Competition and profit orientation in microfinance

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.