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Microfinance Games

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The paper begins by highlighting the well-versed difficulties of banking in low-income communities – banks typically have limited information about their customers and often find it costly or impossible to enforce loan contracts and customers, for their part, frequently lack adequate collateral or credit histories with commercial banks. Moral hazard and adverse selection coupled with small transaction sizes, together limit the possibilities for banks to lend profitably. Yet, as the paper also notes, microfinance practitioners have been finding workable mechanisms through which to make small, uncollateralized loans to poorer customers.

Many of these mechanisms rely on groups of borrowers to jointly monitor and enforce contracts themselves. However, the authors of the paper suggest that group-based mechanisms tend to be vulnerable to free-riding and collusion. As they point out, inefficiencies are well-known to emerge in similar contexts: examples are documented in the literatures on public goods, the tragedy of the commons, insurance, and environmental externalities.

As such, the authors created an experimental economics laboratory in a large, urban market in Lima, Peru, and conducted 11 different games which allowed them to unpack microfinance mechanisms in a systematic way. This paper walks through the games that were undertaken and sets out the findings. The simulated microfinance transactions involved players choosing hypothetical risky investments, receiving loans, and managing the risk of default. The authors point out that by working in Lima and designing the games to replicate actual microfinance scenarios, their aim was to understand the logic of the mechanisms with individuals likely to participate in an actual microfinance program, but not to replicate exactly customers’ experience with microfinance.

The paper shows that the tendency toward free-riding also emerges in experimental settings that simulate microfinance transactions: moral hazard is exacerbated by simple group-based microfinance contracts. However, it shows that moral hazard is allayed by allowing customers to form their own groups voluntarily. Moreover, the mutual insurance induced by joint liability can allow borrowers to invest in profitable risky projects without reducing overall repayment rates. Given endogenous group formation, microfinance contracts do function effectively to reduce moral hazard and facilitate profitable risk-taking. The authors find that in the most “true-to-life” game, participants tend, in fact, to take too little risk relative to the optimum. The finding is consistent with a strong role for social factors in group settings. Furthermore, they find in particular that participants who have a propensity to take risks tend to reduce their risk-taking when their partners act more safely. The result is consistent with altruism or fairness, rather than profit maximization.

Following the introduction, section 2 of the papers discusses microfinance mechanisms that motivate the experiments. Section 3 then outlines the competing roles of ex ante moral hazard and mutual insurance that are at the heart of the study. Section 4 describes the lab setting and participant pool and section 5 presents the theoretical predictions and initial data that relate contract structure to individual choices. Section 6 then presents the main empirical results before section 7 concludes.

  • Resource type
  • Author Giné, X, Jakiela, P, Karlan, D and Morduch, J
  • Organisation
  • Year of Publication2006
  • Region
  • LanguageEnglish
  • Number of pages46 pp.
  • EditionWorld Bank Policy Research Working Paper

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