Microfinance, subsidies and dynamic incentives

Dec 2007
Florida, USA, December, 18 2007 - This paper studies the interaction between subsidised microfinance lending and private, profit oriented lending. The authors build a two period model of a credit market with a monopolistic moneylender and a subsidized microfinance institution (MFI). They apply their model to explain why offering subsidized loans to agents who are poor due to previous project failure does not necessarily lead to moral hazard. Agents’ incentives to work hard and save will not always be distorted.

The authors identify a range of subsidy levels for which the behaviour of the moneylender complements the poverty reduction mission of the MFI. Small subsidies might even be beneficial to the private moneylender.

A subsidy larger than defined by the proposed range would still increase the distribution of microfinance loans to the poor. However, it would cause downward pressure on the interest rate charged by the private moneylender. Eventually, the subsidy could grow to a point where the moneylender cannot afford to offer loans. This would harm both the private moneylender and the poverty reduction mission of the MFI.

The authors conclude that using microfinance to allocate credit subsidies to the poor can work in tandem with a monopolistic moneylender, with each institution maximizing its respective objective function. The condition for this is that the level of the subsidy remains in a certain range. If this is the case the availability of subsidised loans will improve the terms that successful agents negotiate with the private lender and the negative dynamic incentives will be mitigated.


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