Incentives, Supervision, and Regulation of Microfinance Institutions in Developing Countries

This paper examines the optimal regulation of a microfinance institution (MFI) that possesses private information about the intrinsic quality of its loan portfolio (adverse selection) and exerts unobservable effort to improve this quality (moral hazard). The regulator, in designing optimal contracts, must balance the trade-off between incentivising efficient MFIs and the regulatory cost of providing information rents to high-quality MFIs. We derive the conditions under which optimal incentive contracts can be designed and demonstrate that these contracts depend on the accuracy of supervisory signals, the probability of encountering a high-quality MFI, and the cost of supervision. Importantly, since enhancing supervisory accuracy is itself costly, the optimal monitoring scheme generally allows for a positive probability of MFI failure. The structure of information disclosure is determined by the nature of this optimal monitoring arrangement.