Lending to uncreditworthy borrowers

This paper models entry and competition in \"high-risk\" credit markets. An incumbent lender's advantage over any outside bank derives from its knowledge of (i) the risk profile of its (creditworthy) clients and (ii) uncreditworthy types in the borrower population. Screening is costly and the uninformed lender's ability to use collateral as a screening mechanism depends on its cost advantage over its informed rival. Nevertheless, the outside bank can pool uncreditworthy borrowers with creditworthy types, but only if it has a low cost of funds. Therefore, while a secular decline in the cost of funds does not help outside banks to screen uncreditworthy borrowers, it allows them to pool these borrowers with creditworthy types. This not only facilitates entry of outside banks into \"high-risk\" credit markets, but also makes it optimal for them to include non-creditworthy borrowers in their loan portfolio. The framework is relevant for explaining the recent entry of outside banks into the \"subprime\"-end of the loan market, for example, loans to the lowest end of small businesses in developing countries - also known as microfinance.