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

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.