The Impact of Microfinance on the Informal Credit Market: an Adverse Selection Model

This paper looks at ‘the other side’ of the much-celebrated microfinance revolution, namely its potential impact on the conditions of access to credit for nonmembers (the residual market). It uses a standard adverse selection framework to show the advantage of group lending as a single innovative lending technology, and then to assess how the apparition of this new type of lenders might change the equilibria on rural credit markets, taking into account the reaction of other lenders. We find that two antagonist effects coexist: a standard competition effect and a selection effect. While the former tends to lower the residual market rate, the latter raises the cost of borrowing outside microfinance institutions (MFIs) due to a worsening of the pool of borrowers. The relative weights of the two effects depend on the market structure, the heterogeneity of the population and the actual distance between lending technologies. If the individuallending market is competitive, then the only possible effect is the increase of the interest rate charged by moneylenders, which will happen as soon as the pool of borrowers of the two types of lenders are overlapping. If traditional moneylenders have market power, then the two effects are at work. Even then, whenever a group-lending institution is present in the market, a monopolistic moneylender has to give up supplying credit to relatively safe borrowers, which can allow it to raise its interest rate (though making a lower profit). This arguably less intuitive impact of microfinance, which has been overlooked until now, is important given the nearly-universal coexistence of MFIs and traditional lenders in developing countries. Moreover, it is not only theoretically likely, but seems to match some empirical evidence presented in the paper. Our paper is thus a contribution in the understanding of the redistributive impact of the microfinance revolution that has been occurring in the last years.