A rural development bank cannot afford to investigate each borrower's creditworthiness. When it requires borrowers to form groups with joint liability, which mechanism primarily solves the adverse selection problem at no cost to the bank?
APeer pressure — group members shame risky borrowers into behaving responsibly
BPeer monitoring — groups observe each other's investment decisions after loans are made
CPeer screening — borrowers use local knowledge to avoid forming groups with unreliable peers
DPeer insurance — group members pool savings to cover any defaults
Adverse selection (risky borrowers crowding out safe ones) is addressed by peer screening: borrowers have local information about neighbors' reliability that the bank could never cost-effectively obtain. By forming groups voluntarily, borrowers self-select with people they trust, doing the bank's due diligence for free. Peer pressure addresses willful default (a different problem), and peer monitoring addresses moral hazard (post-loan behavior), not pre-loan selection.
Question 2 Multiple Choice
After randomized evaluations of microfinance programs in India, Morocco, and elsewhere, what did researchers find about the impact of group lending on poverty reduction?
AAccess to group loans eliminated poverty for a majority of participants within five years
BMicrofinance was largely ineffective because borrowers defaulted at high rates
CGroup lending worked only in Bangladesh due to Grameen Bank's unique organizational structure
DMicrofinance modestly increased business activity and consumption smoothing, but did not produce the transformative poverty reduction early advocates predicted
Randomized controlled trials found that microfinance access produces measurable but modest improvements — more business activity, better consumption smoothing — without the dramatic poverty elimination early advocates claimed. High repayment rates (like Grameen's 95%+) measure a different thing from poverty reduction. Many participants used loans for consumption smoothing rather than business investment, and transformative effects visible in early case studies did not replicate at scale.
Question 3 True / False
Under the Grameen Bank model, joint liability — where one member's default causes all members to lose future loan access — creates incentives for peer monitoring that address moral hazard without requiring the bank to observe individual borrowers.
TTrue
FFalse
Answer: True
Moral hazard — taking excessive risk because others bear the downside — is precisely what joint liability targets post-loan. Because each member's future credit depends on everyone repaying, members have direct incentives to monitor each other's investment decisions and effort levels. The threat of losing future credit for the whole group means individual risk-taking has a social cost visible to peers, discouraging moral hazard without the bank monitoring each borrower individually.
Question 4 True / False
Because group lending relies on social collateral rather than physical collateral, it is universally superior to individual liability lending, which is why most major microfinance institutions have maintained joint liability structures.
TTrue
FFalse
Answer: False
This is false on both counts. Joint liability can create perverse effects: creditworthy borrowers penalized by unreliable groupmates may opt out, and excessive social pressure can harm welfare. The empirical record shows individual liability lending often performs as well as group lending. Grameen Bank itself shifted toward individual liability loans while retaining group meetings for social support — suggesting the information and monitoring benefits of group structure matter more than the formal joint liability contract.
Question 5 Short Answer
Explain why group lending can solve both adverse selection and moral hazard in credit markets even when the bank has no additional information about borrowers' types or actions.
Think about your answer, then reveal below.
Model answer: Group lending works because borrowers possess private information the bank lacks. For adverse selection: borrowers know who in their community is reliable, so voluntary group formation serves as screening — risky borrowers are excluded by peers who would bear the cost of their defaults. For moral hazard: once loans are made, group members monitor each other's effort and investment choices because their own future credit depends on everyone repaying. The bank outsources both information problems to agents who already possess the relevant local knowledge at zero additional cost.
The key insight is informational: the bank faces high costs to gather credit information, but borrowers already possess it about their neighbors. Joint liability creates incentives to use this information — for screening before loans (adverse selection) and monitoring after loans (moral hazard). Physical collateral solves these problems differently by giving the bank something to seize, but the rural poor lack assets. Social collateral substitutes by making the borrowers' own community relationships the enforcement mechanism.