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

Agricultural Finance Review, Vol. 70, No. 1, pp. 55-65, 2010

Posted: 29 Jun 2010

See all articles by Amitrajeet A. Batabyal

Amitrajeet A. Batabyal

Rochester Institute of Technology (RIT) - Department of Economics

Hamid Beladi

University of Texas at San Antonio - College of Business - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: June 28, 2010

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. 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: Loan, Default, Developing Country, Game Theory

JEL Classification: D81, O12

Suggested Citation

Batabyal, Amitrajeet A. and Beladi, Hamid, A Model of Microfinance with Adverse Selection, Loan Default, and Self-Financing (June 28, 2010). Agricultural Finance Review, Vol. 70, No. 1, pp. 55-65, 2010, Available at SSRN: https://ssrn.com/abstract=1631988

Amitrajeet A. Batabyal (Contact Author)

Rochester Institute of Technology (RIT) - Department of Economics ( email )

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Hamid Beladi

University of Texas at San Antonio - College of Business - Department of Economics ( email )

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San Antonio, TX 78249
United States
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