Building an honest microfinance organization: Embezzlement and the Optimality of Rigid Repayment Schedules and Joint Liability

Abstract

We consider the agency problem of a bank staff member managing microfinancing programs, who can abuse his discretion to embezzle borrowers' repayments. In this context, we study the optimal lending contract. The fact that most borrowers of microfinancing programs are illiterate and live in rural areas where transportation costs are very high make staff's embezzlement particularly relevant as is documented by Mknelly and Kevane (2002). We study the trade-off between the optimal rigid contract and the optimal discretionary contract and how joint liability affects the performance of each contract and the trade-off. Our analysis explains rigid repayment schedules used by the Grameen bank as an optimal response to the bank staff's agency problem. Joint liability reduces borrowers' burden of respecting the rigid repayment schedules by providing them with partial insurance. However, the same insurance can be provided by borrowers themselves under individual liability through a side-contract. We also find that the staff's agency problem creates biases in project selection toward projects of small scale and small risk.