Social Connections and group banking

Social Connections and group banking - The Economic Journal...

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SOCIAL CONNECTIONS AND GROUP BANKING* Dean S. Karlan Lending to the poor is expensive due to high screening, monitoring and enforcement costs. Group lending advocates believe lenders overcome this by harnessing social connections. Using data from FINCA-Peru, I exploit a quasi-random group formation process to find evidence of peers successfully monitoring and enforcing joint-liability loans. Individuals with stronger social connections to their fellow group members (i.e., either living closer or being of a similar culture) have higher repayment and higher savings. Furthermore, I observe direct evidence that relationships deteriorate after default, and that through successful monitoring, individuals know who to punish and who not to punish after default. Lending to the poor is a difficult task throughout the world, as attested to by the many projects that experience high default rates. Starting with the Grameen Bank in Bang- ladesh and FINCA village banking in Latin America, development policy makers have embraced group lending as a possible alternative for lenders to provide credit to the poor. Group lending typically links the fate of borrowers by stipulating that if one borrower within a group fails to repay her loan, the others in her group must repay it for her. This potentially works for a few reasons (which all rely on social connections): individuals are able to select creditworthy peers, are able to monitor each others Õ use of funds and ability to repay, are able to enforce repayment, or perhaps are more likely to repay merely because of altruism towards those in their group. I test whether groups that are more connected socially perform better and, specif- ically, whether this is a causal relationship from ex-post contract monitoring and/or enforcement. The empirical tests employed rule out selection or unobserved dimen- sions, such as economic opportunities, that coincide with social connections. FINCA- Peru has a group formation process that generates a natural experiment in which some groups are endowed with stronger social connections than others. I find that stronger social connections of the group lead to higher repayment and savings. While theoretical models have described the potential of group lending to overcome information asymmetries, little empirical evidence has been found to understand if and how group lending actually improves repayment rates (see Banerjee et al. , 1994; Besley and Coate, 1995; Ghatak, 2000; Stiglitz, 1990 and Varian, 1990). Cull et al . (2007) (this Feature), comparing institutional profitability of 124 institutions in 49 countries, find * I thank my advisors Abhijit Banerjee, Dora Costa, Esther Duflo and Sendhil Mullainathan for their guidance throughout this research. I thank eight anonymous referees, four editors and Niels Hermes, Robert Lensink. I also thank Alexander Aganine, Beatriz Armendariz de Aghion, Robin Burgess, Ben Jones, Leigh Linden, Norman Loayza, Cade Massey, Jonathan Morduch, Ashok Rai, Laura Schechter, Richard Thaler,
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