2004 Reports

Joint liability versus individual liability in credit contracts

Madajewicz, Malgosia

I compare welfare generated by a credit contract with individual liability and a contract with joint liability. The problem is credit rationing caused by limited liability and unobservable investment decisions. Joint liability induces borrowers to monitor each other, however the lender can also monitor. I show that wealthier borrowers may prefer riskier investments when liability is joint, which causes the lender to offer them smaller loans than he would if liability were individual, even if he cannot monitor the individual-liability loan. Therefore, wealthier borrowers prefer individual-liability loans. The result may explain why small businesses grow larger when funded with individual rather than with joint-liability loans. Poorer borrowers may prefer joint-liability loans, because borrowers monitor more efficiently, even when their monitoring technology is the same as the lender's, making joint-liability loans cheaper.