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Contract Structure, Risk Sharing and Investment Choice

  • Greg Fischer
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    Few microfinance-funded businesses grow beyond subsistence entrepreneurship. This paper considers one possible explanation: that the structure of existing microfinance contracts may discourage risky but high-expected return investments. To explore this possibility, I develop a theory that unifies models of investment choice, informal risk sharing, and formal financial contracts. I then test the predictions of this theory using a series of experiments with clients of a large microfinance institution in India. The experiments confirm the theoretical predictions that joint liability creates two inefficiencies. First, borrowers free-ride on their partners, making risky investments without compensating partners for this risk. Second, the addition of peer-monitoring overcompensates, leading to sharp reductions in risk-taking and profitability. Equity-like financing, in which partners share both the benefits and risks of more profitable projects, overcomes both of these inefficiencies and merits further testing in the field.

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    File URL: http://sticerd.lse.ac.uk/dps/eopp/eopp23.pdf
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    Paper provided by Suntory and Toyota International Centres for Economics and Related Disciplines, LSE in its series STICERD - Economic Organisation and Public Policy Discussion Papers Series with number 023.

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    Date of creation: Feb 2011
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    Handle: RePEc:cep:stieop:023
    Contact details of provider: Web page: http://sticerd.lse.ac.uk/_new/publications/default.asp

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    1. Dean Karlan & Jonathan Morduch & Pamela Jakiela & Xavier Gine, 2006. "Microfinance games," Framed Field Experiments 00150, The Field Experiments Website.
    2. Dean Karlan & Xavier Gine & Jonathan Morduch & Pamela Jakiela, 2006. "Microfinance Games," Working Papers 936, Economic Growth Center, Yale University.
    3. Armendariz de Aghion, Beatriz, 1999. "On the design of a credit agreement with peer monitoring," Journal of Development Economics, Elsevier, vol. 60(1), pages 79-104, October.
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