Innovations in the repayment structure of microcredit contracts (2024)

Abstract

I. Introduction

Since its inception, the microfinance industry has taken pride in the ability of small, uncollateralized loans to provide millions of the world’s poor with the opportunity to become entrepreneurs and, as such, to acquire financial, economic, and social emancipation. Nevertheless, the main evaluations of microfinance programmes to date (Banerjee et al., 2015; Angelucci et al., 2015; Tarozzi et al., 2015, among others) have challenged this view by demonstrating that microcredit has limited and highly heterogeneous effects on socio-economic and financial outcomes. In recent years, a growing debate has emerged around the potential for changes in the structure of microcredit contracts to unleash the transformative impact of microfinance. Pioneered by the work of Field et al. (2013), a series of studies (Barboni, 2017; Aragón et al., 2020; Brune et al., 2022; Barboni and Agarwal, 2023; Battaglia et al., 2023) have asked what role contractual innovations that introduce flexibility in traditional microcredit loans could play to improve the business activities of microfinance borrowers. While this strand of research aligns well with increasing evidence that the recent expansion of Fintech has led to innovative lending products, particularly in advanced economies (Vives, 2017; Goldstein et al., 2019; Berg et al., 2022), its focus on disruptions to the classic features of microcredit loans—i.e. small loans, with frequent repayments and very little margin for re-negotiation—puts the whole microlending model under question.

The rationale for the rigid structure of standard microcredit loans is well captured in the words of Muhammad Yunus (1998) in his prominent book, Banker to the Poor, where he points out that

If the repayment time were to come six months or one year after the loan has been taken out, even if the borrower had the cash ready in his pocket, he or she would hesitate to give it back because it’s such a large amount and large amounts are difficult to part with.

Although the disciplinary nature of traditional microfinance contracts may ensure very low default rates (between 2010 and 2018, the average write-off ratio was 0.03 per cent1) and hence limit lending risk (Morduch, 1999), a major downside of this model is that it prevents borrowers from overcoming two critical barriers to business expansion: the need for big, lump-sum investments to kick-start the business (e.g. to purchase an asset that requires a large upfront investment, but whose return is uncertain, as shown by Field et al. (2013)); and cash-flow volatility (resulting, for example, from seasonal demand variation; Barboni and Agarwal (2023)).

Understanding which innovations in the status quo structure of microfinance contracts would allow borrowers to overcome these constraints to entrepreneurship represents a key question for the next generation of work on microfinance, and the focus of this article. In what follows, I review the contractual innovations in microcredit loans that have been studied so far, drawing comparisons from those available in advanced economies; I focus in particular on innovations in the repayment process of microfinance contracts. I discuss the main metrics used to assess their impact and potential for scalability, and comment upon their take-up rate, and the characteristics of borrowers seeking financial innovation. Lastly, I discuss how financial technology (Fintech) represents an opportunity for lenders in emerging economies to offer innovations in debt contracts, and reflect on the trade-off this may entail in terms of customers’ need for more flexibility vis-à-vis the pitfalls of providing complex contracts to populations that are traditionally less financially sophisticated (Célérier and Vallée, 2017).

II. A ‘standard’ loan?

Microcredit loans are debt contracts whereby borrowers, typically a micro or small entrepreneur lacking collateral, agree to a regular and constant repayment schedule, and the lender has the right to seize the whole cash flow when the repayment cannot be guaranteed. Figure 1 below gives a simple overview of a standard microcredit contract: the borrower repays at regular intervals and, as the loan approaches the end of maturity (expressed in terms of number of instalments on the x axis), the outstanding balance declines until full repayment.2 Microcredit loans typically provide businesses the opportunity to leverage a small amount of capital to create growth,3 as outlined in corporate finance theory (see, for example, Hart and Moore (1998)). In the context of microfinance, however, such loans are particularly important because often the only available alternative is informal, more expensive credit from moneylenders (Madestam, 2014; Hoffman et al., 2021). Debt contracts, including microcredit loans, also have downsides.4 For example, borrowers must make repayments regardless of their business revenue and income availability. Additionally, debt financing can be risky for businesses with volatile cash flow (Minton and Schrand, 1999).

A quick look at the MIX Market database reveals that microfinance contracts are not only similar in the repayment structure, but also in size and price: loans are typically small—95 per cent are under 6,000 USD, with a median loan size equivalent to 478 USD—and moderately expensive—with an average interest yield of 26 per cent.5

Although offering loans with small ticket size and regular repayments, as the one exemplified in Figure 1, may help MFIs minimize default rates and operational costs, it is not clear whether this approach allows borrowers to achieve the fullest gains from credit provision. Individuals without stable occupations and with few or no assets, as it is often true for those living in low- and middle-income countries (LMICs), are typically constrained by limited access to financial services and products (Demirgüç-Kunt et al., 2018). The liquidity they can avail of thanks to microfinance loans may trigger sustained economic growth only when these loans are provided at scale (Breza and Kinnan, 2021).

The question of which types of financial innovations are most appropriate to cater to microentrepreneurs’ needs has recently become the focus of a novel stream of the microfinance literature (Field et al., 2013; Barboni, 2017; Battaglia et al., 2023; Aragón et al., 2020; Brune et al., 2022; Barboni and Agarwal, 2023). Financial innovation is not a novel concept per se (see Allen and Gale (1994) or Tufano (2003) for a review of the topic). Yet, innovative financial products like derivative contracts, corporate securities, or pooled investment products, which were introduced in the financial markets of advanced economies in the 1980s/1990s, are rarely offered in emerging economies. Local prudential regulations, poor risk management practices, and inefficient institutional frameworks for lending limit the diffusion of financial innovations in these economies (Ilyina, 2004).6 Weak credit information infrastructures make lending risky for financial institutions in LMICs, and hence contribute to microfinance institutions’ reluctance to bring changes to their model (Luoto et al., 2007).7 Against this background, Fintech lending, which saw a rapid expansion in the last decade, holds the potential to disrupt traditional lending by improving screening and monitoring (Berg et al., 2022), thus offering novel opportunities for financial institutions operating in emerging economies to innovate.

III. Contractual innovation in credit markets

In this paper, as its title suggests, I focus on a specific family of financial innovations in the microfinance industry: contractual innovations in the repayment structure of microcredit loans. As such, I defer to another contribution in this issue of the Oxford Review of Economic Policy on the discussion of how financial innovation can help microentrepreneurs raise capital—i.e. through microequity (Meki and Quinn, 2024); or, of how microfinance lenders can automate some of their operations—e.g. through machine learning methods, as shown by Tantri, 2021; or with robo-advising, as studied by D’Ac*nto et al., 2019; or through digital payments (Annan et al., 2024). The innovations discussed in this article relate to introducing more flexibility in the typical repayment pattern, as shown in Figure 1, to accommodate borrowers’ financing needs which, in turn, should have positive effects on both business and repayment performance.

In advanced economies, financial institutions have long incorporated some degree of repayment flexibility into their consumer and business loans. This includes offering grace periods, which are periods of time after an instalment’s initial due date during which payments may still be made without penalty. Federal student loans typically have a 6-month grace period.8 Mortgage loans have a 15-day grace period; credit cards have a grace period of between 25 and 55 days.9 Another type of repayment flexibility that has become increasingly common, for example in the United States student loan market, is income-driven repayment (IDR) contracts, where the amount borrowers repay each month is tied to their monthly income. By accounting for income shocks, IDR contracts have been shown to reduce delinquency rates and improve financial outcomes (Herbst, 2023). Finally, the diffusion of multinational, e-commerce platforms such as Amazon has given rise to the creation of innovative loans to cater to their merchants’ need to bulk-buy inventories and stock up ahead of peak sales events.

(i) How contractual innovations look in microfinance loans

The contractual innovations mentioned in the previous paragraph are hardly observed in microfinance contracts, raising the question of how to increase their supply from the microfinance industry. Since microfinance borrowers typically lack collateral (Morduch, 1994) and stable income (Fafchamps, 2013), innovative lending represents a risky proposition for lenders—and yet, these are precisely the reasons why contractual innovations should be provided in the first place. In what follows, I review the main contractual innovations evaluated so far in the microfinance literature: the introduction of a grace period and the provision of a repayment flexibility option. I also consider credit lines and income-contingent repayment loans, which constitute a more generalized version of repayment flexibility in credit contracts and discuss their applicability to microfinance loans.

Grace period at the beginning of the loan cycle

For borrowers to make the most out of their loans, it is important that financial constraints are not only relaxed, but that it happens in a timely manner. A critical moment when liquidity demand is the highest coincides with the beginning of the loan cycle, when the initial borrowed amount needs to be invested in high return, but illiquid, projects. In those instances, a grace period immediately after loan disbursal may allow borrowers to make investments that increase their ability to deal with shocks, and that would be too risky otherwise.

Figure 2 shows a simplified version of the grace-period contract that was evaluated in Field et al. (2013) through a randomized controlled trial (RCT). Borrowers assigned to the treatment group received a 2-month grace period before the repayments started, whereas those in the control group began repaying immediately after the loan disbursem*nt, ending their loan tenure earlier than those in the treatment group (by an amount of time exactly equal to the grace period). While I refer the reader to section IV for an extensive discussion of the impact of this contractual innovation on business outcomes and repayment rates, it is worth noticing that Field et al. (2013) find that delaying repayments, particularly at the beginning of the loan cycle, increased borrowers’ likelihood to start or expand their business—particularly through investment in assets (e.g. a sewing machine) or bulk purchase of inputs. This raises the question of whether the implicit liquidity injection that comes with providing a grace period may lead to the same impact on business and repayment outcomes as offering borrowers a larger loan size to start with. While theoretically the two strategies could be considered as equivalent—they both result in a buffer to accommodate the repayment of the first instalments—to the best of our knowledge, they have never been compared empirically.

Providing ‘repayment holidays’ options through the loan cycle

Another major challenge to business growth microentrepreneurs operating in LMICs face is cash-flow volatility. Irregular cash flows increase costs of external capital and negatively affect investments and profitability (Minton and Schrand, 1999). Mitigating cash-flow seasonality through contractual innovations holds the potential to improve business outcomes and to reduce delays in debt repayment by relaxing liquidity constraints throughout the loan cycle, as opposed to only early in the loan cycle, as shown by Field et al. (2013). However, the extent of cash flow irregularity is unpredictable. In these cases, one solution is to provide borrowers with an option to delay their repayment obligations—i.e. to give them the right, but not the obligation, to waive repayments.10

This is the intuition behind Barboni and Agarwal’s (2023) paper, which looks at the impact of providing a 3-month repayment holiday at the borrower’s discretion on repayment and business outcomes. The length of the repayment holiday was set to meet variation in business demand among the target population, mostly small business holders in northern India who face peak and lean seasons that typically last about 3 months each. Figure 3 (left panel) provides a graphical depiction of this flexible contract. Again, in the standard, regular contract, borrowers must repay equal, monthly instalments (which include principal plus interest) until maturity. The flexible contract, in contrast, allows borrowers to suspend payments for a period of 3 months during the loan cycle. At the end of this repayment holiday, repayments resume, and the residual outstanding amount is spread over the remaining instalments. As a result, the size of the instalments after the repayment holiday is larger than before the repayment holiday—this is different from the flexible contract studied in Field et al. (2013), where the inclusion of a grace period resulted in a longer maturity.

For borrowers, demand seasonality is both a barrier to entrepreneurship and a business opportunity to seize, which repayment flexibility can help navigate and take advantage of. Yet, micro and small entrepreneurs can also be exposed to other types of shocks throughout the loan cycle (e.g. an illness, loss of inventory, etc.), which may jeopardize their business operations and have long-lasting effects on their productivity. In those cases, a solution is to let them benefit from skipping one or more repayments throughout the loan cycle. This motivates studies like those by Battaglia et al. (2023) and Brune et al. (2022), where repayment flexibility comes in the form of a ‘pass’ or a ‘voucher’, which borrowers can use multiple times, and either separately or consecutively, as shown in the right panel of Figure 3.

Credit lines and income-contingent repayment plans

The ‘optional’ nature of the flexible contracts studied in Barboni and Agarwal (2023), Battaglia et al. (2023), and Brune et al. (2022) presents many similarities with a line of credit (Sannikov, 2007; Aragón et al., 2020; Lane, 2022), whereby borrowers can adjust their repayment—as well as their borrowing—amounts as needed based on their cash flows. Additionally, contracts that offer borrowers the option to skip repayments when they experience changes in available liquidity provide a proof of the viability of contingent-repayment loans in LMICs. As documented by Fafchamps and Gubert (2007), one way for borrowers to cope with shocks is to delay repayment. Yet, if such debt rescheduling is not provided as a contract feature—as for example in the context of sovereign debt (Aguiar and Amador, 2014)—borrowers who experience a shock and delay payments would end up being considered in arrears or default.

IV. Contractual innovations and underlying mechanisms

(i) Investment or insurance?

The financial innovations reviewed in the previous sections represent a new direction for a more customer-centric approach in the microfinance industry; yet their characteristics and the way they can be made available by lenders also offer the unique opportunity to observe economic and financial mechanisms at play. For example, the vouchers to skip repayments studied by Battaglia et al. (2023) allow the authors to test two main channels underlying the provision of repayment flexibility: first, the relaxation of credit constraints resulting from the opportunity to accumulate a larger buffer before repayments are due; second, the provision of implicit insurance stemming from the use of repayment flexibility in response to a shock.11 The authors find evidence for the second channel.

(ii) Selection effects

For flexible contracts to be viable, it is key that they attract borrowers who are more suitable to take advantage of the opportunity (e.g. those with business potential or who are financially educated). These borrowers are in fact better equipped to leverage repayment flexibility to seize new business opportunities and to manage resources in the face of income shocks, while also ensuring high repayment rates. Conversely, if the flexible contract is taken up by borrowers who would increase consumption without making further investment, credit risk may increase. It follows that a major question in the debate on the scalability of financial innovations centres around clients’ demand for such contracts, and to how they should be made available when lenders cannot acquire adequate information on the quality of their clients. Barboni (2017) provides novel evidence of borrowers’ selection of flexible contracts: higher-revenues borrowers are more likely to take up repayment flexibility, particularly when these loans are more expensive than the standard contracts. Her results indicate that the demand for flexible loans is driven precisely by those borrowers who would benefit the most from repayment flexibility. Barboni and Agarwal (2023) expand on Barboni (2017)’s insights and find that offering a menu of contracts that vary in repayment flexibility and price makes borrowers self-select in the contract that ex ante reveals their type: borrowers with higher cash-flow volatility and greater financial sophistication are more likely to choose contracts with higher flexibility and higher interest rates. Battaglia et al. (2023) add to these results by showing that borrowers opting for the flexible contracts tend to be less risk-averse and hence more willing to expand their business.12 All in all, these studies provide evidence that financially sophisticated borrowers value repayment flexibility and suggest that lenders may be forgoing profits by not offering financial innovations.

V. Comparing contractual innovations across existing studies

In this section, I compare the main metrics used in the studies discussed in the previous paragraphs to assess the impact of repayment flexibility across contexts and types of contractual innovations. Table 1 below reports, for each evaluation, both the characteristics of the setting and of the contract under study and its effects on profits and other socio-economic outcomes.13 This table has been readapted from a recent J-PAL’s report on microcredit (Abdul Latif Jameel Poverty Action Lab (J-PAL), 2023): in addition to the metrics included in that report, here I also discuss the price of the financial innovation, its take-up, and the organization/institution that implemented that particular innovation. This is to reflect not only on the supply of contractual innovations but also on their demand among borrowers, as well as on the financial viability of contractual innovations from the implementing partner’s perspective.

Price of the flexible contract:

Following the intuition that, to screen out borrowers who are not suited for repayment flexibility, lenders should offer this contractual innovation at a higher price, Barboni and Agarwal (2023) is the only study to date to evaluate a flexible contract that is more expensive than the regular one—with the flexible contract being offered at a 2 percentage point higher interest rate than the regular contract. Both in Battaglia et al. (2023) and Brune et al. (2022), as well as Field et al. (2013), the flexible contract is offered at the same price as the traditional microfinance contract. Particularly when the contractual innovation entails a longer maturity (as is the case in Field et al. (2013)), this also implies that clients assigned to the grace-period contract faced a slightly lower effective interest rate.

Take up:

There seems to be variation in terms of take up of the flexible contract—which ranges from 55 per cent in Battaglia et al. (2023) to 30 per cent in Brune et al. (2022). Additionally, it is worth emphasizing that, precisely because of the optional nature of the contractual innovation in all studies but Field et al. (2013), not all borrowers ultimately chose to postpone repayments. For example, in Barboni and Agarwal (2023), 56 per cent of borrowers ultimately used the repayment holiday option, whereas in Battaglia et al. (2023) this share ranges between 57 and 69 per cent. All in all, these figures indicate that borrowers do value the provision of contractual innovations in the form of the repayment flexibility (Gamba and Triantis, 2008), even if they do not necessarily end up benefiting from it.

Effects:

Except for Brune et al. (2022), all the studies I have considered find improvements in business outcomes (profit), indicating that repayment flexibility does in fact help relax credit constraints while also mitigating the negative impact of shocks. More heterogeneity is found in terms of loan default, with Battaglia et al. (2023) finding that providing repayment flexibility improves repayment rates; Barboni and Agarwal (2023) not finding significant differences between the flexible contract and the regular contract in terms of repayment rates; and both Field et al. (2013) and Brune et al. (2022) finding a deterioration of repayment rates as a result of the contractual innovation.

VI. The trade-off of need for more flexible financial products vs their complexity

The characteristics of the contractual innovations discussed so far, alongside the main findings from their evaluation, raise two important questions on their operationalization: first, how customers’ demand for these contracts should be taken into account, and second, what the implications of offering such contracts are on borrowers’ welfare. In their paper focusing on retail structured products, Célérier and Vallée (2017) show that banks are increasingly offering more complex and riskier financial products. By analysing the behaviour of financial advisers, Egan et al. (2019) have found that those who display misconduct cater to more unsophisticated clients. While to the best of our knowledge there is no evidence that microfinance institutions are adopting similar selling strategies, a word of caution must be used regarding how contractual innovations should be made available by the microfinance industry, particularly given that their customers have relatively low education and low financial literacy.

The importance of providing simple products—as well as the adoption of transparent communication on credit terms—emerges from the study of Brune et al. (2022), who find evidence of worsened repayment rates deriving from contractual innovation offered to first-time borrowers. These customers, by definition, are more inexperienced than those who have already completed one or more loan cycles, and hence may be more susceptible to making mistakes and having incorrect beliefs. This paper hence warns against providing products whose characteristics may ‘divert’ unsophisticated borrowers from the repayment discipline they need. Encouragingly, Barboni and Agarwal (2023) provide evidence that when lenders embed financial innovations in a menu of contracts that vary in price and flexibility, borrowers who choose the flexible contract are more sophisticated than those who opt for the regular contract: they are more likely to draft a budget for their business activities and display a higher propensity to be time consistent. Nevertheless, the authors also find anecdotal evidence that some borrowers in their study did not use the flexible option because they felt they did not have full understanding of the contract terms, calling for the need for more transparency of how contracts—and contractual innovations in particular—are offered to borrowers who may lack financial skills.

VII. Open questions on contractual innovations in microfinance contracts

The studies I have discussed suggest that it could be profitable for MFIs to introduce innovations in the repayment structure of their loans. Despite these promising results, the microfinance industry appears reluctant to offer flexible loans. Understanding which motives prevent MFIs from offering these products is key to identifying potential solutions to scale up financial innovations in low- and middle-income countries. A first-order constraint may be of an organizational nature. Designing and offering flexible loans could introduce operational and economic challenges for lenders—e.g. credit officers must be trained about the features of the flexible financial products; management information systems (MIS) must be adapted to accommodate the features of these financial innovations. Since the microfinance industry is characterized by high staff costs and turnover (Hossain et al., 2023), introducing innovative financial products may thus further increase skilled labour costs (Cull et al., 2011) and operating expenses, which is something higher-level MFI management may be reluctant to face. Hence, studying how MFIs can keep the costs associated with financial innovation at a minimum, for example by developing new training modules for branch staff, by providing ad-hoc incentives, or by further automatizing screening procedures, represents a potential pathway to the scalability of flexible microfinance loans. To this end, the rapid entry of Fintech offers an opportunity for MFIs to digitize their operations—e.g. customers’ identification and loan repayment—and hence to facilitate the adoption of financial innovations. Another barrier lenders may face in providing contractual innovation is represented by regulation: in emerging economies, governments and central banks often impose interest rate caps and limits to loan size (Calice et al., 2020). This may restrict MFIs’ ability to price discriminate, thus exacerbating adverse selection problems. More generally, the question of how to optimally price flexible microfinance contracts vs traditional ones is key to assessing the scalability of innovative microfinance loans. Barboni and Agarwal (2023)’s work makes a first step in this direction by showing that since the flexible contract has proved to benefit the borrowers (in terms of profits and business income), then the lender may include it in its lending portfolio at a higher price, which the borrowers can repay precisely using their increased revenues. This is in contrast with the other studies that did not consider price differentials across contracts. A promising line of future research could further explore the pricing of flexible microcredit products and how this may encourage lenders to adopt them. Again, Fintech may play a pivotal role by supporting MFIs in identifying the optimal pricing of financial innovations and tailoring their price on borrowers’ characteristics.

VIII. Conclusions

Financial innovations providing borrowers with repayment flexibility hold the potential to help entrepreneurs adapt to income fluctuations while also seizing business opportunities. Although these innovative contracts are increasingly offered in advanced economies, their use in emerging economies is surprisingly limited. Flexible repayment schedules are shown to enhance business growth and to be taken up by borrowers who may be more equipped to take advantage of the opportunity; however, their impact on default rates is still under debate. This may explain why microfinance institutions are reluctant to introduce these contractual innovations. Managerial and organizational constraints, paired with lack of sophisticated screening processes, may further hinder the adoption and scalability of these contracts. I argue that improved incentives and ad-hoc training for branch managers and loan officers may help mitigate these barriers; at the same time, Fintech could also play a pivotal role in implementing cheap but effective screening mechanisms to identify borrowers that are suitable for flexible microfinance contracts. Lastly, it is important to ensure customer protection when financial innovation is introduced, particularly for those with lower financial and digital literacy, necessitating transparency in product terms and conditions, particularly in pricing. These issues are part of a much-needed body of research that will be foundational to assessing the viability of innovative, microfinance contracts.

The author would like to thank Natalie Theys for providing outstanding research assistance; and the editors and an anonymous referee for the comments received. Financial support from the University of Warwick (Academic Returners’ Fellowship) is gratefully acknowledged.

References

1

According to the World Bank’s MIX Market Data (https://datacatalog.worldbank.org/search/dataset/0038647), which covers nearly 3,000 microfinance institutions (MFIs) based around the world. The write-off ratio is equal to the value of loans written-off divided by the average gross loan portfolio.

2

Interest rates for each instalment may be computed through a declining balance method or as a flat rate.

4

The pecking order theory of capital structure indeed postulates that debt may not be the most preferred source of financing for firms (Frank and Goyal, 2008).

5

Interest yield is defined as all income from loans (interest, fees, other loan charges) as a percentage of the lender’s average annual gross loan portfolio (GLP). Further analysis of the MIX market data reveals that, among active borrowers, 65 per cent are females and 52 per cent live in rural areas.

7

Anecdotal evidence also indicates that lenders refrain from innovating because of concerns of increased default rates.

10

In finance jargon, the option to postpone repayment should be regarded as a real option vis-à-vis traditional options as it does not include derivative financial instruments such as stocks or other financial assets.

12

On the contrary Brune et al. (2022) do not find any evidence of selection effects among first-time borrowers.

13

In this table, I focus on the studies discussed in section III(i), Providing ‘repayment holidays’ options through the loan cycle.

© The Author(s) 2024. Published by Oxford University Press on behalf of The Oxford Review of Economic Policy Ltd.

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Part IV: Microfinance and repayment flexibility

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