| Abstract: |
The paper attempts to find the socially best loan contract by comparing exante
welfare, interest and default rates of individual and group lending. We
introduce a general framework which allows auditing policies and interest
rates to be simultaneously determined by maximising the social welfare. Both
variables vary with the types of risk considered: independently identically
distributed and positively correlated risk. An individual project outcome is
private information of its owner, but reported outcomes can be audited at a
cost which then publicly reveals the true project outcome. We find that
incentive compatibility in a group loan context is delicate: the conditions
for truth telling vary with the borrowers’ perception of the overall solvency
of the group. In addition, group loans are often made to local groups who have
established local networks. This may mean that the group has cheaper policing
of truthtelling, but also that the risks on projects within the group are
likely to be correlated. To explore this, we numerically solve for the optimal
contracts with varying audit cost differences and correlation, using a
betabinomial distribution. We find that with an audit cost advantage, small
group loans (typically to two borrowers) dominate individual loans even with
correlation. But if audit costs are identical, the individual loan dominates.
In the larger the group, the higher the audit probability is required to
ensure truthtelling. Our finding provides an argument for why the number of
borrowers should be limited to 2-5. |