Dynamic microlending under adverse selection: Can it rival group lending?

We derive an optimal lending contract in a two-period adverse selection model with limited commitment on the borrower side. The contract involves "penalty" interest rates after default, and favorable rates after success. Under some conditions, it also charges first-time borrowers higher rates than repeat borrowers, as in "relationship lending", because the lender is constrained to keep borrowing attractive while using revealed information to price for risk. We compare the efficiency of a group lending contract (of the kind popularized by the microcredit movement) to the dynamic, individual contract. Both types of contracts reveal the same information, but the contracts face different constraints on using the information to improve risk-pricing. As a result, either type of contract can lead to greater efficiency depending on specifics of the environment - opening the possibility that dynamic lending has played a role comparable to that of group lending in the success of microcredit. We also characterize the optimal dynamic group contract when both lending techniques are feasible, and find that it combines both approaches, but with varying emphases. A recurrent theme is that in more marginal environments, dynamic lending performs relatively better than, and is prioritized over, group lending. We also discuss a number of extensions, including (spatially and serially) correlated risk and the effect of competition. (C) 2014 Elsevier B.V. All rights reserved.