Contractual Flexibility, Firm Growth, and Information Asymmetries in Microfinance: Experimental Evidence from Bangladesh

A randomized pilot experiment of BRAC Microfinance’s new flexible loan contract provides information on credit take-up, the pool of borrowers, and the potential for moral hazard abatement among microfinance borrowers. 

Experimental studies on microfinance show that loan demand remains low despite the large number of organizations offering credit. Moreover, borrowing firms and households fail to see substantial increases in terms of business growth or consumption. One explanation may be found in the details of credit contracts, and recent research suggests that the effectiveness of microfinance (in terms of business outcomes) can improve if contractual terms are altered, such as greater repayment flexibility. This research will aim to address the questions of what the direct effects of introducing greater repayment flexibility in microfinance contracts on borrowers’ repayment behaviour and business outcomes are, whether there are selection effects of introducing loan contracts with greater repayment flexibility on the pool of borrowers, and whether a flexible repayment loan contract can be used as a tool to reduce moral hazard problems within a microfinance institution’s (MFI) current and future client base if offered to clients with good credit histories.

To answer these questions, the researchers will partner with the BRAC Microfinance program in Bangladesh to randomize the pilot of BRAC’s new “flexible contract” loan product, which allows borrowers to delay two repayments within their loan cycle through the use of repayment vouchers and will first only be offered to those borrowers with good credit histories. By comparing profits and repayments of those who are offered flexible contracts and those that are not, the team will be able to identify the causal impact of the flexible contract. By also considering the profits and repayments of borrowers who recently joined BRAC but do not yet qualify for the flexible contract, considering their repayment behaviour will identify any incentive effects, if those borrowers wish to qualify in the future. The characteristics of new clients who join after the introduction of the experiment might also differ from existing borrowers, as they may be attracted by the premise of qualifying for a flexible loan in the future.

Recent work suggests that making the loan contract more flexible can improve the impact of microfinance on business outcomes but also increase the default rates of current borrowers. However, there is a lack of evidence on how increasing the flexibility of the standard microfinance contract affects credit take-up or the selection of clients who decide to borrow. This project tests for such selection effects, as well as the direct impact a flexible loan contract may have on an MFI’s current borrowers. These findings may influence the way in which many MFIs design their contracts, which in turn can affect firms’ access to capital and subsequent growth.