Solidarity and Microfinance

In this paper we analyze the role of peer solidarity in fostering productive investments in the context of microfinance. When there is asymmetric information between lenders and borrowers and loans are not collateralized, borrowers may divert loans towards current consumption rather than investing in production. We assume that solidarity is accorded by a network of individuals close enough to the borrower (peers) so as to share private information about hidden effort in the productive project. The model shows that peer solidarity might have contrasting e¤ects on the effort in the productive investment. On the one hand, since solidarity transfers are contingent on the effort, they increase borrower's incentive to invest. On the other hand, solidarity tranfers decrease the marginal utility of future consumption at the expense of productive investment. The predictions of the model are tested on households enrolled in micro-lending programs who were surveyed in Bangladesh by the World Bank during the period 1991-1992. Empirical findings suggest a positive relationship between the financial capability of borrowers' solidarity network and the share of loans invested in productive activities.