Keeping the Little Guy Down: A Debt Trap for Lending with Limited Pledgeability

Abstract

Microcredit and other forms of small-scale finance have failed to catalyze entrepreneurship in developing countries. In these credit markets, borrowers and lenders often bargain over not only the division of surplus but also contractual flexibility. We show these lending relationships may lead to endogenous poverty traps for poor borrowers if future income is not pledgeable, yet richer borrowers unambiguously benefit. Improving the bargaining position of rich borrowers can harm poor borrowers, as the lender tightens restrictions and prevents them from growing. The theory rationalizes the low average impact and low demand of microfinance despite its high impact on larger businesses.