(i)
Peer selection : The social pressure exerted by peers bound by group
lending contracts which entail joint liability for the borrowers helps to
mitigate the incentive to default. Because borrowers have better
information about each other, joint liability will lead to the grouping of
similar types. Morduch shows that by appropriately setting the interest
rate and joint liability payment, a group lending contract can provide a
way for the bank to price discriminate and improve repayment rates.
(ii) Peer monitoring : Another aspect of group lending contracts is that
borrowers have an incentive to monitor the investment of their peers,
leading all borrowers in a group to choose the less risky investments
and thus reduce the probability of default. This in turn enables the bank
to lower the interest rates, raising the expected utility of the borrower’s
investment projects. In a way, group lending leads to a win-win
scenario for the lender and borrower as a result of peer monitoring with
an attendant reduction in moral hazard and monitoring costs for the
bank.
(iii) Dynamic Incentives : Through the establishment of lender-borrower
relationships spanning long term horizons, the promise of streams of
increasingly larger loans and the threat to cut off lending when loans
are not repaid, dynamic incentives are exploited by microfinance
institutions as a mechanism reducing the borrowers’ incentives to
default. Although the power of this mechanism can be reduced by
competition among microfinance institutions and the availability of
12