Student Blog: Flexibility in Microfinance
by Steven Young, 2L Editor
Microfinance gives low-income, seasonal-income, and otherwise indigent persons access to financial products that are typically reserved for wealthier customers. Microfinance Institutions (MFIs) specifically target these individuals who cannot participate in typical credit markets by providing atypical financial products and services. However, microloans are costly. Default risks are high, and the burden of administering numerous small loans can be significant. As a way to combat these additional costs for microloans, MFIs issue typical microloans with high interest rates, sometimes well over 30%, and standardized terms and conditions. Some microloan contracts even require the borrower to begin paying back the loan the week after the loan is issued.[1]
The purported primary goal of all of microfinance is poverty alleviation. Yet, research suggests that these rigid contracts may do little to actually improve the lives of the borrowers. The strict terms and seemingly harsh consequences of default can detract from the benefits that would otherwise flow from financial inclusion. A borrower may be barred from ever borrowing again if she defaults. Likewise, because many microloans rely on social pressure rather than collateral to substantiate the microloan, other people may not qualify for a loan if another member of the community defaults. This incentive scheme reduces the possibility that borrowers will realize the true potential of the microloan proceeds. Rather than invest in profitable, long-term projects, borrowers of these microloans become so preoccupied by repaying them. For example, a borrower may elect to either sell productive assets or skip a few meals in order to make the next set of payments.[2]
Research suggests restructuring microloans to incorporate more flexibility could reduce these unintended consequences. Grace-periods, relaxed payment schedules, and individually-tailored contracts may provide more opportunity for borrowers to deploy capital for productive purposes, without countervailing detriments to MFIs.[3]
However, the empirical data supporting the need for more flexible microfinance contracts is unfortunately limited. Despite being conducted under rigorous academic standards, studies typically have small sample sizes and contain almost no demographic diversity.[4]Deducing any generalized principles about flexibility in all of microfinance is nearly impossible, as the results of an experiment may not hold true for other demographics.[5]Microfinance is also typically issued in turbulent conditions, where identifying cause and effect is difficult. Finally, flexibility does not address the fact that most microloans are specifically sought to augment consumption. Introducing flexibility may not encourage investment if borrowers are never looking to invest in the first place.
[1]Katherine Hunt, Law and Economics of Microfinance, 33 J.L. & Com. 1 (2014).
[2]Navjot Sangwan, Make Microfinance Great Again: A Shift Towards Flexibility, Developing Economics (Mar. 8, 2019), https://developingeconomics.org/2019/03/08/make-microfinance-great-again-a-shift-towards-flexibility/.
[3]Giorgia Barboni, Repayment Flexibility in Microfinance Contracts: Theory and Experimental Evidence on Take Up and Selection, 142 J. of Econ. Behav. & Org. 425 (2017).
[4]Rachael Meager, Understanding the Average Impact of Microcredit, Microeconomic Insights (July 17, 2019), https://microeconomicinsights.org/understanding-the-average-impact-of-microcredit/.
[5]Of course, abstracting principles may not be necessary if the vast majority of microloans are issued to demographics similar to the ones in the studies. For example, over 90% of microloans worldwide are issued to women. What flexibility in microloans does for female borrowers may hold true for microfinance generally, despite its effects for male borrowers.