Grameen Bank

All micro-finance institutions face the problem of the absence of credit history and information of their borrower. The lender faces a problem due to its inability to verify either the borrower’s characteristics (e.g. nature of the project, risk involved, etc.), or to verify the borrower’s effort to realize profits. This leads to the problem of adverse selection where the lender is left with very little information about the quality of the borrower (whether a good/safe, or a bad/risky borrower.) As a result, the bank cannot charge a higher interest rate to compensate the risk of the bad/ risky borrowers as those rates might not be viable for the safe borrowers. This adverse selection problem of the bank is solved by the Grameen Bank lending model.
The crux of the Grameen Bank lending model is the feature of joint liability. This feature states that if a certain member of the group is unable to repay an instalment then the other members of the group are jointly liable to repay for them. This feature greatly reduces the problem of adverse selection.
The presence of joint liability induces the role of peer monitoring. Members of a group are forced to monitor activities and utilization of resources of the current borrowers within the group because if a certain borrower defaults the group as a whole would be jointly liable. This keeps in check the undertaking of any risky investments by any group member. This not only helps the lending institution in eliminating bad/risky borrowers but also reduces its monitoring cost.
Another effect of the joint liability feature is that of assortative matching. The concept of joint liability leads to endogenous group formation which states that borrowers would try to form groups with other borrowers sharing the same risk preferences. This means that safe borrowers would form groups with other safe borrowers rather than the risky borrowers in order to reduce the overall risk of the group and to benefit from lower interest rate. The