How Does Microcredit Work? A Review of the Theories of Microcredit

The remarkable speed at which the reach of microcredit has expanded around the world in the last three decades has piqued the curiosity of practitioners and theorists alike. While assessing the impact of microcredit on the lives and livelihoods of the poor remains a contentious issue, there is no disputing the fact that there is something novel, something special, about microcredit that has allowed an altogether new mode of financial intermediation to emerge, providing credit to millions of hitherto ‘unbankable’ poor without breaking the lender’s back. That is an extraordinary achievement in itself. Theorists have been keen to unearth the secrets behind this remarkable achievement. In particular, they have tried to understand why is it that the special features of microcredit seem to work, at least in terms of embracing those who were previously excluded from the formal credit market, without compromising the financial viability of the lenders. This has led to an enormous outpouring of theoretical speculations, often drawing upon the latest theoretical advances in economics and finance. The ideas and tools developed in the economic theories of imperfect information, and in the related theories of screening, incentives and mechanism design _ which are themselves of fairly recently origin _ as well as the tools of game theory, have been enthusiastically applied by a new generation of economists to unearth the secrets of microcredit. The present paper tries to present the main contours of this theoretical journey in a relatively accessible manner. As a backdrop to microcredit theories, the paper begins by reviewing the old and new theories of the rural credit market. The major theories of microcredit are then reviewed under three different themes depending on the nature of market imperfection that a particular theory is concerned with - namely, ex ante moral hazard, adverse selection and strategic default or the enforcement problem.