In 1976, when Muhammad Yunus, an economics teacher at the time, lent $27 to a group of 42 women in the village of Jobra, Bangladesh, he could not have imagined the eventual impact this small gesture of goodwill would have.
Yunus went on to found the Grameen Bank in 1983 and kick-started the microfinance industry, eanring himself a Nobel Prize in the process. Since then the Grameen Bank has disbursed more than $29 billion to poor borrowers, while its microfinance methods have spread across the globe. As one early recipient of a Grameen micro-loan noted: "My parents gave me birth, but Grameen Bank gave me a life."
At the time Yunus' intention was to provide immediate relief for the hunger and poverty he saw around him and help people "get through another day with a little more ease".
In doing so he aimed to empower women, entrusting them with loans that were until then only obtainable from informal moneylenders, along with the responsibility that went with formal financing arrangements. Since then, though, what was simply a need to survive has often become a desire to create economic prosperity as micro-entrepreneurs. But while the aspirations of millions of micro-loan recipients have evolved, the microfinance industry has not always evolved with them.
In many developing countries there has been an economic transformation from agricultural to non-agricultural jobs. As small entrepreneurs emerge, often lacking collateral, they need a more flexible approach to funding.
The option of borrowing small sums of money on a highly rigid repayment structure, which entails frequent repayments, starting immediately after the loan is disbursed, remains. But these types of contracts do not offer micro-entrepreneurs sufficient liquidity, as and when they need it, to grow and sustain their business.
As many business leaders in India's microfinance industry have told me, one difficulty with providing a suitably flexible contract is that lenders are worried it will lead to greater default rates. Particularly when, as is often the case, lenders are unable to gauge a borrower's suitability for a more flexible loan.
What little research has been done on the issue seems to back up their concerns. A study that looked at a standard contract with a payment holiday feature revealed that although the contract increased the lender's revenues, it also raised default rates. Consequently, when I began my project in 2016, no microfinance institutions in India were incorporating any sort of flexibility into their microfinance contracts.
But what if it were possible to devise a flexible contract structure that attracted responsible lenders; micro-entrepreneurs that are no more likely to default with a flexible loan than with a standard contract. This is the challenge I set out to meet, along with my co-researcher Parul Agarwal, at the time a research associate at the Institute for Financial Management and Research (IFMR) in Chennai, India.
To create a contract that is sustainable for lenders we believed that (after establishing basic eligibility for a standard individual micro-loan) offering a more flexible contract at a higher rate of interest than the standard contract might trigger a positive self-selection mechanism, that separated 'good' and 'bad' repayers to some extent.
The flexible element and additional cost should discourage both borrowers that needed to be tied to a rigid repayment schedule, but also more risky borrowers. While it should attract micro-entrepreneurs with the potential to create greater expected returns on capital to compensate for the additional costs. Thus, the additional interest rate would mitigate for any inability to determine a borrower's characteristics and create a sustainable product for financial institutions.
How flexible repayments help entrepreneurs in developing countries
To test this theory in the field we partnered with India-based Sonata Microfinance. Together with our research partner we designed a flexible contract with an interest rate priced two percentage points higher than the regular contract. The flexible element allowed borrowers to take a three-month payment break, whenever needed, adjusting the repayment amount upwards accordingly once payments resumed.
A randomised contract trial was set up in Uttar Pradesh, India, involving 28 of Sonata's bank branches. Half the branches offered customers a choice between a flexible and standard contract. At the other branches customers were only offered the basic contract.
The 799 borrowers included in the study were all male and already customers at Sonata. They had previously been group loan borrowers, had successfully repaid at least one loan, and were therefore eligible to get a slightly larger individual loan (the average size for individual loans was approximately $500). Thus, there was an existing element of trust between borrower and bank, which may have helped overcome any reluctance to enter into a flexible contract.
Our findings were very encouraging for both micro-entrepreneurs and microfinance institutions, as well as for policymakers interested in promoting entrepreneurship and economic growth.
The data across the 24-month loan cycle showed that repayment rates were the same for both types of contract. This indicates that microfinance institutions can offer a flexible type of micro-loan and increase revenues without incurring higher debt default rates.
Furthermore - and of particular interest to policymakers - based on self-reported sales figures, recipients of loans under the flexible contract reported approximately 20 per cent higher sales on average. They also reported that they made smaller losses than their standard loan counterparts and were less likely to request a loan top-up from Sonata. All of which suggests that the additional liquidity provided to micro-entrepreneurs benefits their business and not at the expense of the loan provider.
Interestingly, interviews with some of the micro-entrepreneurs revealed that they used repayment holidays for two purposes in particular.
All the borrowers reported taking the flexible contract in anticipation of periods where there is a downturn in business and below average revenues. This was often during the monsoon season, for example. Here they used the repayment holiday as a form of insurance.
The other reason often given for using the repayment holiday was to capitalise on opportunities to earn above average revenues during periods of high demand, such as during the festival season, for example.
Can flexible microfinance lift people out of poverty?
Now that we have demonstrated a proof of concept, we would expect microfinance institutions and policymakers to be keen to promote flexible micro-loans, if only due to competitive forces.
Ideally, given that this was a relatively small study in a controlled setting, that necessarily lacked advertising promotion, there would be further pilot studies initially. This would allow different types of flexibility to be investigated, other than the three-month repayment holiday. For example, repayment flexibility might also be achieved through instalments matching the cash flow of customers, mirroring some sort of credit line.
The micro-loans in our pilot study provided the cash-flow flexibility needed to boost the businesses of just a few hundred micro-entrepreneurs. But scaled up, flexible micro-loans have the potential to give millions of micro-entrepreneurs the freedom they need to grow their businesses sustainably and, in doing so, benefit developing economies across the world.
As Yunus noted in his 2006 Nobel Lecture, we create the world in accordance with our mindset. If we are able to change our perspective as new knowledge emerges then we can reconfigure our mindset and the world.
"All it needs to get the poor people out of poverty is for us to create an enabling environment for them," said Yunus. "Once the poor can unleash their energy and creativity, poverty will disappear very quickly."
Flexible micro-loans can help to create that environment.
Barboni, G., Cassar, A. and Demont, T. (2017) "Financial exclusion in developed countries: a field experiment among migrants and low-income people in Italy", Journal of Behavioral Economics for Policy (JBEP), 1, 2, 39-49.
Giorgia Barboni (2017) "Repayment flexibility in microfinance contracts: theory and experimental evidence on take up and selection", Journal of Economic Behavior & Organization, 142, 425-450.
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