A little skin in the microfinance game: reducing moral hazard in joint liability group lending through a mandatory collateral requirement

Both collateralized individual loan contracts and joint liability group lending contracts have received much attention in the microfinance literature, yet neither contract has been found to be optimal from a welfare perspective. On the one hand, a heavily collateralized individual loan contract is very risky for borrowers, resulting in low levels of credit market participation. On the other hand, while joint liability contracts are designed to harness the social collateral among community members, numerous studies have shown that such contracts are prone to moral hazard, free-riding, and collusion. This paper analyzes an alternative contract which combines joint liability with a modest collateral requirement. Using a simple theoretical framework, we show that adding a collateral requirement to a joint liability contract reduces moral hazard but has an ambiguous effect on credit market participation. To test the predictions of the model, we conduct a unique framed field experiment among active credit group members in Tanzania. The results demonstrate that adding a collateral requirement reduces moral hazard among borrowers and helps increase repayments without compromising the effect of the social collateral in the groups. Moreover, we find evidence that a collateral requirement leads to a modest reduction in credit market participation.