Expansion and welfare in microfinance: A screening model☆

a r t i c l e i n f o The expansion of microfinance has triggered concerns of rising indebtedness, and higher default and interest rates. Using a screening model, we show that even if interest and default rates increase due to expansion, borrower welfare may improve. This is because: (i) all borrowers previously denied credit can obtain loans, and (ii) screening costs for pre-existing borrowers go down. Hence, policies that seek to regulate interest and screening levels can be counterproductive. Microfinance refers to the idea of providing financial services to low-income households, who are typically defined to be " non-bankable " by the traditional banking system. While there are some operational dissimilarities across countries, the fundamental idea—collateral-free lending to the poor—remains the core idea behind microfinance. Historically , microfinance originated as a benevolent institution—often with limited funds—designed to enhance the welfare of such poor households. However, over time, it has experienced high growth both in terms of access to larger funds, as well as the number of microfinance institutions (MFIs). This change in the scale of operations has led to several concerns like borrowers having easier access to credit, which, in turn, can lead to an increase in interest and default rates. 1 The main objective of this paper is to analyze the validity of these concerns and assess whether the consequent policy responses are in the right direction. We believe this is an important objective. This is because microfinance represents an important alternative source of credit, particularly for the poorer households in developing economies. Assuming that the borrowers behave rationally, access to microfinance is presumably welfare-enhancing for them. Therefore, policy interventions in this sector need to be rigorously analyzed, both theoretically and empirically. Our paper is a contribution in this direction. There is some empirical evidence that the growth of microfinance does lead to an increase in default rates. For example, in their study of the Ugandan microfinance sector, McIntosh et al. (2005) show that default rates have risen following an expansion of the MFI sector. However , the more interesting question is how the welfare of borrowers changes when the microfinance industry expands. In this paper, we develop a theoretical perspective that allows us to answer this question. Using a standard screening model, we show that an increase in the scale of operations in the MFI sector can, indeed, raise interest rates and default rates. Despite …