Peer group formation in an adverse selection model

This paper develops an adverse selection model where peer group systems are shown to trigger lower interest rates and remove credit rationing in die c ase where borrowers are uninformed about their potential partners and ex po st state verification (or auditing) by banks is costly. Peer group formatio n reduces interest rates due to a 'collateral effect', namely, cross subsid isation amongst borrowers acts as collateral behind a loan. By uncovering s uch a collateral effect, this paper shows that peer group systems can be vi ewed as an effective risk pooling mechanism, and thus enhance efficiency, n ot just in the full information set up.