Optimal (partial) group liability in microfinance lending

This paper develops a model of group borrowing that incorporates partial group liability, where borrowers are penalized if their group members default but are not held responsible for the entirety of the failed loan. The model illustrates a trade-off of group liability lending: while higher levels of group liability increase within group risk-sharing, if liability is too high, borrowers strategically default. The model predicts the existence of an optimal partial liability that maximizes transfers between group members while avoiding strategic default. Consistent with this prediction, loan officers from a large microfinance institution in southern Mexico who rarely allow one group member to repay while the other defaults achieve substantially lower default rates than loan officers for whom the practice is commonplace or for those for whom it has never occurred. Structural estimation using repayment data suggests that while a partial liability below full liability may reduce default rates, the incidence of strategic default is rare.