Testing the impact of contracts to improve financial access for small firms

Access to finance for the purchase of productive assets is central to the success of small firms. This project studies three scalable financial instruments designed to address behavioural constraints that may limit small firms’ financial access, investment and technology adoption:

  • asset-collateralised loans (ACLs);
  • layaway contracts; and
  • a hybrid layaway-ACL contract.

ACLs, wherein the asset being purchased is itself used as collateral, are ubiquitous in developed countries (e.g. mortgages, car loans). However, such loans are much less common in the developing world and require high down-payments when available. Recent research (Jack et al. 2018) finds that ACLs may dramatically increase the take-up of loans while achieving high repayment rates. This could partly be because they address two behavioural barriers: the endowment effect and present bias.

Under the endowment effect, borrowers will be more willing to collateralise loans with the asset they purchase, rather than existing assets because they particularly dislike losing what they already own. However, once they obtain the new asset, their reference point may shift, making them averse to losing the asset and willing to work hard to repay the loan.

Under present bias, farmers may have difficulty saving, so may be unable to make investments. ACLs can serve as a commitment device for farmers who are sophisticated about their present bias. The commitment effect is particularly strong under the endowment effect since farmers experience a sense of loss if they default and lose the asset. However, repossession is also costly for lenders, therefore, lenders require substantial down-payments before offering ACLs.

Layaway contracts, in which the financial institution provides the asset once payments into the labelled account are complete, provide a softer commitment with a lower risk for both borrowers and lenders. This suggests a third type of contract, layaway contracts, with the option to convert to ACLs once a sufficient amount has been saved for a down payment to make the lender and borrower willing to accept the risk of an ACL.

The researchers aim to compare ACLs, layaway plans and the hybrid contract, through randomising contract offers among Kenyan dairy farmers to finance a rainwater harvesting tank and observing take-up and payments. They will use a Karlan-Zinman approach to separate out selection and treatment effects and will benchmark effects against randomised price variation. They will also estimate how loan demand and adoption respond to higher prices, which may be profitable for the lender.