Loans are given to individual group members, but the whole group is jointly liable for the repayment of each member's loan. Since borrowers from a given village are likely to have much better information about each other than an outside lender, the bank is able to induce the borrowers to screen out the bad risks using the instrument of joint liability. This process reduces one of the major sources of transaction costs in banking - screening a borrower to ascertain what kind of a risk a potential borrower is. A lender can try to deal with this information problem directly, by trying to assess these characteristics, or indirectly by offering loan terms that only good risks will accept. The typical method used to separate good risks from bad risks is to ask the borrower to pledge collateral.
Risky borrowers are likely to fail more often and lose their collateral.
Both methods are likely to be costly for lending to the rural poor in developing countries. A recent study by Signe-Mary McKernan, an economist at the US Federal Trade Commission, based on a large scale survey conducted in 87 villages in Bangladesh, provides evidence that a major cause behind the successful lending programme of the Grameen Bank is its ability to screen out bad credit risks. One example is group health insurance in the United States, under which the premium paid by the members of a group, such as workers in a firm, depends on the size, demographic composition and, to some degree, on the average claims made by the whole group. Another potential application is preventing abuse of targeted programmes such as poverty alleviation or welfare. A research report by Beatriz Armendariz de Aghion and Christian Gollier published in the same issue of the Economic Journal also focuses on microlending.