Contract Structure, Risk Sharing, and Investment Choice

Few micro…nance-funded businesses grow beyond subsistence entrepreneur-ship. This paper considers one possible explanation: that the structure ofexisting micro…nance contracts may discourage risky but high-expected returninvestments. To explore this possibility, I develop a theory that uni…es modelsof investment choice, informal risk sharing, and formal …nancial contracts. Ithen test the predictions of this theory using a series of experiments with clientsof a large micro…nance institution in India. The experiments con…rm the theo-retical predictions that joint liability creates two ine¢ ciencies. First, borrowersfree-ride on their partners, making risky investments without compensatingpartners for this risk. Second, the addition of peer-monitoring overcompen-sates, leading to sharp reductions in risk-taking and pro…tability. Equity-like…nancing, in which partners share both the bene…ts and risks of more pro…tableprojects, overcomes both of these ine¢ ciencies and merits further testing in the…eld.[...]