Contract Design and Microfinance Performance: A Global Analysis

Microfinance contracts have proven able to secure high rates of loan repayment in the face of limited liability and information asymmetries, but high repayment rates have not translated easily into profits for most microbanks. Profitability, though, is at the heart of the promise that microfinance can deliver poverty reduction while not relying on ongoingsubsidy. We examine why this promise remains unmet for most institutions. Using a newly-available data set with unusually high-quality financial information on 124 institutions in 49 countries, we explore the determinants of:

• Profitability;
• Loan repayment:
• Cost reduction.

We find that contract design matters substantially. Within limits,raising interest rates can be a helpful financial strategy for lenders. But, consistent with the economics of information, we find that raising interest rates too high can undermine portfolio quality and profitability for lenders that do not take advantage of group-based methods. For these individual-based lenders, one key to achieving profitability is investing more heavily in staff costs-a finding consistent with the economics of information but contrary to the conventional wisdom that profitability is largely a function of minimizing cost.

[Author's abstract]