The role of inequity aversion in microloan defaults

Abstract

Microcredit—joint liability loans to the poorest of the poor—has been touted as a powerful approach for combatting global poverty. But sustainability varies dramatically across banks. Efforts to improve the sustainability of microcredit have assumed defaults are caused by free24 riding. Here, we point out that the response of other group members to delinquent groupmates also plays an important role in defaults. Even in the absence of any free-rider problem, some people will be unable to make their payments due to bad luck. It is other group members’ unwillingness to pitch in extra – due to, among other things, not wanting to have less than other group members – that leads to default. To support this argument, we utilize the Ultimatum Game (UG), a standard paradigm from behavioral economics for measuring one’s aversion to inequitable outcomes. First, we show that country-level variation in microloan default rates is strongly correlated (overall r = 0.81) with country-level UG rejection rates, but not free-riding measures. We then introduce a laboratory model “Microloan Game,” and present evidence that defaults arise from inequity averse individuals refusing to make up the difference when others fail to pay their fair share. This perspective suggests a suite of new approaches for combatting defaults that leverage findings on reducing UG rejections.