Competing lending platforms, endogenous reputation, and fragility in microcredit markets

This paper shows that market fragility and mass default can arise in microcredit markets as a result of the strategic interaction between a microlender using a reputation-based mechanism and a traditional lender using physical collateral. In our model, borrowers solve a dynamic programming problem which induces an endogenous equilibrium distribution of reputational capital. Because the quality of each lender's pool of borrowers is affected by both lenders' interest rates, lender reaction curves are non-monotonic and discontinuous. This can result in knife edge equilibria and mass default on the microlender precipitated by minor parametric perturbations. Fragility is exacerbated by borrower screening and sovereign risk, but ameliorated when microlenders have social welfare goals. Our results highlight the importance of studying the entire credit market rather than microfinance in isolation.