How does Micro-credit Work? Risk-Matching, Diversification, and Borrower Selection Preliminary Draft

The micro-credit movement has used innovative lending techniques to push financial frontiers. Many micro-lenders operate in an environment with no collateral and limited information about borrowers. If borrowers vary in unobservable risk, individual lending contracts may involve safe borrowers cross-subsidizing risky ones, and thus may drive safe borrowers from the market. Ghatak (1999, 2000) shows that group-based, joint liability contracts embed an effective discount for safe borrowers, given that borrowers match homogeneously by risk-type. This discount can attract safe borrowers and revive a relatively dormant lending market. We extend borrower heterogeneity to a second dimension, correlated risk. We show that borrowers will anti-diversify risk within groups, in order to lower chances of facing liability for group members. We directly test homogeneous sorting by risk and intra-group diversification of risk using data on Thai micro-credit borrowing groups. Univariate tests involve calculating the between-group contributions of borrower differences in a village as well as rank correlations between borrower characteristics and group identity. Non-parametric tests show evidence of both homogeneous sorting by risk and risk anti-diversification within groups. Multivariate analysis based on Fox’s (2006) maximum score estimator gives some support to the univariate results by suggesting that homogeneous matching along both dimensions is profitable. We also quantify the degree to which theoretically predicted matching discounts are being realized in practice, and give some indication of the barriers to their realization. ∗I thank Yanqin Fan, James Foster, Jeremy Fox, Xavi Gine, Alex Karaivanov, Ethan Ligon, Andrew Newman, Moto Shintani, Rob Townsend, Jonathan Zinman, and seminar participants at Chicago, Georgia, Michigan State, Vanderbilt and NEUDC 2005 for valuable input. Jisong Wu provided excellent research assistance and computational algorithms. Do not quote without author’s permission. All errors are mine.