Making loans to make friends: explaining the dismal financial performance of financial service associations

This paper investigates the ways in which microfinance provision can unravel and yield perverse outcomes that run counter to its stated objective. It presents a theoretical challenge to the Stiglitzian notion that large endowments of social capital induce inexpensive peer‐monitoring efforts which render jointly‐liable contracts efficient. Reliance on a specific set of assumed community characteristics that often do not adequately represent the incentive structure facing borrowers and lenders grossly overestimates the efficiency of informal finance institutions. In particular, by focusing on Financial Service Associations, a specific form of microfinance institution, the effectiveness of such institutions is found to be very sensitive to the behavioral motivations of both clientele and provider, as well as the social norms upon which such transactions take place.