Group lending with endogenous group size

Abstract

This paper focuses on the size of the borrower group in group lending. We show that, when social ties in a community enhance borrowers incentives to exert e¤ort, a pro t-maximizing nancier chooses a group of limited size. Borrowers that would be fundable under moral hazard but have insu¢ cient social ties do not receive funding. The result arises because there is a trade-o¤ between raising pro ts through increased group size and providing incentives for borrowers with less social ties. The result may explain why many micro-lending institutions and rural credit cooperatives lend to groups of small size