Signalling Through Joint-Liability: An Adverse Selection Model

Joint-liability is maybe the most distinctive feature of microfinance contracts in developingcountries. Yet, very little evidence exists on the impact of joint-liability contracts as compared to individuallending contracts. On the one hand, theory claims that joint-liability plays a key role in mitigatingagency problems and thus enhancing repayment rates, especially when borrowers lack collateral. On theother, experimental evidence has shown mixed, sometimes contradictory results, highlighting major pitfallslike harsh social sanctions and peer pressure. We contribute to the debate on the relative merits (andweaknesses) of joint-liability by showing that, under certain conditions, joint-liability may not be able tosolve adverse selection problems. We build a model in which a risk-neutral lender offers both individuallyand jointly-liable contracts, but has limited funds and limited knowledge about borrowers' quality. In thiscase, joint-repayments can be used as a signalling device of borrowers' type. Our model shows that if thelender allows for competition among borrowers, risky borrowers may have an incentive to reveal a higherjoint-repayment level than safe borrowers. In other words, joint-liability may increase adverse selection.We test our predictions in a small experimental environment.