (1981) tradition demonstrates that when banks are imperfectly informed about the riskiness of borrowers' projects and therefore cannot discriminate against risky borrowers, interest rates become inefficiently high, and worthy borrowers are driven out of the credit market. The extent of this problem is substantially magnified when borrowers do not have adequate collateral to secure a loan. Typically, adverse selection combined with lack of collateral leads to prohibitively high interest rates. Poorly endowed individuals (e.g. students, immigrants, the unemployed, and a vast majority of poor individuals in developing countries) often face such high rates, and therefore cannot take advantage of profitable investment opportunities. A peer group formation system represents a possible solution to the above problem. Under this system a bank lends to borrowers without collateral on condition that the borrowers organise themselves into groups, and that participant borrowers within each group accept to take 'joint responsibility' for a loan. Thus, in addition to repaying their own share of the loan, each group member must accept to repay the obligations of their defaulting peers, otherwise the entire group is denied access to future refinancing. Systems of this kind have been very successful in practice: they have generated lower interest rates for the rural poor in, for example, Bangladesh, the Philippines, Bolivia, and the State of Arkansas in the United States. Moreover, group lending has also been successfully implemented in large urban areas such in the cities of Dhaka and Chicago.1