Mutual Loan-Guarantee Societies in Monopolistic Credit Markets with Adverse Selection

In many countries, Mutual Loan-Guarantee Societies (MGSs) are assuming ever-increasing importance for small business lending. In this paper we provide a theory to rationalize the raison d’être of MGSs. The basic intuition is that the motivation for MGSs lies in the inefficiencies created by adverse selection, when borrowers do not have enough wealth to satisfy collateral requirements and induce self-selecting contracts. In this setting, we view MGSs as a wealth-pooling mechanism that allows otherwise inefficiently rationed borrowers to obtain credit.