Group Lending under Costly Group Formation

Abstract

The success of joint liability programs depends on nature and composition of borrowing groups. Group formation is a costly process and in our model these costs vary with the social identity of group partners. We show that risk heterogeneity in a borrowing group may arise due to the social identity of the agents. The presence of caste and gender bias may not resolve the adverse selection and moral hazard problems created by information asymmetry between the borrowers and the lender. We also find that with costly group formation and state verification,individual liability lending may be better than joint liability lending.Thus ignoring social identity and group formation costs can lead to the failure of a joint liability program. Finally,the paper also suggests that targeting different social groups requires the use of a menu of joint liability costs.

Keywords: Group lending, Risk heterogeneity, Formation Costs, Social identity

JEL Classification: D82, G20, N23, O12