Contract Structure, Risk‐Sharing, and Investment Choice

Few microfinance‐funded businesses grow beyond subsistence entrepreneurship. This paper considers one possible explanation: that the structure of existing microfinance contracts may discourage risky but high‐expected‐return investments. To explore this possibility, I develop a theory that unifies models of investment choice, informal risk‐sharing, and formal financial contracts. I then test the predictions of this theory using a series of experiments with clients of a large microfinance institution in India. The experiments confirm the theoretical predictions that joint liability creates two potential inefficiencies. First, borrowers free‐ride on their partners, making risky investments without compensating partners for this risk. Second, the addition of peer‐monitoring overcompensates, leading to sharp reductions in risk‐taking and profitability. Equity‐like financing, in which partners share both the benefits and risks of more profitable projects, overcomes both of these inefficiencies and merits further testing in the field.