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

Have you read?

Straight Talk on Client Protection – The Proper Handling of Contracts

Why the Find Print Matters

Behavioral Insights to Advance Financial Inclusion

In preparation for the launch of its Certification Program, the Smart Campaign’s Straight Talk blog series highlights standards that may be overlooked by microfinance institutions but that are an important part of client protection. This sixth post in the series by guest blogger Juan Carlos Izaguirre highlights a very specific practice at the heart of the client protection principle on transparency—and essential for certification: client contracts.

Can you imagine renting an apartment, an office, or a farm, based on a purely verbal agreement? Centuries ago codes of honor and verbal agreements may have been the norm, but not anymore. People want to avoid misunderstandings and forgetfulness by having written contract agreements, especially for long-term transactions. Now, can you imagine signing a rental agreement but then not receiving a copy of that agreement? In practice, not having a copy is almost like trusting in a verbal agreement. To be honest, I would not feel comfortable signing a document without receiving a copy. I would be suspicious of that transaction. Why would the owner not want me to have a copy of the contract? What is there to hide? I have a sense that you would feel similarly uneasy.

If this is well understood in rentals, then why does the financial industry not follow suit? In more than five years working in different countries across the globe, I keep discovering that many financial institutions do not give a copy of the financial contract to their customers. I have heard several reasons/excuses for this behavior: “The client would not like me to charge him/her for an extra copy of the contract.” “The lawyer charges a lot for a signature, so we cannot afford another copy.” Perhaps, but if there is not enough money to afford paper sheets and ink cartridges, then I would be afraid of the financial situation of the institution!

Other institutions say that “clients do not care about the full contract, they only ask for the payment schedule,” or “clients will not understand the contract, they just need the payment schedule.” Maybe clients are not aware that they can have a contract, maybe they have never seen one in their lifetime, or maybe they don’t think they will need the contract later. However, consumers really do need the full contract terms and conditions, as a matter of principle. Contracts contain the legal basis of a transaction and as such consumers have the right to receive a copy.

Contracts are like the user’s manuals for financial products. They contain detailed information that may not seem quite useful when the financial product is acquired, but will become useful when questions arise. Now that many of us are in the pre-Christmas shopping mood, can you imagine buying a new TV and not receiving any type of manual? Surely there are several paragraphs in that manual that have technical information and are not easy to understand, but there is also information that can be quite handy when we have a problem—and we can check the manual first before calling a store or manufacturer.

Contracts are a symbol of transparency, a mechanism to instill trust and reduce fears, especially with clients that are not savvy on financial transactions. Having a copy of the contract would also contribute to the efficiency of the system. If clients have any doubt about their financial product or service, they can first read the contract on their own or with the help of friends, relatives, or community leaders. If clients have a problem, their dialogue with an MFI officer would be easier if they have read the contract, which might in turn reduce the time spent to solve problems.

It is true that contracts are often hard to understand. It is a great idea to work toward more streamlined and simple documents. It is also a good idea to provide a “key facts” statement that summarizes the contract terms and conditions. That step has been implemented in other countries. However, the contract is the basis of a financial transaction, so however difficult it may be, the client still needs to have it.

Sharing a copy of the contract with the consumer should be a basic, obvious, common practice for financial institutions, which would help them to build a more trustful and transparent relation with their customers. There is nothing more valuable in business than earning the trust and loyalty of a client. Regulators should not even have to intervene to make it a requirement – it should be common sense! And, for sure, clients should not have to ask Santa for copies of their contracts this Christmas.

Juan Carlos Izaguirre works as a Financial Sector Specialist with the World Bank’s Global Program on Consumer Protection and Financial Literacy.

Image Credit: Villages Connected

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Can Providers Take More Responsibility for Client Protection? The Smart Campaign Says Yes.

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Client Protection in Honduras: Basic Infrastructure in Place