Sameer is a farmer who subsists on three acres of land in rural India. While much of the land is fertile, nearly 50% of his income goes towards the interest payments from money-lender loans, loans which are necessary to finance his crops. Moreover, some of his land is unused because he cannot profitably finance irrigation at the money-lender's rates (5 to 10% per month). As a result, his family's nutrition and education are compromised.

Angela runs a small provisions shop in the city. For her business she has many financing needs from working capital to longer term investments. Luckily there is an MFI nearby which she uses, yet she only uses it to finance a part of her needs. For the remainder she chooses to use the money lender who charges a much higher rate, even though she could borrow more from the MFI. When asked why she responds that she likes the money lender's "flexibility" of allowing her to skip payments during the hardest weeks.

We feel these two examples illustrate how, despite years of stunning growth, MFIs still fulfill only a small fraction of the financial needs of the poor.

Debt Payments and Insecure Income

Being poor is not just about having too little income. It is about having insecure income. The income of the poor can vary dramatically from day to day, month to month, season to season. Contrast this with the single most salient fact of micro-finance: nearly all contracts are fixed in their repayment schedules. This mismatch between debt payments and income can create serious distortions. Are these distortions inevitable? The implicit presumption is that they are. Many good reasons have been articulated for using fixed debt contracts.

First, a flexible payment stream may generate many operational headaches. For instance, portfolio monitoring requires clear information on default status. It may be difficult (or impossible) to distinguish between someone exercising their flexibility and someone intending to default further. The faster lenders deal with default, it is often believed, the better they are able to recover the loans. Furthermore, depending on how the flexibility was structured it could cause confusion in the field. It is easier to train staff to collect equal and constant weekly payments. The flexibility should be such that staff can easily understand and implement it.

The poor often have insecure incomes, but microfinance contracts tend to be fixed in their repayment structure. This mismatch can create serious distortions.

Second, flexibility can actually save on loan officer time. If every monsoon, we know clients have a difficult time paying, might it not be more cost-effective to have lower or less frequent payments during that period rather than use valuable loan officer time to chase down "delinquent" clients?

Third, the rigidity of contracts may effectively be keeping some lucrative borrowers from borrowing. Client retention is an issue for many MFIs. Perhaps many leave because they experience too many "close calls" and then drop out in order to avoid going into default. Or perhaps out of this fear, they never join in the first place. Thus flexibility may increase client retention and help attract more clients. Ironically, these clients who leave, or never join, because of fear of default are "dream" clients for the MFI. They are clients of such strong integrity that they refuse to borrow for fear of defaulting.

Finally, flexible contracts may greatly increase the impact of the loan. Clients with rigid contracts may take actions which reduce the return on their investments. Owners of milk animals may under-feed during difficult times. Asset owners may sell off (productive) assets to repay debts. Flexibility would prevent the destruction of this value and could be as useful as the initial loan itself. Moreover, this increased income could actually allow the MFI to further increase loan size.

Implementing Flexibility into Microfinance

Given these benefits, how can we practically implement flexibility in the current micro-finance structure? We give three examples, each highlighting a different element of flexibility.

First, we observe that flexibility can be pre-built into the contract. For example, the monsoon is a difficult time for everyone. Contracts could reflect this by reducing payments during this period in a pre-specified manner. Similarly, dairy farmers face two months a year without milk. Again, the contract could pre-specify a smaller loan during this period. Pre-specification of flexibility has many benefits. Notably, the client does not feel that she can negotiate down other payments. The flexibility is not after the fact. It is actually a "rigid" flexibility, with tightly delineated rules. As a result, it also eases concerns of MIS, cash management, and loan officer fraud.

Contracts that allow for several lower payment periods, or allow borrowers to increase their credit lines at vital times, could add flexibility to micro-finance programs.

Second, one could provide less rigid flexibility by pre-specifying a number of low payment periods, but not their timing. For example, one could give clients several tokens and tell them that each token can count for one weekly payment. In this way, the client agrees to a slightly higher payment each week in return for getting a few difficult weeks (of their own choosing) off. Again, the creation of a token ought to ease the logistical problems of MIS, cash management and fraud. Yet it still provides the borrower a great deal of flexibility.

Finally, consider an MFI who feels that their borrowers could handle Rs. 2,000 higher loans than they currently receive. Should they just increase the initial loan size? What if instead they told all borrowers that they would be eligible for a Rs. 2,000 second loan, at any point during the cycle? This second loan might actually help the client more than simply increasing the initial loan by Rs. 2,000 since it gives the client a safety valve in case of emergencies.

Pushing the Boundaries

Will these products work? Or will operational hurdles prevent them from working? Will they erode repayment discipline and increase default? Or will they allow for much larger loan sizes and greater client income growth? We simply do not know. A common retort is that borrowers can use other sources of income or debt to fill in the gaps. This misses the basic point about the financial policy for the poor: these alternatives either do not exist or are very expensive. Why cede this important and potentially lucrative financial service without ever testing the waters? There is only one way to know if microfinance can be more flexible: to test flexibility.

Much remains unknown in microfinance. We focus here on one issue in particular: the flexibility or rigidity of debt products. Nearly everyone feels they know how to structure a microfinance loan. Yet everyone differs on the answer. We label these as unknown not because nobody knows the answer but because we all "know" different answers. The goal of our research around the world, as with the Center for Micro Finance in India, is to bring about consensus.




This article, written by Dean Karlan and Sendhil Mullainathan, originally appeared in the Newsletter of the Centre for Micro Finance (CMF) at the Institute for Financial Management and Research (IFMR). Karlan, economics professor at Yale University, and Mullainathan, economics professor at Harvard University, coordinate research through the Innovations for Poverty Action and the MIT Jameel Poverty Action Lab and are involved in several projects with CMF. Reprinted with permission from Innovations for Poverty Action.

To read another Global Envision article about microcredit, see Microcredit Is Becoming Profitable, Which Means New Players and New Problems.



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