Repayment flexibility in credit contracts boosts small firms
Lack of access to credit and insurance markets can prevent small-scale firms in low- and middle-income countries from making profitable investments. This is shown in a study in the Review of Economic Studies by Andreas Madestam, professor of economics, Stockholm University.
Andreas Madestam, professor of economics, Stockholm University. Photo: Rickard Kilström
In Bangladesh, Andreas Madestam, along with Marianna Battaglia, University of Alicante, and Selim Gulesci, Trinity College Dublin, partnered with the organization BRAC to evaluate the impact of repayment flexibility in credit contracts for microentrepreneurs. Their recent publication in the October issue of the Review of Economic Studies investigates how offering more flexible repayment terms affects entrepreneurship and risk-taking among small firms.
A simple solution with powerful effects
In developing countries, access to both credit and insurance is often limited, preventing small firms from making high-risk, potentially profitable investments. The study investigates the effect of allowing borrowers to delay up to two monthly repayments during a 12-month loan cycle.
Results from a randomized field experiment show that repayment flexibility leads to significant improvements for small microfinance clients. Borrowers with flexible contracts are more likely to invest in their businesses, generate higher revenues, and even report lower default rates (see figure below for a summary of the key findings).
Impact of repayment flexibility. The figures plot the standardized effect sizes and 90% confidence intervals around the treatment effects for the findings on credit market outcomes, business outcomes, and household economic status.
Importantly, theoretical and empirical evidence indicates that the primary driver of these improvements is increased entrepreneurial risk-taking, as borrowers have a safety net that allows them to manage income fluctuations better. However, the effects are notably stronger among smaller microfinance clients compared to larger borrowers, suggesting that repayment flexibility may help bridge critical insurance gaps for the most vulnerable firms.
The findings highlight how a relatively simple financial product design – increasing repayment flexibility – can play a significant role in fostering enterprise growth in challenging economic environments. Taken together, these results demonstrate that repayment flexibility provides a novel way to spur risk-taking and entrepreneurship among low-income people.
Further reading
In the autumn 2023, Andreas Madestam was rewarded by Swedish House of Finance for having the article accepted in the top-ranked journal Review of Economic Studies.
Last updated: 2024-10-18
Source: Department of Economics