Default and Risk Premia in Microfinance Group Lending

For a risk neutral lender and a group of borrowers facing identical revenue risks we compare individual loans and group lending. We stress the importance of group liquidity in defining the necessary risk premium. There are no welfare differences between the loan forms. However, the default rates and risk premia vary ambiguously between the loan forms. Simulations replicating empirical interest rates and default rates show that the group interest rate is lower for a larger group while the effect of group size on default risk is ambiguous. We then consider the case of identical correlated risks between borrowers. Positive correlation of projects gives a higher downward risk, so a higher group interest rate and a higher fraction of successes are required. Unlike independent group lending, the interest rate and the default risk are not lower in the larger group loan with correlated returns. Simulations using beta-binomial distributionsare presented.