Asymmetric Information Separating Equilibrium Failure

Picture this

Imagine an auto insurance company that offers a policy covering risky stunt driving at a higher price. Safe drivers refuse to buy the expensive policy, leaving only reckless drivers in the pool. To stay afloat, the insurer raises prices even more, which encourages the remaining drivers to take even wilder risks until the whole insurance product collapses.

What the evidence says

Microfinance institutions must charge an interest rate of 38% APR (compared to a baseline 17.5% APR) to break even under adverse selection; if moral hazard elasticity exceeds 0.46, no zero-profit separating equilibrium exists at any interest rate.

Who was studied

N = 845 MFI borrowers in Kolkata, India (calibrated using experimental default data and willingness-to-pay survey data).

How

Empirical model calibration of microfinance lender profits analyzing client self-selection, stated willingness to pay, adverse selection, and moral hazard elasticities.

What to do

Utilize targeted public credit subsidies or loan guarantee reserves (calculated at approximately Rs 150 per client) to absorb default risk rather than attempting to price grace periods through higher interest rates.

From the source

"The calibration suggests that asymmetric information in credit markets is an important reason for the absence of grace period contracts: in the absence of moral hazard MFIs can break even when they offer existing clients the choice between the regular contract at 17.5 percent interest and a grace period contract at 37 percent. However, no such zero profit separating equilibrium exists if, in addition, study clients exhibit a modest amount of moral hazard..."

101_290 microfinance and entrepreneurship AER2013.pdf

Tags

• adverse selection
• moral hazard
• mfi sustainability