The Role of Loss Aversion in Take-up and Repayment of Financing Contracts

In the developed world, when small businesses and consumers wish to purchase an asset, they often take a loan to purchase the asset and use the same asset as collateral for the loan. Yet this is not usual practice in most of the developing world due to difficult lending environments, which often have weak contract enforcement, weak legal institutions or regulatory caps on interest rates. In these settings, lenders may introduce restrictive borrowing conditions to minimize default risk. However, a recent study in Kenya (Jack et al., 2016) shows how relaxing collateral requirements for loans increased loans’ take-up without affecting default. A theoretical explanation is provided by the endowment effect (Kahneman et al., 1990), which could lead potential borrowers to prefer loans collateralized with new assets, since these loans do not put existing assets (the endowment) at risk. Furthermore, these behavioural factors imply that once a borrower acquires the asset, the latter will enter their reference point, and they will subsequently work harder to repay the loan. This project will therefore conduct a randomized controlled experiment in Kenya to test the role of behavioural factors in the observed high take-up rates and subsequent high repayments for asset-collateralized loans.

The project comprises two experiments. The first experiment analyses whether loans’ take-up for durable assets is higher if the new asset itself can be used as collateral for the loan, as compared to using a borrower’s existing assets of similar market value. Hence, the researchers will randomly endow all participants with one of two goods. After a time lag of a few weeks - so the first good enters their reference point - participants are then offered a loan to acquire the other good under (i) a standard loan (the participant uses the given good as collateral) or (ii) an asset-collateralized loan (the participant uses the newly acquired good as collateral). By comparing take-up in (i) and (ii) the researchers will observe whether the borrower will dislike the prospect of losing their existing asset more than losing the new asset, which is not yet in their reference point, even though the two items are similarly valued and the first item was randomly endowed. The second experiment studies whether asset-collateralized loans increase borrowers’ repayment rates due to loss-aversion over the collateral. Repayment will be compared in two types of contracts: (i) asset-collateralized loans and (ii) layaway contracts (individuals pay periodic instalments for the item and they receive it only if they complete the payments, otherwise they are given back the money).

Access to finance for the purchase of productive assets is central to the success of small enterprises. Yet credit markets are incomplete in many developing economies. This project will provide insights into behavioural factors shaping loan take-up decisions for durable assets and, in so doing, will inform the design of products that can increase access to finance in developing countries. The evidence on repayment behaviour will also illustrate the feasibility of asset-collateralized loans from the perspective of a lender, and welfare calculations will inform government regulations and subsidies to lenders. While this experiment will focus on less expensive assets for budgetary reasons, the same behavioural mechanisms is likely to apply for a range of assets purchased by small businesses and enterprises in low-income countries.


Gautam Rao

Harvard University

Michael Kremer

University of Chicago