Essays on Microfinance under Weak Enforcement

Abstract

This paper theoretically and empirically studies the optimal lending contracts for both non-profit and for-profit microcredit lenders. I begin by building a theoretical model, where both types of lenders use dynamic incentives mechanism to mitigate borrower strategic default due to two reasons. First, competition among lenders increases the borrower’s outside options, thus lowering borrower’s cost of default. Second, lacking traditional enforcement technologies, such as no credit history check or collateral, weakens borrower’s incentive to repay. The model shows that, (i) as competition increases, both types of lenders ensure repayment by increasing ex ante threat to terminate loan renewal, and (ii) for-profit lenders are more likely to deny loan renewal than nonprofit lenders and charge higher interest rate. Furthermore, I find that borrower welfare under non-profit lending remains unchanged given any level of competition. But borrower welfare under for-profit is lower than under non-profit. I then provide empirical evidence on the implications (i) and (ii) derived from my model with a unique panel dataset from Bangladesh that contains itemized information on the lender’s financial statements. Identifying the effects of competition and profit motives (non-profit or for-profit) is challenging due to difficulty of mapping the model variables into the empirical setting. I overcome this by introducing multiple innovative proxies, and utilize fixed effects strategies to account for unobserved heterogeneity. Consistent with the theory, I find that higher competition and profit-motive induce lenders to maintain higher loan loss reserves ratio, suggesting potential increase in loan termination. The results shed light on the importance of introducing credit bureaus in the microcredit market to improve information sharing among lenders, which limits borrower’ outside options and reduces strategic default.