Bogus joint liability groups in microfinance

In a random sample of clients of CFPAM, the largest microlender in China, 73% of all joint-liability groups practice Lei Da Hu. That is, one person uses all group members’ loans in a single project. We call such borrower groups ‘bogus groups’. The Lei Da Hu practice violates a key premise of group lending, that each borrower must use their loan in a separate project (what we call ‘standard group’). We extend the theory of group lending by analyzing the endogenous formation and coexistence of standard and bogus groups and characterize the efficient lending terms. The chosen group form depends on the borrower productivities and probability of success. Bogus groups are formed by heterogeneous borrowers, when the gains from larger expected output exceed the foregone default risk diversification. Accounting for bogus groups in their lending strategy can help MFIs raise productive efficiency and borrower welfare.