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

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.