- Despite the pervasiveness of microfinance in developing countries, there are thought to be too few success stories of it enabling entrepreneurs to grow their business.
- One explanation for this is the rigid and frequent repayment schedules that borrowers tend to be bound to, which leads them to engage in “low-risk, low-return” business activities.
- Using a randomised control trial in Uttar Pradesh, India, this project sought to investigate whether giving borrowers more flexible repayment schedules improved both their business outcomes and repayment rates.
- Results show flexible repayment schedules lead to higher repayment rates and higher business sales.
- A comprehensive cost-benefit analysis for microfinance lenders offering these products is now underway, but for now, flexible loan products are being designed on the basis of this evidence.
Since the beginning of the microfinance experience, rigid and frequent repayments have proved to be an effective tool in helping microfinance clients commit to repaying their loans in the future. Nevertheless, a strict repayment schedule may represent one of the main growth constraints to entrepreneurship, requiring borrowers to stick to the well-known “low-risk/low-return” paradigm, as more profitable and riskier projects take longer to become productive.
Generically speaking, repayment flexibility allows borrowers to make larger investments and to insure themselves against negative cash-flow shocks. In developing countries in particular, flexible repayment schedules can be especially useful for microentrepreneurs, who are likely to experience irregular income streams but are constrained by a limited set of financial instruments to cope with volatile cash flows.
To test these predictions, researchers in collaboration with the microfinance lender Sonata designed a flexible contract that allowed borrowers to waive repayments during the loan cycle and to exercise this option whenever they needed it the most.
This flexible contract was given as an option alongside the standard rigid product to a number of individual borrowers who had approached Sonata for a loan in Uttar Pradesh, India. The repayment rates and business performance of flexible borrowers was then compared to those who were only offered the rigid product.
The results showed that firstly, flexible contracts are desirable for microfinance borrowers, even when they are more expensive than the standard rigid contract, with a third of those offered a flexible loan signing up. Secondly, after a year, weekly sales of those with flexible loans were 20% higher than those with rigid loans. Also, those with flexible loans had an increased variability in their week by week sales, suggesting that they are more likely to invest in high-risk and high-return business activities. Finally, borrowers under the flexible scheme were 5% less likely to be late on their monthly repayments, showing that flexible lending could also be beneficial for microfinance institutions.
This study has helped Sonata further develop the flexible loan products they offer, and researchers are now conducting a wider cost-benefit analysis for Sonata and other microfinance institutions (MFIs) based on these results. More generally, this study has helped to show how innovations in microfinance can not only benefit lenders, but also the broader economy by stimulating small business growth.