Simultaneous Borrowing and Saving in Microfinance

This paper studies dynamic incentives provided by the microfinance institutions (MFIs) to ensure repayment. MFIs provide collateral-free loans, and yet observe near perfect repayment rate. In this paper, we provide an explanation of two widely practised mechanisms by MFIs – progressive lending i.e. increasing loan size over time and deposit collection. In our model, the MFI provides both credit and savings services. These help a strategic, poor borrower to accumulate a lumpsum amount and “graduate†to an improved lifetime utility which is not achievable when only credit is provided. These savings also act as an incentive device for repayment. We find that the optimal loan scheme is weakly progressive. It is “progressive with a cap†when the increase in utility from graduation is “modestly positive†. Further, we show that, since the MFI is benevolent, an improvement in the borrower’s outside option lengthens the time required to graduate which in turn reduces her welfare.