Microfinance Games

Do endogenous group formations reduce moral hazard?
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This paper aims to demonstrate that the tendency towards free riding, seen in group-based lending mechanisms, also emerges in experimental settings that simulate microfinance transactions.The paper argues that:

  • The inefficiencies of group lending are allayed when customers are allowed to form their own groups voluntarily;
  • The endogenous formation of groups allows customers to sort into relatively homogenous pairings that limit the degree to which groups induce free riding and tax-safe behavior;
  • Endogenous group formation reduces moral hazard.

The authors describe the methodology as follows:

  • The simulations were implemented as a series of microfinance related experiments (or games) in Lima, Peru;
  • They took place in a local market populated with small-scale entrepreneurs;
  • The participants chose hypothetical risk projects, received loans and managed the risks of defaulting;
  • 491 participants played an average of eleven games over the course of seven months;
  • The approach involved modifying important parts of credit contracts in order to isolate specific features that drive successes and create tensions;
  • The controlled setting allowed identification of participants' choices as "risky" or "safe", enabling precise testing of hypotheses.

The paper concludes that:

  • Group-mechanisms reduce defaults;
  • Allowing participants to form groups by themselves helps to mitigate moral hazard and establishes the positive features of group banking;
  • The microfinance games played showed how strategic behavior and social concerns interact to yield effective contracts that work for both customers and lenders.

About this Publication

By Gine, X., Jakiela, P., Karlan, D. & Morduch, J.