Long-Term Relationships, Group Lending, and Peer Monitoring in Microfinance : Experimental Evidence

Microfinance is generally associated with high repayment rates. However, it is not clear whether the success of microfinance results only from the use of group lending or mainly rely on peer sanctioning and long-term relationships that typically characterize microfinance contracts. In this paper, we aim to contribute to the existing literature by investigating experimentally the effect of each of these dimensions of microfinance. For this purpose we run a laboratory experiment that allows us to disentangle the effects of each of these components. Our findings indicate that group lending alone, in absence of peer sanctioning mechanism induces free riding and is not sufficiet to mitigate ex ante and ex post moral hazards. In sharp contrast, we find that individualized long-term relationships perform significantly better than group lending mechanisms with or without peer sanctioning. Consequently, borrowers’ final payoffs are lower in the group lending schemes than in the individual lending scheme due to the fact that borrowers receive on average fewer loans from lenders in the group lending schemes. Our study also sheds light on the social cost of peer pressure mechanisms. Finally, we observe differences across subject pools with social bankers making fairer credit offers than commercial bankers and students