Simultaneous borrowing and saving in microfinance

Abstract

AbstractThis paper provides a rationale for one of the most widely practised mechanisms by microfinance institutions (MFIs)—simultaneous borrowing and saving. Unlike the existing literature, our explanation does not involve any behavioral aspect. We study a dynamic relationship between a benevolent MFI and a borrower who is subject to an ex post moral hazard problem. The optimum contract involves simultaneous borrowing and saving—at each date, the MFI provides a small loan, the borrower invests that in a production technology, and saves the net return with the MFI. These help her to accumulate a lumpsum amount and ‘graduate’ to an improved lifetime utility which is not achievable when only credit is provided. Over time, as her savings increase, her incentive to repay increases. The optimal loan scheme is weakly progressive, i.e. weakly increasing over time. We also provide a sufficient condition for the non-existence of any incentive compatible contract.