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

Listed author(s):
  • Amitrajeet A. Batabyal

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 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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References listed on IDEAS
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  1. Dean Karlan & Jonathan Zinman, 2009. "Observing Unobservables: Identifying Information Asymmetries With a Consumer Credit Field Experiment," Econometrica, Econometric Society, vol. 77(6), pages 1993-2008, November.
  2. Niels Hermes & Robert Lensink, "undated". "The empirics of microfinance: what do we know?," ULB Institutional Repository 2013/14198, ULB -- Universite Libre de Bruxelles.
  3. Laffont, Jean-Jacques & N'Guessan, Tchetche, 2000. "Group lending with adverse selection," European Economic Review, Elsevier, vol. 44(4-6), pages 773-784, May.
  4. 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.
  5. McIntosh, Craig & Wydick, Bruce, 2005. "Competition and microfinance," Journal of Development Economics, Elsevier, vol. 78(2), pages 271-298, December.
  6. Laffont, Jean-Jacques, 2003. "Collusion and group lending with adverse selection," Journal of Development Economics, Elsevier, vol. 70(2), pages 329-348, April.
  7. repec:pri:rpdevs:morduch_microfinance_poor is not listed on IDEAS
  8. 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.
  9. de Aghion, Beatriz Armendariz & Gollier, Christian, 2000. "Peer Group Formation in an Adverse Selection Model," Economic Journal, Royal Economic Society, vol. 110(465), pages 632-643, July.
  10. repec:eme:afrpps:v:66:y:2006:i:2:p:251-265 is not listed on IDEAS
  11. Jean Hindriks & Gareth D. Myles, 2006. "Intermediate Public Economics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262083442.
  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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