Joint liability versus individual liability in credit contracts

I offer an explanation for the coexistence of joint-liability and individual-liability microcredit contracts. I show that both contracts maximize welfare when credit is rationed due to limited liability, but for different borrowers. Borrowers monitor each other when liability is joint, while the lender monitors individual loans. Joint liability offers poorer borrowers larger loans with less monitoring effort than would have to be exerted by the lender. Individual liability offers the wealthier among credit-constrained borrowers larger loans even without monitoring. The theory explains why individual loans serve the wealthier among poor borrowers and are larger, and why businesses funded with individual loans grow more.

Research highlights▶ Microcredit lenders lend to poor people using individual or group loans. ▶ Moral hazard constrains the size of the loan that a poor borrower can obtain. ▶ Group loans may be larger than individual loans for the poorer borrowers. However, incentives for the wealthier among the poor, credit-constrained borrowers may be better under the individual contract. ▶ For these borrowers, individual loans are larger than group loans and result in larger businesses.