Social Capital, Individual Incentives and Loan Repayment

Abstract: In the last few years the loan programs of several prominent microfinance institutions have moved away from group liability towards individual liability. The Grameen Bank, for ex-ample, has been relying exclusively on individual liability contracts since 2002. We investigate the question of social repayment incentives versus incentives generated through individual lia-bility in a theoretical model. We remove the usual assumption of exogenous social penalties, and consider the interaction between incentives generated through social risk-sharing and those gen-erated through a group-loan program that bootstraps on those incentives. In our model agents are heterogeneous, with differing degrees of risk aversion, and the setting is one of full information implying that strategic default is the only issue. We first consider a loan that depends purely on social enforcement. We show that the threat of exclusion from social risk-sharing fails to deter deviation by types below a cutoff, which could be quite high. Essentially, a loan program using social penalties does not add to penalties, but adds to deviation benefits, creating greater incen-tive to deviate simultaneously from social risk-sharing as well as the loan program. This reduces the fraction of types covered by the loan program. Further, coverage is decreasing in loan dura-tion. We then show that an individual loan program augmented by a mandatory savings plan can deliver greater coverage, and can even cover types excluded from social risk-sharing (i.e. types for whom social penalties are not available at all). Further, the coverage of an individual loan program increases with loan size as well as loan duration. The results offer an explanation for the observation by Giné and Karlan (2009) that, compared to group lending, individual lending does no worse in procuring repayment, and expands the scope of lending. Finally, we show that stronger social ties (greater underlying social cooperation) enhance the performance of individual loans. Thus fostering social cooperation is beneficial even though it has limited usefulness as a penalty under social enforcement of repayment. JEL classification: O12