Contractual flexibility in the credit market, selection into borrowing, and firm growth: Experimental evidence from Bangladesh

• Evidence shows microfinance borrowing firms and households fail to see substantial increases in business growth or consumption resulting from loans.
• Researchers evaluated the direct and indirect effects of a new flexible BRAC loan contract through a randomised control trial.
• Results showed increasing repayment flexibility improved the effectiveness of microfinance loans in terms of business outcomes and reduced default levels.
• On the basis of the findings, BRAC has introduced a flexible loan contract under the seasonal loan scheme.

IGC collaborated with BRAC in Bangladesh to evaluate the effects of introducing a more flexible loan contract. The new contract was offered to two types of BRAC borrowers: small loans and SME loans clients. After a baseline survey, BRAC randomly introduced the new loan product in 25 branches. Researchers followed up the entire sample of eligible clients and SMEs to monitor both the direct effects of taking up the new loan contract and the selection effects it had on the types of borrowers who apply for new BRAC loans.

The research found that increasing repayment flexibility improved the effectiveness of microfinance loans in terms of business outcomes and reduced default rates among the eligible microfinance clients. Moreover, more productive entrepreneurs who want to expand their business activities wanted to become new BRAC clients. These findings suggest that offering repayment flexibility to clients who have demonstrated a good credit history under the standard loan contract may be one way to improve the effectiveness of microfinance loans and to unleash the growth potential of SMEs.

Fifty-seven percent of microfinance clients who were offered it took the flexible loan product. This lead to an increase in their business assets and revenues, but had no effects on their profits. Clients' household income increased, and they are more likely to own land. Overall, the findings imply that microfinance clients value flexibility. In line with this, the default rate diminishes significantly, which is consistent with the idea that clients would like to keep getting flexible loans in the future and therefore want to maintain a good relationship with the lender. As such, offering repayment flexibility to microfinance clients with a good credit history seems to be a win-win situation, both from the perspective of the borrowers and the lender.

Among SME clients, no significant effects on business outcomes were found, with the exception of labour: SME borrowers with flexible loan contracts are significantly more likely to hire new workers, suggesting that offering loans with repayment flexibility may be one way to increase job creation within the SME sector.

Finally, the findings imply that flexible loan products are particularly likely to attract entrepreneurs with highly productive businesses, who want to diversify and expand their business activities by starting up additional new business. This suggests that the introduction of such a loan may have significant impacts on the pool of borrowers who are attracted to microfinance.

On the basis of the findings and discussions with the researchers, BRAC has introduced a new flexible loan contract under their seasonal loan scheme. Similarly, a flexible loan is being offered to BRAC’s ultra-poor beneficiaries. Going forward BRAC will be providing flexible loan products where they deem repayment flexibility is beneficial to clients and is operationally viable.