How Do Flexible Microfinance Contracts Improve Repayment Rates and Business Outcomes? Experimental Evidence from India

Abstract

Can financial innovations be offered in the presence of information frictions without increasing credit risk? We address this question through a randomized experiment with 799 microfinance clients holding microbusinesses in India. In treated branches, borrowers select between the standard rigid microfinance contract and a more expensive innovative contract designed to mitigate irregular business cash flows through repayment flexibility. In control branches, customers are only offered the standard contract. Offering a menu of contracts that vary in price and flexibility improves business outcomes without deteriorating repayment rates. These effects are driven by financially sophisticated microentrepreneurs selecting the flexible contract to a higher extent.

Keywords: Microfinance, Repayment Flexibility, Borrowers' Selection, Contract Design

JEL Classification: O12, O16, C93, D91