Re-examining the impact of frequent repayment schedule in microfinance

Many microfinance institutions require their clients to repay the loan in small amounts weekly or biweekly. Though widely acclaimed as useful tools to encourage (petty) savings and prevent default, the high frequency of repayment can also limit borrowers to shorter horizons and less ambitious projects. Two papers by Erica Field and her coauthors shed light on these negative impacts of frequent repayment. Both papers can be downloaded here.

In the short paper “Re-payment Frequency and Default in Microfinance: Evidence from India”, Erica Field and Rohini Pande used randomized controlled trials to estimate whether a longer repayment cycle (monthly instead of weekly) leads to higher default. They found no significant effect of type of repayment schedule on client default.

But their conclusions are highly limited to the particular context, as with many other researches in microfinance and development economics in general. Village Welfare Society (VWS), their partnering microfinance institution, is the only credit agency in the whole area and is considered by many as the only source of credit. So clients have a  bigger incentive to repay on time as failing to do so would lower their future ability of borrowing from VWS. The patterns of default and risk taking may be very different in contexts where multiple channels of credit are available.

In another (longer and more complicated) paper “Does the Classic Microfinance Model Discourage Entrepreneurship Among the Poor? Experimental Evidence from India”, Erica Field and her coauthors examined whether a two-month grace period would affect investment choices and default rates. Erica Field talks about this in 3ie-IFPRI seminar series. As their abstract says:

Using a field experiment, we compare the classic contract which requires that repayment begin immediately after loan disbursement to a contract that includes a two-month grace period. The provision of a grace period increased short-run business invest-ment and long-run profits but also default rates. The results, thus, indicate that debt contracts that require early repayment discourage illiquid risky investment and thereby limit the potential impact of microfinance on microenterprise growth and household poverty.

When offered a grace period, people tend to invest in bigger and riskier projects (e.g. giving credit to clients and allowing pre-order), and in the long-term they tend to do better in terms of profits. Grace period clients are less likely to report a business closure between loan disbursal and the three-year follow-up: 38.6% of the regular clients but only 31.4% of grace period clients report a business closure. But they also experience higher variation in business profits.

It seems that MFIs can also generate their revenues by offering their clients a grace period option with higher interest rates. Notice, however, that adverse selection kicks in as riskier people are more likely to take on the option in this self-selection process. It is observed in their survey that the default rates among grace period borrowers are significantly higher than regular borrowers.

The authors extrapolated the grace period contract to have two effects: a portfolio effect which makes illiquid investments more feasible and an income effect which increases total repayment time, making it easier for a client to accumulate income for repayment. They only addressed the portfolio effect in their paper. Dealing with income effect is more difficult because measuring client welfare gains requires a clear utility function for the clients, and the consumption levels of treatment and control groups before the intervention.


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