Moral Hazard Repayment Elasticity Threshold
Expert TheoryReview
Raising loan interest rates to compensate microfinance institutions for the higher default risk of flexible debt contracts increases borrower incentives to default strategically, establishing a tipping point beyond which private credit markets collapse.
Picture this
If a bank charges an extremely high interest rate because your business is risky, you start feeling that if your business succeeds, the bank takes almost all the profit. As a result, you lose the motivation to work hard and pay back the loan if things go slightly wrong.
What the evidence says
The maximum moral hazard repayment elasticity tolerable for a viable grace period loan product is 0.46 under adverse selection (and 0.80 without adverse selection); empirical literature benchmarks (Karlan & Zinman 2009) indicate real-world moral hazard elasticities often reach ~1.6%, explaining why commercial MFIs cannot offer grace period loans at market rates.
- Who was studied
- N = 845 urban MFI clients in Kolkata, India (simulated via numerical model calibration).
- How
- Model calibration evaluating the maximum repayment elasticity with respect to interest rate (percentage decline in repayment per 1 percentage point interest rate increase) that permits a zero-profit separating equilibrium.
What to do
Monitor repayment elasticity responses during flexible credit product trials to prevent interest rate increases from triggering strategic default tipping points.
From the source
"No separating equilibrium exists beyond an elasticity of 0.46, which is significantly lower than what has been estimated experimentally in other settings (Karlan and Zinman 2009)."
101_290 microfinance and entrepreneurship AER2013.pdf