Repayment flexibility in microfinance contracts: Theory and experimental evidence on take up and selection

Abstract

This paper studies the impact of introducing repayment flexibility in microfinance contracts. I build an adverse selection model that predicts the existence of a separating equilibrium where lenders are able to achieve higher profits by simultaneously offering a rigid and a flexible repayment schedule, instead of just a rigid contract. Lab-in-the field games with Indian microentrepreneurs confirm the model predictions. I offer subjects both a flexible and a rigid repayment schedule and exogenously vary the price of the flexible schedule. I find that high-revenues borrowers are more likely to take up the flexible schedule than low-revenues ones, and even more so when the flexible schedule is more expensive than the rigid one. Risk-averse borrowers, on the contrary, are more likely to stick to the rigid contract when this is cheaper than the flexible contract. The paper thus indicates that lenders should offer a menu of contracts where the flexible and the rigid contract are provided simultaneously, at different prices. Back-of-the-envelope calculations indeed suggest that this mixed contract is more profitable than the standard, rigid microfinance contract.