A recent study conducted in India, reveals that a flexible repayment option improves borrowers’ business outcomes without undermining repayment rates. Lenders in developing countries need to adopt a more customised approach towards borrowers.
Irregular income and flexible repayment
Borrowers who have irregular incomes often find it hard to adhere to frequent, rigid repayment schedules. Rigid schedules can also be less appealing to those who would like to invest in high-volatility or high-return business activities. Introducing repayment flexibility therefore represents a potential solution both to mitigate the mismatch between income realisation and repayments, and to boost investment. However, with flexibility comes an increased rate of default. So how can lenders have it both ways i.e. limit default rates while retaining flexibility.
Research from Uttar Pradesh, India shows that offering a flexible schedule as a more expensive contract option than the standard, rigid contract leads to higher business sales without undermining repayment rates. Over the last few years, microfinance literature has focused on the inability of microloans to propel borrowers’ business activities to grow beyond the subsistence level (Fischer, 2013).
Repayment flexibility, in the form of a grace period (Field et al., 2013) or a more generic “repayment holiday”, has been seen as a potential solution to increase business returns, as it allows borrowers to invest in more illiquid investment opportunities. It can also be beneficial to borrowers who have irregular income and might need this flexibility to be able to ‘’re-shuffle’’ their cash flows.
However, introducing repayment flexibility, can be costly for lenders: In fact, it may increase default rates (Field et al., 2013; Czura, 2015). This may explain why microfinance institutions are so reluctant to offer flexible repayment schedules.
We suggest a novel way to introduce repayment flexibility in microfinance contracts: offering it as a pricy contract option. The underlying hypothesis is that a more expensive flexible option filters out borrowers whose returns to capital are lower than the contract price (McKenzie and Woodruff, 2008). In addition, if borrowers value continuing their relationship with the lender, they will likely select the contract that maximises their chances to repay, based on their behavioural characteristics (Barboni, 2017).
In partnership with the Indian microfinance institution, Sonata Microfinance Ltd. (Sonata), we designed a flexible contract that allows borrowers to “waive” three repayments in a row during the loan cycle, and to exercise this option when they need it the most, by giving Sonata one month’s notice. Through a Randomised Controlled Trial (RCT), we then studied how offering this flexible contract, along with the standard rigid one, at different prices, performs in comparison with just offering a rigid microfinance contract.
We selected twenty-eight Sonata branches located in Uttar Pradesh. In half of them (chosen randomly), Sonata offered both the flexible and the rigid contract, priced at 26% and 24%, respectively; in the other half, only the standard, rigid contract was offered, at 24%.
About 800 microfinance clients were involved in the experiment. These were borrowers who had just graduated from group loans, and who were approaching Sonata to get individual business loans. The field operations started in the beginning of 2016, and we carried out a follow-up survey roughly eight months after.
One year after the start of the intervention, we compared the two groups of Sonata branches – those that were offered both the flexible and the rigid contract (treatment branches) and those that were only offered the rigid contract (control branches).
- Approximately one out of three borrowers in the treatment branches chose the flexible contract;
- borrowers in the treatment branches are 5% less likely to be late on their monthly repayments;
- weekly sales are 20% higher in treatment branches versus control branches;
- an increased variability of sales in treatment branches;
- a lower need for extra liquidity, in the form of additional requests for formal credit to Sonata, in treatment branches versus control branches.
Our results suggest that including a flexible repayment option improves borrowers’ business outcomes without undermining repayment rates. One caveat to the interpretation of our results is that we only have data for the first year of the borrowers’ loan cycle – additional survey rounds will be necessary to understand whether these short-term outcomes persist over time.
In addition, our novel design allows us to understand which borrowers’ characteristics drive the choice for rigid versus flexible contracts. We find that behavioural characteristics matter: time-consistent borrowers, those who draft a budget for their business activity more frequently, as well as those who worry more about household expenditures, are more likely to opt for the flexible versus the rigid contract. This suggests that more disciplined and forward-looking borrowers seem to highly value repayment flexibility.
Our experiment casts new light on the role of repayment flexibility and how it can be innovatively introduced into microfinance contracts in a way that is sustainable for lenders. More generally, our study shows that a screening mechanism, which builds on contract choice through different prices, could be implemented effectively to identify more entrepreneurial and financially sophisticated borrowers when lenders lack information on their quality.
From a policy perspective, our findings highlight the need for conducting further research that explores different ways of modifying contract characteristics and introducing repayment flexibility in microfinance contracts. The main objective of this research agenda is to guide lenders in developing countries to adopt a more customised approach towards their customers, catering to borrowers with heterogeneous business opportunities and financial needs, as well as different behavioural characteristics.