A dynamic model of individual and group lending in developing countries

This paper examines the contract design problem of microfinance institutions seeking to maximize outreach to the poor while remaining financially sustainable. A dynamic model of group lending is developed that shows how optimal interest rates depend on information regarding moral hazard and adverse selection problems, correlated project risks, and strategic default. Relative to traditional static models, the results indicate a dynamic model better explains the current experience with individual and group lending in developing countries.