For more than three decades now, “microloans” have been all the rage in international development. The idea is simple: by giving a small loan to someone living in a poor country, you could help them expand a small business, which would lift their family out of poverty. When they pay back the loan, the money can be cycled to more borrowers, getting more families out of poverty. According to the World Bank, between 2009 and 2017, the number of borrowers in the microfinance sector more than doubled to 1.8 billion, three times the number of borrowers of commercial banks.
While microcredit lies upon a strong and evidence-backed economic scheme, it is important to bear in mind the impact of people’s behavior on the success, or not, of this repayment mechanism.
When the Grameen Bank was created in 1976, the goal was not really to make huge profits but rather to understand the needs and behavior of a huge part of the world population living in dire straits. As Mohammed Yunus mentioned in 2017: “Young people should learn that there are two kinds of businesses in the world. One is a business which makes money, and the other solves the problems of the world.” And to solve these problems you need to understand how people behave and why such problems arise. Therefore, this article will focus on two main aspects of economic behavior that microcredit institutions need to take into account when granting loans.
Social pressure
One of the key characteristics of microcredit lies in the profile of its borrowers: it specifically targets women and generation of self-employment who do not have access to classic commercial banks because of their risk profile. Once they get the microloan from a financial institution or a private investor, they form a group and repay their loans through regular installments. The principle of joint liability is key: every member is responsible for the other in the group and all members are held accountable if one defaults. The necessity to repay the loan is not only based on the legal contract signed with the lender, but also (and above all) on the social pressure of their peers. No one wants to be associated with the stigma of non-repayment. Churchill devoted an entire monograph to individual microcredit in emerging countries in 1999 highlighting how the social sanction mechanism operates with microloans.
Another interesting fact underscored by the Microcredit Summit report in 1997 is that “women are consistently better in promptness and reliability in payment”. How gender can explain this difference? Studies led by Goetz and Gupta in 1996 suggest that women may have a higher incentive than men for loan repayment since it allows them to retain access to village groups, whereas men have many more opportunities for social contact. All in all, social pressure appears to be a major driver for repayment of microloans, much more efficient that economic sanctions imposed by financial institutions. It is also interesting to bear in mind that this social effect only operates under a certain social framework in which the status is of utmost importance (i.e. a strong social structure).
Psychology of planning
Moreover, there is a fundamental assumption within the structure of the loan that suggests that when the income of the borrower is high he will put money aside to repay the loan. While the assumption is in line with rational models, these models are not necessarily the best evaluations of human behavior. In fact, experiments have shown that people in developing countries keep borrowing money for expenses instead of saving funds and repaying loans.
This can be explained by the psychology of planning or the tendency of individuals to underestimate their future needs. Did it ever happened to you to go crazy and buy the new phone or luxurious bag without thinking that, by the time your next paycheck come, you may have some unexpected expenses to cover (excess of mobile package, train tickets, medical emergency…)? Don’t worry, it is quite common. The only issue being that, in some circumstances, especially in developing countries, people have little margin for error: any unexpected event can drastically affect their way of living. Indeed, mistakes matter more for the poor, given that insufficient planning can spiral further and faster, leading to worse outcomes like compromising education or nutrition. Given the psychological evidence, repayment discipline, implemented either through product design or group trainings, helps mitigate these self-control problems when it comes to debt. It is crucial that any individual who has access to a microloans understand its social and economic implications.
All in all, understanding the micro-psychological processes involved is a vital part of developing new microfinance products and services. Behavioral economics can be a powerful tool to anticipate bankruptcy and improve the design of microfinance portfolio. People should not underestimate the importance of social pressure as well as psychology in the decision-making process of individuals in developing countries.
Nudges
Nudges are changes in choice architecture intended to influence behavior positively. Given the importance of psychology behind microfinance, one can easily deduct that using nudges could help improving the efficiency of the system. Features such as commitment savings accounts or reminder messages could encourage saving. A study conducted by the Financial Conduct Authority (FCA) in March 2015 revealed that, in order to be efficient, nudges should incorporate four fundamental aspects: Timing, Channel, Self-enrolment and Format.
- Timing: sending text and mobile bank apps alerts “just in time” (i.e. when a remedial action is required)
- Channel: using multi-channel approach (letters, emails, text messages etc.). In fact, the FCA found out that using both text alerts and mobile banking apps reduce the risk of defaulting by 24% vs 5% to 8% for text alerts alone
- Self-enrolment: letting consumers voluntarily register for alerts instead of automatically enrolling them. Research shows that giving this flexibility to consumers reduces significantly overdraft costs.
- Format: reducing the complexity and length of notifications to avoid confusion and miscommunication.
All in all, nudges are powerful tools to avoid psychology from being a hurdle in the microfinance system. By following these key principles, they can effectively mitigate detrimental financial decisions.
By Margaux Michel
References:
CHURCHILL, C. [1999], Client-Focused Lending: The Art of Individual Lending, Toronto: Calmeadow.
D’ESPALLIER, B. [2009], Women and Repayment in Microfinance
BANERJEE, A., MULLAINATHAN, S. AND SHAFIR, E. [2004], “Poor in more than one way.”
CECCHI, A. [2018], Nudges in Personal Finance: The Case of Overdrafts
Featured image: Signing of a credit loan in Kenya, photo by Panos / Giacomo Pirozzi
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