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Information Asymmetry in Microfinance

http://digitalcommons.unl.edu/cgi/viewcontent.cgi?article=5143&context=libphilprac

Information asymmetry is a major problem in many markets where people on one side of a transaction have more information than those on the other side of a transaction.  One example of a market where information asymmetry could exist is the credit market.  Borrowers, or those who wish to obtain credit, know more about the riskiness of the projects they wish to invest in than lenders, who wish to sell credit at a fixed interest rate.  While information asymmetry is always an issue in lending situations at conventional banks, it becomes a much larger issue in the realm of microfinance.  Microfinance is the market for issuing small loans at reasonable interest rates to impoverished individuals as a method of spurring economic development and empowerment in poor countries.

The attached research paper analyzes the presence of information asymmetry in microfinance banks in Oyo State, Nigeria.  These banks have played a large role in the development of poor, rural women in Nigeria, who would not have been able to access funds through a conventional bank.  In conventional banks, information asymmetry is partially alleviated through collateral or credit checks.  Thus, lenders can learn more about the creditworthiness of their borrowers before offering them a loan or assigning an interest rate for that loan.  For poor Nigerian women who spend most of their time working in the informal economy, they do not have a credit history or any sources of collateral.  Microfinance banks exist to provide funding to these people, even when lenders do not know which borrowers are good investments and which are bad investments.

Since microfinance banks incur a significant amount of risk when assigning loans to poor Nigerian women, they need to compensate by charging a higher interest premium on their loans.  When microfinance banks believe that there are more bad borrowers than good borrowers, fewer poor women who wish to obtain funds for profitable, viable investment purposes can obtain these high-interest loans.  Thus, microfinance banks have the potential to crowd out good borrowers and instead loan to bad borrowers who are more likely to enter risky investments and default on their loans.  This is an example of self-fulfilling expectations.  Despite this possibility of market failure, where microfinance banks would no longer find it profitable to lend to poor borrowers, this article concludes that microfinance banks are still thriving in Nigeria.

The significant takeaway from this article is that different methods are needed to ameliorate information asymmetry in microfinance as opposed to conventional finance.  In conventional finance, credit checks and collateral are sufficient for quality signaling.  However, the methods proven most effective for microfinance are group lending, social collateral, incentives, and flexible repayment methods.  Thus, borrowers are less likely to default on their loans and therefore become better borrowers; in turn, microfinance banks can lend to more people at lower interest rates, accomplishing their original goal of economic development.  In the case of the Oyo State of Nigeria, these microfinance banks are succeeding and continuing their noble efforts today.

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