Through her research, Giorgia Barboni, Professor of Finance at Warwick Business School, provides compelling evidence in favour of affording entrepreneurs more flexible microfinancing options, highlighting the potential benefits for developing economies around the world.
By CoBS Editor Tanvi Rakesh with kind acknowledgements to CORE magazine and Warwick Business School.
In 1976, Muhammad Yunus, a young economics professor, lent $27 to a group of 42 women living in a forgotten Bangladeshi village named Jobra. He couldn’t have known at the time, but with this small act of goodwill, Mr Yunus had sown the seeds of what would blossom into a global microfinance industry. Billions of dollars have since been disbursed to impoverished borrowers, financing small entrepreneurial ventures around the world. However, as the aspirations of these micro-loan recipients have evolved, the microfinance industry has not always evolved along with them. Today, highly rigid repayment structures can often inhibit the growth and even sustainability of borrowers’ businesses. Through a partnership with a microfinance institution in India, Professor Giorgia Barboni of Warwick Business School tests the viability of affording entrepreneurs more flexible micro-loans.
From humble beginnings
Following his first $27 loan, Mr Yunus founded Grameen Bank in 1983 and pioneered the microfinance industry—earning a Nobel Prize in the process. The organization has since disbursed more than $29 billion to impoverished borrowers while its microfinancing methods have spread around the globe. As one early recipient of a Grameen micro-loan once noted: “My parents gave me birth, but Grameen Bank gave me a life”. At the time, Mr Yunus’ intention was to provide immediate relief for the hunger and poverty he saw around him in Bangladesh. He sought to help people “get through another day with a little more ease”. In doing so, he empowered women, entrusting them with loans that, until then, had only been obtainable through informal moneylenders, along with the responsibilities that accompanied formal financing arrangements. However, what borrowers initially saw as assistance to survive, often sparked a desire to create economic prosperity for themselves through entrepreneurial ventures.
In many developing countries, the economic transformation from agriculture to industry has created new business opportunities. However, many small entrepreneurs need flexible funding options to bring their ideas to life but often lack sufficient collateral to obtain it. At present, microfinance institutions allow them to borrow small sums of money on a highly rigid repayment structure which entails frequent repayments starting immediately after the loan is disbursed. But these types of contracts do not offer these micro-entrepreneurs enough liquidity to grow and sustain their businesses. According to Professor Barboni, one of the reasons for this is because lenders are worried that providing a suitably flexible contract to micro-entrepreneurs will lead to greater default rates. Moreover, it is often difficult for lenders to gauge a borrower’s suitability for riskier, more flexible loans. What little research has been conducted on the issue seems to validate these concerns. A study that put forth a standard loan contract with a flexible one found that, although the flexible contract increased the borrowers’ revenues, it also raised default rates. This contributes to explain why no microfinance institution in India incorporated any sort of flexibility into their microfinance contracts.
A flexible solution
However, theory predicts that it is possible to devise a flexible contract structure that attracts “good” borrowers. These contracts would have to be given to micro-entrepreneurs that were no more likely to default with a flexible loan than with a standard contract. Professor Barboni argues that offering a more flexible contract at a higher rate of interest than the standard contract would trigger a positive self-selection mechanism that would filter out risky borrowers. Indeed, the flexible element and additional cost of the loans would discourage borrowers that needed to be tied to a rigid repayment schedule while attracting micro-entrepreneurs with the potential to create greater expected returns on capital to compensate for the additional costs. Therefore, the additional interest rate would allow to disclose borrower’s characteristics and create a sustainable product for microfinance institutions.
To test this theory in the field, Professor Barboni and her research team partnered with Sonata Microfinance, a micro-loan provider based in India. They designed their flexible contract with an interest rate priced two percentage points higher than the regular loans. The new contract allowed borrowers to take a three-month payment break, whenever needed, adjusting the repayment amount upwards accordingly once payments resumed. A randomised contract trial was organized in Uttar Pradesh, India, involving 28 of Sonata’s bank branches. Half of the branches offered customers a choice between the flexible and standard contracts while customers at the other branches were only offered the standard contract. Nearly 800 borrowers were included in the study. They had all previously borrowed from Sonata and had successfully repaid at least one loan. This made them eligible for slightly larger individual loans worth an average of approximately $500. According to Professor Barboni, as previous customers, the existing element of trust between borrower and bank may have helped overcome any reluctance to enter into a flexible contract.
Returns on investment
Professor Barboni’s study provides encouraging findings for micro-entrepreneurs, microfinance institutions, as well as for policymakers interested in promoting entrepreneurship and economic growth. The data across the 24-month loan cycle showed that the repayment rates were not statistically different across the flexible and standard contracts. This indicates that microfinance institutions can offer a flexible type of micro-loan and increase revenues without incurring higher debt default rates. Furthermore—and of particular interest to policymakers—based on self-reported sales figures, borrowers under the flexible contract reported on average approximately 20 per cent higher sales. They also reported that they incurred smaller losses than their standard loan counterparts and were less likely to request a “loan top-up” from Sonata. This suggests that the additional liquidity provided to micro-entrepreneurs by the flexible contracts benefits their business with no additional cost to the lenders.
Moreover, interviews Professor Barboni conducted with some of the micro-entrepreneurs in question revealed the opportunities provided by the repayment holidays. The borrowers reported using the repayment holiday in anticipation of periods where there is a downturn in business and below-average revenues. Borrowers added that they used the repayment holiday also to capitalise on opportunities to earn above-average revenues during periods of high demand such as during India’s festival season. Having demonstrated a proof of concept, Professor Barboni argues microfinance institutions and policymakers should promote flexible micro-loans, if only due to competitive forces.
Unleashing energy and creativity
The new micro-loans Professor Barboni and her team offered in their pilot study provided the cash-flow flexibility for only a few hundred micro-entrepreneurs. But if scaled, flexible micro-loans have the potential to give millions of micro-entrepreneurs the freedom they need to grow their businesses sustainably and, in doing so, benefit developing economies around the world. As Mr Yunus noted in his 2006 Nobel Lecture, “all [the world] needs to get the poor people out of poverty is for us to create an enabling environment for them. Once the poor can unleash their energy and creativity, poverty will disappear very quickly.” According to Professor Barboni, flexible micro-loans can help create that enabling environment.
- View Prof. Giorgia Barboni’s academic profile
- Discover the degree portfolio at Warwick Business School
- Read Warwick Business School’s CORE magazine
- Read a related article: The Missing Middle in Microfinance.
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