A Model of Microfinance with Adverse Selection, Loan Default, and Self-Financing

Abstract

We 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. We use a game theoretic model that explicitly accounts for adverse selection and then we study the trinity of adverse selection, loan default, and self-financing. Our analysis leads to four results. 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.

Keywords: Adverse Selection, Loan Contract, Microfinance, Self-Financing

JEL Classification: G21, O12, D82