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Contract structure, risk sharing and investment choice

  • Gregory 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://eprints.lse.ac.uk/41890/
    File Function: Open access version.
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    Paper provided by London School of Economics and Political Science, LSE Library in its series LSE Research Online Documents on Economics with number 41890.

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    Length: 60 pages
    Date of creation: Feb 2011
    Date of revision:
    Handle: RePEc:ehl:lserod:41890
    Contact details of provider: Postal: LSE Library Portugal Street London, WC2A 2HD, U.K.
    Phone: +44 (020) 7405 7686
    Web page: http://www.lse.ac.uk/

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    1. Wydick, Bruce, 1999. "Can Social Cohesion Be Harnessed to Repair Market Failures? Evidence from Group Lending in Guatemala," Economic Journal, Royal Economic Society, vol. 109(457), pages 463-75, July.
    2. Narayana Kocherlakota, 2010. "Implications of Efficient Risk Sharing Without Commitment," Levine's Working Paper Archive 2053, David K. Levine.
    3. Marcel Fafchamps & Susan Lund, 2000. "Risk-Sharing Networks in Rural Philippines," Economics Series Working Papers 10, University of Oxford, Department of Economics.
    4. Carlsson, Hans & van Damme, Eric, 1993. "Global Games and Equilibrium Selection," Econometrica, Econometric Society, vol. 61(5), pages 989-1018, September.
    5. John C. Harsanyi & Reinhard Selten, 1988. "A General Theory of Equilibrium Selection in Games," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262582384, June.
    6. Chowdhury, Prabal Roy, 2005. "Group-lending: Sequential financing, lender monitoring and joint liability," Journal of Development Economics, Elsevier, vol. 77(2), pages 415-439, August.
    7. Ghatak, M. & Guinnane, T.W., 1998. "The Economics of Lending with Joint Liability: Theory and Practice," Papers 791, Yale - Economic Growth Center.
    8. Guinnane, T. & Banerjee, A. & Besley, T., 1993. "Thy Neighbor's Keeper: the Design of a Credit Cooperative with Theory and a Test," Papers 705, Yale - Economic Growth Center.
    9. Udry, Christopher, 1994. "Risk and Insurance in a Rural Credit Market: An Empirical Investigation in Northern Nigeria," Review of Economic Studies, Wiley Blackwell, vol. 61(3), pages 495-526, July.
    10. Dean S. Karlan, 2005. "Social Connections and Group Banking," Working Papers 181, Princeton University, Woodrow Wilson School of Public and International Affairs, Research Program in Development Studies..
    11. Besley, Timothy & Coate, Stephen, 1995. "Group lending, repayment incentives and social collateral," Journal of Development Economics, Elsevier, vol. 46(1), pages 1-18, February.
    12. Sylvain Chassang, 2010. "Fear of Miscoordination and the Robustness of Cooperation in Dynamic Global Games With Exit," Econometrica, Econometric Society, vol. 78(3), pages 973-1006, 05.
    13. Christian Gollier, 2004. "The Economics of Risk and Time," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262572249, June.
    14. Eswaran, Mukesh & Kotwal, Ashok, 1989. "Credit as insurance in agrarian economies," Journal of Development Economics, Elsevier, vol. 31(1), pages 37-53, July.
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