Microfinance and Dynamic Incentives

Abstract

Dynamic incentives, where incentives to repay are generated by granting access to future loans, are one of the methodologies used by microfinance institutions (MFIs). In this paper, I present a model of dynamic incentives where lenders are uncertain over how much borrowers value future loans. Loan terms are determined endogenously, and loans become more favorable as the probability of default becomes lower. I show that in all equilibria but one all borrowers, including the most patient ones, eventually default. I then consider an extension where borrowers can take loans from several lenders, double-dipping. Qualitatively, properties of equilibria with and without double-dipping are similar. In absolute terms, when borrowers are credit-constrained double-dipping equilibrium loans have to be more favorable to outweigh increased gains from default.