Increased loan flexibility for clients with a good credit history improves client satisfaction and socio-economic status. It also attracts highly productive entrepreneurs who want to expand their business to take a loan, making this approach a win-win.
Microfinance has been heralded as an effective pro-poor policy instrument to ease the problem of credit rationing. However, recent evaluations of mainstream microfinance products have found little evidence of the transformative effects initially claimed by its proponents. Our research shows that one possible reason for the limited impact of traditional microfinance is the lack of flexibility, which is needed for poor borrowers to start or expand their businesses, affecting both how the loan is put to use as well as the type of clients who borrow.
Together with the BRAC microfinance programme in Bangladesh, we conducted a randomised control trial that evaluated the effect of a loan product with greater repayment flexibility.
The standard microfinance contract offered by BRAC entails:
- individual liability,
- a flat 25% annual interest rate,
- and a 12-month loan repayment cycle with monthly instalments of equal size.
The new flexible loan contract allowed borrowers to delay up to two repayments within their loan cycle through the use of repayment vouchers.
BRAC client survey
Credit officers in 50 BRAC branch offices selected clients/borrowers with good credit histories to receive the vouchers. Following this selection, we conducted a baseline survey of the eligible borrowers, as well as a survey of 3,500 small and medium-sized enterprises (SMEs) operating in similar sectors as most BRAC borrowers (light manufacturing and retail services).
After the baseline, 25 out of the 50 branches were randomly selected as “treatment” and the eligible clients were offered the flexible loan product. Moreover, within the treatment branches, we conducted an information campaign, informing the SMEs in our sample that BRAC was piloting a new flexible loan product and if they were interested, they may want to consider becoming BRAC clients. We then resurveyed the eligible borrowers and the SMEs in our sample one and two years after the baseline.
We find that 57% of the microfinance clients who were offered the flexible loan contract took it up. These borrowers:
- increased their business investment and revenues,
- had higher household income,
- were more likely to be landowners
- remained BRAC clients to a greater extent
- and were less likely to default on their loans.
This suggests that a large fraction of microfinance clients value the repayment flexibility that they were offered which improved client satisfaction, as well as their socio-economic status. Offering increased flexibility to clients who have demonstrated a good credit history can thus be a win-win situation, both for the microfinance institutions and their borrowers.
Assessing borrower type
To understand if the flexible contract attracts different types of borrowers, we examine whether the SMEs who were exposed to our information campaign, and then decided to become BRAC clients, are significantly different in terms of their baseline characteristics relative to those in the control SME branches.
We find that entrepreneurs who (at baseline) had higher profit per worker, expressed a desire to start a new household business, and were less risk averse, are more likely to become BRAC clients. We do not find evidence of differential selection in terms of other characteristics, such as the entrepreneur's schooling level, wealth, or whether he was present-biased.
Overall, our results imply that introducing flexible loan products is likely to have significant selection effects on the pool of borrowers. It has the potential to attract entrepreneurs with highly productive businesses, who want to diversify and expand their business activities by starting additional enterprises.
Our findings imply that offering a loan with greater repayment flexibility to borrowers with good credit histories may lead to business growth, while maintaining the low repayment rates that microfinance institutions are renowned to have. Moreover, such products are likely to attract more productive firms as microfinance clients. Both of these effects are expected to increase business growth and unleash the potential of SMEs.