Adverse Selection and Moral Hazard in Joint Liability Loan Contracts: Evidence from an Artefactual Field Experiment

We design an artefactual field experiment to study the relationship between joint-liability lending and adverse selection, moral hazard and risk preferences. While theories concerning joint-liability lending have highlighted its ability to mitigate adverse selection in credit transactions, our experimental results indicate that joint-liability lending may actually induce problems of adverse selection. The results of our experiment, carried on in partnership with a Bolivian microlender, show that borrowers exogenously endowed with a risky project are disproportionately likely to choose jointly-liability contracts over individually-liable contracts. This behavior does not appear to be motivated by risk-diversification, but rather by free-riding, as these subjects disproportionally switch from safe to risky projects when exogenously given a joint-liability contract instead of an individual contract. Thus the results of our experiment offer a possible explanation why joint liability loans have diminished in popularity in recent years among both borrowers and microfinance lenders.