Competition and profit orientation in microfinance

Abstract

This study examines how microfinance lenders design their loan contracts to motivate borrower repayments under competition. We develop a model of an individual lending scheme in which a dynamic incentive mechanism is employed to mitigate borrower strategic defaults. We find that competition affects loan terms and borrower welfare in different ways depending on whether lenders are non‐profit or for‐profit. Non‐profits always charge the lowest feasible interest rate and show some degree of leniency toward defaulters by renewing their contracts. An increase in competition leads non‐profits to curtail leniency to a level that induces repayment, without affecting borrower welfare. In contrast, for‐profits charge the highest feasible interest rate and show no leniency to defaulters. They respond to competition by lowering the interest rate, leading to welfare gains for borrowers.