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A model of microfinance with adverse selection, loan default, and self-financing

  • Amitrajeet A. Batabyal
  • Hamid Beladi

Purpose – The purpose of this paper is to analyze a market for microfinance in a region of a developing nation in which all projects are either of high or low quality. There is adverse selection because only borrowers know whether their project is of high or low quality but the microfinance institutions (MFIs) do not. The MFIs are competitive, risk neutral, and they offer loan contracts specifying the amount to be repaid only if a borrower's project makes a profit. Otherwise, this borrower defaults on his contract. Design/methodology/approach – A game theoretic model is used that explicitly accounts for adverse selection and then a study is made of the trinity of adverse selection, loan default, and self-financing. Findings – First, in the pooling equilibrium, a borrower with a low-quality business project will obtain positive expected profit. In contrast, this borrower will obtain zero expected profit in the separating equilibrium. Second, for small enough values of the probability p that a business project is of high quality, MFIs will not finance any business project in the pooling equilibrium. Third, the cost of sending a signal is not too high and hence a separating equilibrium exists. Finally, under some circumstances, self-financing can be used to mitigate adverse selection related problems Research limitations/implications – This paper studies a model with only two types of business projects. In addition, no allowance is made for repeated interactions between borrowers and MFIs. Originality/value – This paper usefully shows that under some circumstances, a credible signaling device such as self-financing can be used to mitigate adverse selection related problems that routinely plague interactions between poor borrowers in developing countries and MFIs.

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Article provided by Emerald Group Publishing in its journal Agricultural Finance Review.

Volume (Year): 70 (2010)
Issue (Month): 1 (May)
Pages: 55-65

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Handle: RePEc:eme:afrpps:v:70:y:2010:i:1:p:55-65
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  1. Hartarska, Valentina & Nadolnyak, Denis, 2008. "Does rating help microfinance institutions raise funds? Cross-country evidence," International Review of Economics & Finance, Elsevier, vol. 17(4), pages 558-571, October.
  2. McIntosh, Craig & Wydick, Bruce, 2005. "Competition and microfinance," Journal of Development Economics, Elsevier, vol. 78(2), pages 271-298, December.
  3. de Aghion, Beatriz Armendariz & Gollier, Christian, 2000. "Peer Group Formation in an Adverse Selection Model," Economic Journal, Royal Economic Society, vol. 110(465), pages 632-43, July.
  4. Jonathan Morduch, 1998. "Does Microfinance Really Help the Poor? New Evidence from Flagship Programs in Bangladesh," Working Papers 198, Princeton University, Woodrow Wilson School of Public and International Affairs, Research Program in Development Studies..
  5. Dean Karlan & Jonathan Zinman, 2005. "Observing unobservables: identifying information asymmetries with a consumer-credit field experiment," Proceedings 961, Federal Reserve Bank of Chicago.
  6. Hindriks, Jean & Myles, Gareth D., 2013. "Intermediate Public Economics," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262018691, June.
  7. Andersen, Thomas Barnebeck & Malchow-Moller, Nikolaj, 2006. "Strategic interaction in undeveloped credit markets," Journal of Development Economics, Elsevier, vol. 80(2), pages 275-298, August.
  8. Laffont, Jean-Jacques & N'Guessan, Tchetche, 2000. "Group lending with adverse selection," European Economic Review, Elsevier, vol. 44(4-6), pages 773-784, May.
  9. Niels Hermes & Robert Lensink, 2007. "The empirics of microfinance: what do we know?," Economic Journal, Royal Economic Society, vol. 117(517), pages F1-F10, 02.
  10. Laffont, Jean-Jacques, 2000. "Collusion and Group Lending with Adverse Selection," IDEI Working Papers 95, Institut d'Économie Industrielle (IDEI), Toulouse.
  11. Ani L. Katchova & Mario J. Miranda & Claudio Gonzalez-Vega, 2006. "A dynamic model of individual and group lending in developing countries," Agricultural Finance Review, Emerald Group Publishing, vol. 66(2), pages 251-265, September.
  12. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
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