Building an Honest Microfinance Organization: Embezzlement and the Optimality of Rigid Repayment Schedules and Joint Liability

The paper examines the agency problem of staff members managing microfinance programs; those who can abuse their discretion to embezzle borrowers' repayments. The paper addresses the question of 'how an organization that manages so much money in a corrupt society can remain honest'.The paper argues that:

• In poor countries, most borrowers of microfinance are illiterate;
• Means of transportation are primitive;
• They depend on the bank's representative to get information about their loans;
• This creates scope for misconduct and embezzlement.

The paper:

• Studies the optimal lending contract and the optimal supervisory contract;
• Assumes away any adverse selection or moral hazard at the level of the borrower;
• Explains two main features of the contracts used by the Grameen Bank - rigid repayment schedules and joint liability - as optimal responses to the bank staff's agency problem;
• Considers a simple model of hierarchy - a lender, a supervisor and borrower;
• Assumes that, when a cheating supervisor is discovered, the lender can recover the original payment made by the borrower, but cannot impose a fine on the supervisor because of limited liability.

The paper concludes that:

• Joint liability is the optimal response to the embezzlement problem;
• If borrowers can sign a side-contract for mutual insurance, the outcome of the optimal rigid contract under joint liability can also be achieved under individual liability.