> Posted by Rohini Pande, Professor of Public Policy, Harvard University

The issue of financial stress is an important one since there has been widespread concern in India and elsewhere that debt to microfinance lenders is causing distress to many borrowers. Financial stress is well-documented as an important factor leading to mental health problems. Mental health problems, in turn, are among the most important causes of morbidity in the world, and studies in developing countries have found strong associations between common mental disorders and economic problems. A 2010 World Health Organization Report warns that poverty and mental health disorders can create a “vicious cycle” where not only do they exacerbate each other, but also lead to reduced development and increased vulnerability. However, the net impact of limiting a borrower’s debt level on her level of stress is unclear. On one hand, curbing indebtedness may reduce stress; on the other, if less credit worsens her economic well-being, then this may increase stress.

With Erica Field of Duke University, I led a study to shed light on this question. We asked whether small changes in contract design could help alleviate borrower reports of stress. The answer, published in the PLOS ONE journal, seems to be yes.

We conducted the study in 2008 with Village Financial Services in Kolkata, India. This MFI recruited clients and formed 148 five-member loan groups comprising 740 clients. We randomly assigned the groups to the control arm of the study, where groups made the standard weekly payments, or the treatment arm, where groups paid on a monthly basis. For a seven-week period starting a few months after loan disbursal, team members interviewed a random sample of 105 weekly and 105 monthly clients regarding their state of mind every 48 hours via cell phones distributed specially for the study. We administered 5000 surveys over the course of the study, asking clients questions regarding their confidence in their ability to repay the loan, their anxiety about loan repayment, whether they argued with their spouse about finances, and the time they spent thinking about repayment.

The results were striking: Clients on a monthly schedule were 51 percent less likely to report feeling “worried, tense, or anxious” about repaying, were 54 percent less likely to report a lack of confidence about repaying, and reported spending less time thinking about their loan compared to weekly clients.

Furthermore, monthly clients more than doubled their business income relative to weekly clients, increasing their total household income by 84 to 88 percent. This suggests that a more relaxed repayment schedule encouraged them to use their loans more profitably. Considering that the correlation between financial deprivation and financial stress problems is well established, we hypothesized that this large increase in income was probably an important contributor to the stress reductions we saw.

Further evidence to support this comes from an analysis of the time series data. Comparing weekly and monthly groups, the differences in business investments were concentrated in the early part of the loan cycle, while stress levels were about the same until around the twelfth week of the 45-week loan cycle, at which point monthly clients’ stress levels began to drop steadily. This pattern supports our hypothesis that better investment led to increased income, which in turn reduced psychological stress.

These results suggest that the financial stress associated with the standard Indian microfinance contract, with its rigid repayment schedule starting immediately after disbursement, can be reduced with a small design adjustment. If such a simple and inexpensive change can have such dramatic benefits, then maybe gradual, evidence-based redesigns can optimize microfinance and help it deliver on its original promise.

This study was one of a series our team is conducting to explore the effects of contract flexibility on the lives of microfinance borrowers. Increasingly it appears that product design can play a key role in influencing how microcredit works.

Rohini Pande, together with Asim Ijaz Khwaja, are co-founders of Evidence for Policy Design, or EPoD, a research initiative at Harvard that seeks to apply nuanced, evidence-based methods to policy issues in the developing world. In February 2014 they will be offering a week-long executive course, “Rethinking Financial Inclusion: Smart Design for Policy and Practice,” through the Harvard Kennedy School’s Executive Education program, with the aim of bringing design insights from economic theory and empirical evidence directly to decision-makers. 

Rohini Pande is a Professor of Public Policy at the Harvard Kennedy School and Co-Director of Evidence for Policy Design (EPoD) at Harvard’s Center for International Development. Her research examines how the design of financial access initiatives, democratic institutions, and government regulation affects policy outcomes and citizen well-being, with a particular focus on gender. She leads several large-scale research projects testing the design of financial products and evaluating the impact of microfinance on a range of social and economic outcomes. Pande holds a PhD in Economics from the London School of Economics.

Image credit: Deutsche Bank

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