Microfinance has been recognized as an effective tool in helping poor people and developing rural economy since its beginning in the late 1970s. Empirical research provides convincing evidence for its significant contribution to social development in various economies. However, we see huge variation at their performance level among different economies. Considering their immense impact on economic development and poverty reduction, it is important to understand sustainability of the microfinance institutions (MFIs). It is believed that the entry of MFIs would adversely impact informal sector lenders. It is puzzling that even with enormous growth of MFIs over the last few decades; we still see coexistence of these two forms of lending. I analyze how informational asymmetry may explain this coexistence. I develop a simple theoretical model to explore the role of informational constraint on the optimal contract offered by MFIs. Among other findings, we see that MFIs objective to screen good projects from the bad projects may put additional constraint in removing informal sector lending or in increasing borrowers’ payoff. In addition, in my thesis, I provide a review of empirical evidences on microfinance’s poverty reduction effect. Finally, I briefly discuss the issues related to sustainability of microfinance.