Ryan Hahn asks:
In the case of microfinance, however, it seems to me the problem of limited liability is rearing its ugly head. Poor borrowers generally have little or no collateral, so they usually have little reason to avoid a strategic default.
It is a common myth that microfinance loans have no collateral. I sooner worry that the process of collateralization is too thorough. Remember that microfinance loans are made to small groups of five to ten people, typically neighbors. If you don’t pay up, your associate has to. The reality is that the person left holding the bag — who knows you well — will come seize your TV set or in some cases the process is a bit less pleasant. Part of the efficiency of microfinance is simply the separation of the lending and the "thug" functions. Banks can lend to high-risk individual borrowers without themselves resorting to the illegal intimidation practices of the village moneylender. The dynamics of cooperative behavior in the village are not always pretty but overall it works better than the moneylender; if nothing else the person seizing the collateral knows that next time around he or she may be the non-payer. For more detail, see my Wilson Quarterly article with Karol Boudreaux.