Collateral Substitutes in Microfnance

This paper studies the use of "collateral substitutes" in microfinance. It argues that:

• Microfinance institutions (MFIs) are perceived to face the twin disadvantages of operating in environments where collateral is scarce and diversion easy;
• Micro-lending uses social sanctions and credit denial as punishments for defaulting borrowers;
• These punishment mechanisms serve the role of collateral substitutes;
• However:
  • Successfully imposing social sanctions requires navigating a delegation problem,
  • Credit denial lacks market value and so may be prone to a severe adverse selection problem;
• Also, the use of credit denial as a punishment sets up the possibility of a non-repayment equilibrium, called "debtor run".

The authors conclude that:

• Under some circumstances, social sanctions can be effective even outside the joint liability setting;
• However, social sanctions become less effective if the individual imposing the sanctions is endowed with greater commitment ability;
• Credit denial is a threat that can be unilaterally invoked by an MFI; however, here, the lender does not actually know how much the borrower values future access to credit;
• High loan repayment rates are consistent with a severe adverse selection problem;
• Enforcement problem lies at the heart of credit provision;
• Loan sizes are smaller when collateral is scarce.

The authors question current policy views that microfinance should be made more competitive and profitable, and argue that the desire to have MFIs achieve self-sufficiency is unrealistic.