Who does the grace-period really grace? Repayment flexibility in microfinance contracts

Repayment rigidity in microfinance contracts has always been crucial in order to discipline borrowers and ensure repayments. However, a strict repayment schedule might also inhibit entrepreneurship and force borrowers to undertake low-risk but also low-return investments. A possible solution is therefore to introduce more flexibility in the repayment mechanism. We build a simple adverse selection model where a monopolistic microfinance lender faces two types of present-biased borrowers who have different misperceptions about their future utility; the MFI's problem is to decide whether or not to provide a flexible repayment schedule within the microfinance contract. Our main result is that if the pool of clients is made of a sufficiently high share of entrepreneurial borrowers, it is always more profitable for the lender to provide both a rigid and a flexible repayment schedule than simply a rigid repayment contract. Surprisingly, it is still more profitable even though the contract doesn't perfectly screen out very present-biased borrowers who enter the flexible schedule but end up not being able to repay in the final period. However, this implies that more entrepreneurial borrowers are always charged a higher repayment rate in order to compensate the other borrowers' potential default.