Make Good Choices: Rethinking Microcredit with Behavioral Economics

Microcredit seems simple. Provide the poor with access to credit and businesses and entrepreneurship will flourish in the developing world. But what happens when people lack information and are stifled by stress, as many poor people are?

People living in poverty don’t always make rational financial decisions, according to the World Bank’s  2015 World Development Report. Imperfect information leads to financial decision-making based on short-term needs rather than long-term gains and little free time leads to cursory financial choices. The financial pressure that comes with living in poverty takes a toll on mental resources: A study found that farmers scored an average of 10 IQ points lower on the same cognitive tests before earning their harvest income than after they were paid.

In other words, poverty causes people living at the bottom of the global economic pyramid to make different, and sometimes worse, financial decisions compared to their more affluent counterparts. This is because people rely on mental shortcuts, social norms, and shared histories when making decisions. So, when a farmer decides what crop to grow the choice may not be based on international market prices. Instead, the farmer might grow what people in the region have always grown, what his neighbors grow, or what is easiest to grow. And that crop may not generate the most money. 

Even though economists typically assume we make rational financial decisions, dozens of studies show that when faced with complicated or imperfect information, we actually don’t.

A study in Mexico City found that subjects offered a summarized loan sheet were almost twice as likely to choose the cheapest loan option than people offered more complicated bank leaflets.

In another study, participants that received envelopes with the total cost of a loan on them were 11 percent less likely to borrow in the next four months than those who received envelopes with fill-in-the-blank payment calendars on them. Borrowing decreased when consumers could think more broadly about the true cost of the loan. This means that when the cost of the loan is made clear, people don’t take out loans they cannot afford or do not need.

In yet another study, borrowers in India were three times less likely to default on their loans when they met with a loan officer once a week compared to once a month.

So when it comes to microcredit, institutions need to keep these realities in mind. Financial inclusion doesn’t just entail providing credit to the poor. It requires a variety of strategies that provide clear and accessible information and engage clients at an interpersonal level. Although not every microcredit institution has caught on to this, a few have.

The Foundation for International Community Assistance accompanies its microloans with a wide range of regionally-specific financial and non-financial products and services that are informed by rigorous customer research. The foundation’s Village Banking program, or group loans, addresses the tendency for people to make decisions based on social norms and collective actions. Mobile technology increases the ease in which customers can do business and decreases the tax on mental resources. Mandatory financial literacy training ensures the best decisions are made regarding cash flow management, savings, and business expansion.

Opportunity International is another microfinance institution that is accounting for the way people think in their programs. An Opportunity International loan is not just about money, it includes a whole system of support, guidance and accountability. The organization focuses on financial training and realizes access to credit may not be enough to help clients escape poverty. Basic skill-building regarding earning, spending, budgeting and borrowing are central to Opportunity International’s mission. Innovative products like digital fingerprint scanning, cell phone banking, and mobile banking vehicles provide convenient financial access to people in rural locations where brick and mortar banks are scarce. Quick, secure and efficient banking allows clients to focus on generating income and reduces fiscal pressures.

When microcredit institutions pay attention to the way people think and act, they can develop better services and products. For someone living in a rural location where the nearest bank is half a day away, interest rates are not made clear, and payment plans are complicated, a microloan is likely to do more harm than good. But, when microcredit institutions adapt to the reality of the way people make choices, the cycles of poverty can be broken.