Equilibrium Risk-Matching in Group Lending

This paper examines group formation in group-credit contracts recently popular in credit programs for the poor. The joint-liability in these contracts induces a correlation between the choice of partner and of repayment strategy. We show that this leads to non-monotone matching patterns, which differs with the homogeneous or assortative matching assumptions prevalent in the literature. The heterogeneity in equilibrium arises from the ability of borrowers to use the joint liability to create credible insurance arrangements among group partners in missing insurance market environments. Beyond a certain risk level, nonetheless, borrowers are unable to remunerate safer partners for the asymmetric insurance, and are hence left to match homogeneously. Distributional measure-consistency requirements can also lead to pockets of homogeneous matching in heterogeneous matching regions. The exact matching pattern depends on the distribution of borrower types, although we show it remains non-monotone for any finite or continuous distribution. This result challenges the common assumption that joint-liability induces borrowers to form groups with partners with similar risk profiles. In missing market contexts, institutional innovations may spillover to fill other failures. This highlights, in particular, the necessity for empirical analyses to carefully account for the endogeneity of group characteristics, as a failure to so can seriously jeopardize the validity of decisions reached.