A little skin in the game: reducing moral hazard in joint liability lending through a mandatory collateral requirement

While joint liability group lending has been shown to resolve information problems in rural credit markets, the mutual insurance against default provided by such contracts is subject to moral hazard, resulting in the well-known free-riding problem. As with standard insurance, one solution to this problem is the imposition of a deductible, which under a joint liability contract amounts to an individual collateral requirement. Conceptually, such a hybrid contract should reduce morally hazardous behavior but have an ambiguous impact on credit market participation, as the collateral requirement would simultaneously crowd in and ration out different types of borrowers. In order to empirically test these effects, we employ a framed field experiment with credit group members in Tanzania. Our results show that the imposition of a modest (20%) individual collateral requirement in a joint liability group significantly increases effort supplied to the loan-financed project by 5% while reducing credit market participation by 7 percentage points. This amounts to an overall reduction in loan defaults of approximately 20%. Although we conceptually would expect the effect of the individual collateral requirement to vary by risk aversion and social connectedness, we find no such heterogeneous impacts in the data.