Separating the wheat from the chaff: Signaling in microfinance loans

• Published in: World development 2018-06, Vol.106, p.40-50
• Main Authors: Bauchet, Jonathan, Chakravarty, Sugato, Hunter, Brian
• Format: Article
• Language: English
• Subjects: Analysis; Credit ratings; Group lending; Health insurance; Insurance; Insurance coverage; Joint liability; Liability (Law); Life insurance; Loans; Mexico; Microfinance; Microinsurance; Repayments; Signaling; Studies; Wheat
• ISSN: 0305-750X; 1873-5991
• DOI: 10.1016/j.worlddev.2018.01.025

•We investigate whether microfinance borrowers signal their creditworthiness to the lender.•We analyze the purchase of costly voluntary insurance alongside the loan as the signal.•Borrowers who bought insurance were significantly more likely to fully repay their loan.•Insurance buyers also received larger loans on average.•Buying insurance indicates higher borrower quality and provides a direct benefit. We examine how microfinance borrowers might signal their repayment responsibility (i.e., borrower quality) by opting into (costly) life insurance purchase along with their micro-loans. We show empirically that borrowers who bought additional life insurance coverage were significantly more likely to fully repay their loan, and were allowed to receive higher loan amounts, even after controlling for borrower health and other determinants of loan repayment and insurance purchase. The relationship is stronger in magnitude for new borrowers’ first loan than for their second loan, and in several situations in which borrowers would have a higher incentive to signal their creditworthiness. We interpret this evidence as borrowers signaling their creditworthiness (or quality) by purchasing costly insurance in an environment subject to a high level of information asymmetries and devoid of credible tools to demonstrate creditworthiness.