Peer Group Formation in an Adverse Selection Model

Abstract

This paper develops an adverse selection model where peer group systems are shown to trigger lower interest rates and remove credit rationing in the case where borrowers are uninformed about their potential partners and ex post state verification (or auditing) by banks is costly. Peer group formation reduces interest rates due to a ‘collateral effect’, namely, cross subsidisation amongst borrowers acts as collateral behind a loan. By uncovering such a collateral effect, this paper shows that peer group systems can be viewed as an effective risk pooling mechanism, and thus enhance efficiency, not just in the full information set up.

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