Key message 2 – Flexibility can boost entrepreneurial activity but also increase risk‑taking and defaults.

One of the major challenges within the traditional microfinance model is immediate and strict payment obligations, making it difficult for borrowers to use the money for productive investments. An IGC study by Field et al. (2013) examines whether immediate repayment obligations of the classic microfinance contract inhibit entrepreneurship and therefore diminish the potential impact of microfinance. The study compares the traditional contract, which requires that the repayment of microcredit loans begins immediately after loan disbursement, to a new contract that includes a two-month grace period.

The study finds the introduction of a grace period led to a significant change in economic activity: microenterprise investment was higher and the likelihood of starting a new business was more than double among clients who received a grace period contract. Moreover, nearly three years after receiving the loan, weekly business profit and monthly household income for grace period clients remained significantly higher than for traditional contract clients. However, the study also finds evidence of heightened risk-taking among grace period clients, and they were three times more likely to default than regular clients in the short run. Given such high risk-taking, an open question is whether subsidising microfinance institutions (MFIs) offering grace period contracts can encourage higher returns but riskier investments among poor borrowers 2.

In a companion study, Field et al. (2012), explored the impact of switching from weekly to monthly repayment frequency. The change more than doubled business income, increasing household income by 84–88%, and caused no increase in the default rate during the study period. The same study also found that clients were 51% less likely to report feeling “worried, tense, or anxious” and substantially more likely to report feeling confident about repaying.

These results suggest some simple changes to loan contract design could significantly enhance the effectiveness of microfinance. In particular, products providing higher flexible capital and loosening credit constraints at the start of the loan appear to effectively boost the entrepreneurial capacity of poor clients. However, there is an important caveat of higher default rates being associated with more flexible contracts. It is therefore important to know whom to offer the loans and flexible contracts to.

Why do most MFIs not offer a grace period or flexible contract at higher interest rates given the likelihood of bigger business profits for clients? It appears that lack of information about creditworthiness and the entrepreneurial qualities of clients plays an important role.

A market in Dhaka, Bangladesh. Photo: Getty | Munir Uz Zaman

 

Footnotes

  • 2 A complete answer will require knowledge of the welfare gain to clients and total subsidy cost to the government. However, Field et al (2013) show a subsidy of INR 150 per client would make the MFI indifferent between only offering the regular contract and offering both the regular and grace period contracts at the baseline 17.5% interest rate.