Term Structure of Debt and Entrepreneurship: Experimental Evidence from Microfinance

This paper presents a field experiment that quantifies the short- and long-run trade-offs associated with the classic microfinance debt contract.

Financiers across the world structure debt contracts to limit the risk of entrepreneurial lending. But debt structures that reduce risk may inhibit enterprise growth, especially among the poor. The paper contrasts the classic contract which requires that repayment begins immediately after loan disbursement with a contract that provides a two-month grace period before repayment begins.

Introducing flexibility into MFI debt contracts in the form of a grace period presents a trade-off for banks and clients. Findings include:

• Shift to grace period also saw a significant increase in the variance of profits and a tripling of default rates;
• Early initiation of repayment reduces risk to financiers, but also reduces the potential impact of microfinance on microenterprise growth and household poverty;
• Interest rate caps are likely to go hand-in-hand with MFIs adopting debt structures aimed at minimizing default.