Underinvestment via Contract Design
When credit market institutions prioritize contract structures that minimize default risk, they unintentionally impose restrictions that prevent poor entrepreneurs from funding high-return, illiquid projects, generating widespread underinvestment.
Picture this
Imagine a bank offering loans to farmers but requiring them to pay back a chunk of cash every three days. Farmers who could buy fruit trees that yield huge harvests in six months are forced instead to grow low-yield radishes that ripen every three days just to meet the bank's schedule, leaving the town with much less food overall.
What the evidence says
Standard rigid microfinance contracts achieve high repayment rates (over 95%) but induce underinvestment by constraining borrowers to low-yielding liquid projects, forfeiting an average 41.0% increase in long-run weekly profits (Rs 640.9 top-coded).
- Who
- Theoretical synthesis and profit calibration based on 845 microfinance borrowers in Kolkata, India.
- How
- Market failure calibration model linking lender contract choice to entrepreneurial investment distortions.
What to do
Design credit policies that evaluate the social cost of entrepreneurial underinvestment alongside lender default risk when establishing lending guidelines.
From the source
"Thus, consistent with a large literature on asymmetric information in credit markets, it appears that the contract that maximizes MFI profits also creates inefficiencies via underinvestment."
101_290 microfinance and entrepreneurship AER2013.pdf