Mutual Loan-Guarantee Societies in Credit Markets with Adverse Selection: Do They Act as a Sorting Device? ISSN: 2279-9567

Mutual Loan Guarantee Societies (MLGSs) are crucial players in credit markets of many European and non-European countries. In this paper we provide a theory to rationalize the raison d'étre of MLGSs. The basic intuition is that the foundation for MLGSs lies in the inefficiencies created by adverse selection, when borrowers do not have enough collateralizable wealth to satisfy collateral requirements and induce self-selecting contracts. In this setting, we view MLGSs as a wealth pooling mechanism that allows otherwise inefficiently rationed borrowers to obtain credit. We focus on the case of large, complex urban economies where potential entrepreneurs are numerous and possess no more information about each other than do banks. Despite our extreme assumption on information availability, we show that MLGSs can be characterized by assortative matching in which only safe borrowers have an incentive to join the mutual society. In the last section, we show that the available evidence on the structure and performance of MLGSs active in Italy is consistent with some implications of our theory concerning their diffusion, the average number of their associates and the average default rate on guaranteed loans in developed and backward regions.