Savings-and-Credit Contracts

Abstract

In this paper, we present a Savings-and-Credit Contract (SCC) design that mandates a savings period with a default penalty before providing credit. We demonstrate that SCCs mitigate adverse selection and can outperform traditional loan contracts amidst information frictions, thereby expanding access to credit. Empirical evidence from a financial product incorporating an SCC design supports our theory. While appearing riskier on observables, we observe lower realized default rates for product participants than for bank borrowers. Further consistent with the theory, a reform that reduces the default penalty during the savings period induces worse selection and higher realized default rates.

Keywords: contract design, information asymmetry, signaling, access to credit

JEL Classification: D47, G21, G23, G51, J61