When is the Optimal Lending Contracts in Microfinance State Non-Contingent?

Designing appropriate lending contracts for group and individual lending
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This paper examines the optimal lending contract and supervisory contract in individual and group lending. It identifies the condition that determines whether the optimal repayment is state-contingent, where a state refers to a realized return of a borrower’s project.

Although a state-contingent loan can provide insurance for borrowers, the classic Grameen Bank model uses state non-contingent repayment, which forces poor borrowers to make their payments even under difficult circumstances. The paper examines the lending and supervisory contracts in group and individual lending, wherein a staff member can embezzle borrowers’ repayments by misrepresenting realized returns. Findings include:

  • Staff members can be induced to behave well through audit in group lending in case of state-contingent optimal lending contracts;
  • Mix of audit and incentive pay would work well for individual lending;
  • State non-contingent schedule is optimal if the cost of monitoring staff behavior is larger than the borrowers’ gain from full insurance;
  • Group lending is better for optimal lending contracts that are state non-contingent because it provides borrowers with partial insurance.

Finally, individual lending is as good as group lending if borrowers have an incentive to mutually provide insurance.

About this Publication

By Jeon, D. & Menicucci, D.