A theory of interactions between MFIs and informal lenders

We provide a theoretical analysis of effects of entry of a microfinance institution (MFI) into an informal credit market which is segmented, whereby informal lenders derive some market power owing to privileged information concerning borrower-specific default risks. Relative to informal lenders, the MFI has a cost advantage and an informational disadvantage regarding borrower risk. Borrowers differ along another dimension: landholding, which is observable to all lenders. MFI entry is shown to induce selection effects (across risk and landownership dimensions) in shifts of borrowers from informal lenders to the MFI, which could raise informal interest rates, as observed in many LDCs. The model is consistent with evidence from Bangladesh and West Bengal, in contrast to hypotheses based on cream-skimming, scale-diseconomy-inducing, collusion-facilitating or crowding-in effects of MFIs on informal credit. The model implies that MFI entry is Pareto improving for borrowers, irrespective of effects on informal interest rates.