Moral Hazard Repayment Elasticity
When microfinance institutions attempt to raise interest rates to compensate for higher default risk on flexible loans, borrowers may deliberately reduce repayment effort, undermining lender viability.
Picture this
If a bank doubles the interest rate on a loan, borrowers feel the bank is taking too big a piece of their hard work, so they become less motivated to work hard to pay it back, causing default rates to skyrocket.
What the evidence says
When moral hazard elasticity exceeds 0.46 (percentage fall in repayment per 1 percentage point rise in interest rate), no zero-profit separating equilibrium exists for grace period credit contracts.
- Who
- Model calibration based on 845 field experiment clients and survey willingness-to-pay data from 769 study participants in Kolkata, India.
- How
- Empirical parameter calibration measuring the elasticity of the loan repayment rate with respect to a one-percentage-point increase in interest rates.
What to do
Measure borrower moral hazard elasticity prior to adjusting interest rates on flexible credit products to avoid triggering unsustainable default spirals.
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"
101_290 microfinance and entrepreneurship AER2013.pdf