Keeping the Little Guy Down: A Debt Trap for Lending with Limited Pledgeability

Microcredit and other forms of small-scale finance in the developing world have failed to catalyze entrepreneurship. This prompts a re-examination of the special features of informal credit markets that cause them to operate inefficiently. We present a theory that highlights two of these features. First, the borrower has limited commitment and cannot pledge the benefits of her growth. Second, borrowers and lenders bargain not only over division of surplus but also over contractual flexibility (the ease with which the borrower can invest to grow her business). These two features lead to a poverty trap for poor borrowers, while unambiguously benefitting richer borrowers. The theory features nuanced comparative statics – improving the bargaining position of rich borrowers can harm poor borrowers, as the lender tightens restrictions on them to prevent them from growing. The theory facilitates reinterpretation of a number of empirical facts about microcredit: business growth resulting from microfinance is low on average, high for businesses that are already relatively large, and microlenders have experienced low demand.