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 non-members (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 can coexist: a standard competition effect and a composition 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 risk heterogeneity of the population and the actual distance between lending technologies. 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 the empirical facts presented in the paper. Our paper is thus a contribution in the understanding of the redistributive implications of the microfinance revolution that has been occurring in the last years.