Microfinance and Mechanism Design: The Role of Joint Liability and Cross-Reporting

Applying the mechanism design theory in microfinance
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This paper applies the mechanism design theory to microfinance, and examines the role of joint liability and cross-reporting in the loan contract designed by the lender.

The success of Grameen Bank in Bangladesh has been attributed to the joint liability mechanism which induces borrowers to help each other in hard times. This paper studies the Grameen group lending methodology and uses the principal-agent framework to analyze how the bank designs loan contracts with its borrowers. Further, it examines the joint liability theory in the context of adverse selection, the main problem in credit markets. The study identifies the following benefits of joint liability and cross-reporting to lender and borrower:

  • Joint liability minimizes adverse selection through peer selection and screening;
  • Joint liability can help in lowering interest rates, improving repayment rates, and enhancing social welfare;
  • Cross-reporting mechanism reduces the problem of asymmetric information in credit markets;
  • Cross-reporting helps to minimize deadweight loss and encourages borrowers to share risk.

The paper recommends that besides joint liability and cross-reporting, banks should consider using a combination of lending mechanisms including regular repayment schedules, sequential financing, and progressive lending.