Peer Monitoring and Credit Markets

A major problem for institutional lenders is ensuring that borrowersexercise prudence in the use of the funds so that the likelihoodof repayment is enhanced. One partial solution is peer monitoring:having neighbors who are in a good position to monitor the borrowerbe required to pay a penalty if the borrower goes bankrupt.Peer monitoring is largely responsible for the successful financialperformance of the Grameen Bank of Bangladesh and of similargroup lending programs elsewhere. But peer monitoring has acost. It transfers risk from the bank, which is in a betterposition to bear risk, to the cosigner. In a simple model ofpeer monitoring in a competitive credit market, this articledemonstrates that the transfer of risk leads to an improvementin borrowers' welfare.