Subsidies and capital markets: implications for microfinance loan portfolios

I model a microfinance lender that receives subsidized funding from external investors who value the social impact of the lender. The impact depends on the lender’s type, which is not observable to the investors. In a pooling equilibrium, the subsidy raises the lender’s profit but distorts the loan portfolio choice of the low-quality lender. The lender’s portfolio choice can be improved two different ways. One is through a separating equilibrium, where the lender specializes in the type of lending at which it is most effective. The other is through arms-length contracting, characterized by less informed external investors. In this case, less information implies that the lender wastes less resources trying to justify access to subsidies.