Social collateral, dynamic incentives, and joint liability in a two‐step trust game: Lending to the unbankable

Abstract

AbstractAsymmetric information and lack of collateral creates a suboptimal allocation of financial resources to those in most need. When uncollateralised borrowers approach financial institutions, the presence of moral hazard and adverse selection results in no lending. Conversely, group‐lending contracts—joint liability, dynamic lending, and social cost for defaulting—control for information asymmetries and create a co‐operative trust game between borrowers leading to an undominated optimal strategy to repay, and therefore, for the lender to Give. Group lending proves superior to typical individual borrowing and lending when no collateral is available. Social collateral and trust are fundamental pieces of the successful work of MicroFinance. Resulting contracts and correspondent payoffs are Pareto efficient.