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In many countries, Mutual Loan-Guarantee Societies (MLGSs) are assuming ever-increasing importance for small business lending. In this paper the authors provide a theory to rationalise the raison d' etre 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 collateralisable wealth to satisfy collateral requirements and induce self-selecting contracts. In this setting, they view MLGSs as a wealth-pooling mechanism that allows otherwise inefficiently rationed borrowers to obtain credit. They 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.
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