Repayment flexibility, contract choice, and investment decisions among Indian microfinance borrowers

Since the beginning of the microfinance experience, rigid, and frequent repayments have proved to be an effective tool in helping microfinance clients to commit to repay in the future, by mitigating time- inconsistency problems. 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 before becoming productive. Borrowers’ difficulties to comply with repayment obligations, for entrepreneurial and consumption motives, have pushed several Microfinance Institutions to introduce some degree of flexibility during the loan cycle. Yet, evidence on the impact of repayment flexibility is quite limited and debated. Moreover, very little is known about which type of borrowers are more likely to select into flexible repayments contracts when these are made available by an MFI, and, in turn, how their business activities perform if their repayment obligations are waived for some time. This represents a crucial aspect for any MFI, as understanding borrowers’ preferences for repayment flexibility and relating these preferences to their customers’ characteristics (in terms of risk aversion, time preferences, business characteristics, entrepreneurial attitude) may limit MFIs’ default rates and costs associated to the provision of higher repayment flexibility.

This research addresses exactly this point. We will study the drivers and the impact of the choice for greater flexibility in microfinance contracts, in the form of repayment relaxation during the peak season of borrowers’ business activities. To this end, we will offer a set of new borrowers in India Bihar and West Bengal the opportunity to choose between a standard, rigid, individual lending contract and a flexible contract. Another set of borrowers will be kept as control and will borrow under the standard rigid contract offered by our partner MFI.The underlying intuition is that borrowers may prefer repayment relaxation during the peak season of their business activity, when their businesses are more likely to perform better in terms of sales and profits. During those months, repayment flexibility would allow them to further invest in their activity, without worrying about their repayment obligations. The credit contracts we propose (and which will differ in terms of costs) are intended to mitigate the mismatch between Customers’ Sales Cycles and Repayment Cycles, which may differ because of business seasonality. We will particularly focus on the festival period (given their importance and scale especially in the study areas, as mentioned earlier), the time of the year when this mismatch becomes more relevant.

Through a comprehensive and detailed questionnaire that will collect information upon borrowers’ business activities, savings and borrowing behaviour, time and risk preferences, as well as level of entrepreneurship, conscientiousness and use of time, our design will allow us to understand which borrowers will opt for the flexible contract, and will inform how repayment flexibility can mitigate seasonality effects in businesses.

Results from this pilot study will then be used to design and set up a broader Randomised Controlled Trial with different treatment arms that will allow us to study different forms of flexibility in microfinance contracts, being these exogenously given or endogenously determined by microfinance borrowers’ choice.