Microfinance, subsidies and local externalities

We analyse equilibrium borrowers' effort and the cost of microcredit loans in the presence of moral hazard, project correlation and subsidies under group lending conditions. Our results show that under the assumption of endogenous effort, project correlation has significant effects on borrowers' effort only when it is determined by asymmetric (positive or negative) shocks. These findings indicate that the well-known negative effect of within-group (symmetric) project correlation on group lending with joint liability disappears once endogenous effort is taken into account. We also analyse the effects of subsidised lending (and asymmetric correlation) on the relative convenience (in terms of borrowers' effort) of the alternative (1) between group lending and individual lending with notional collateral and (2) among three different market structures of the microfinance industry