Microfinance institution and moneylenders in a segmented rural credit market

The poor heavily rely on informal sources for their capital needs as they lack collateral required by formal institutions. Furthermore, local moneylenders operate in distinct market segments and borrowing opportunities may not be equal for every household.The role of a microfinance institution (MFI) operating in such environment becomes even more crucial. The effectiveness of MFIs in rescuing poor borrowers from ‘clutches of’ moneylenders has been a much-debated topic over the last few decades. This paper attempts to contribute to this debate by presenting a model of competition between a socially motivated MFI and profit-maximising moneylenders in the presence of marketsegmentation. We characterise equilibrium conditions in the presence of market segmentation under scenarios where only moneylenders operate, only MFI operates and finally the case where both co-exist. We find unambiguous benefits arising from the entry of a welfare maximising entity such as an MFI. We also see the values of having local agents like moneylenders on the ground who have information gathering advantages. We conclude that an effective system of both these entities working together can bring about increases in efficiency and welfare. Key Words: microfinance, market segmentation, collateral substitution, mandatory savings, information asymmetry, moral hazard, adverse selection JEL Codes: D82, O16