Microfinance with divisible investment projects

In this paper we examine how the traditional results of the microfinance literature change under the project divisibility assumption. We show that, under standard debt contracts, loan size and borrower profits are unchanged when lending to uncollateralized borrowers with an individual lending or with a group lending/joint liability scheme, as the positive effect of the latter on bank risk is offset by a negative effect on borrowers’ optimal loan size. We also show that participated (debt plus profit sharing) loan contracts which reduce the lending rate (with respect to standard debt contracts) generate higher loan size and output, but lower borrower profits. Such contracts, however, cannot be enforced in presence of ex post hidden information, unless costly state verification by the lender is possible and economically convenient. We finally show that a problem of borrower heterogeneity may be solved by the lender with a participated loan/group lending scheme since, in this case, it is possible to devise a menu of contracts discriminating among heterogeneous quality groups. In such case we show that, under reasonable parametric conditions, a participated loan/group lending contract ensures higher profits to the high quality borrower than a standard debt individual lending contract.