The Applicability of Micro Finance to Higher Risk Business Ventures: An Experimental Study

This paper reports the results of a micro finance lab experiment that seeks first to replicate the difference in loan repayment rates between groups composed of high vs. low risk borrowers, and then to test a mechanism we propose to make micro finance work better for high risk borrowers. The mechanism involves revenue sharing among members of a borrowing group, above and beyond usual repayment bailouts that successful members can choose to make on behalf of unsuccessful members. Revenue sharing makes repayment of the total group loan optimal under more business outcome states, and thus increases the expected benefit of repaying the current loan to qualify for future ones. We compare loan repayment rates between high and low risk borrowing groups, with and without the option of entering into binding ex ante agreements to revenue share. For high risk borrowers, we further test the effect of allowing them to renege on revenue sharing agreements once individual business outcomes are known. We are able to capture the result that loan repayment rates are lower for higher risk borrowers than for lower risk borrowers. We also find that introducing the option of binding revenue sharing agreements modestly but significantly increases loan repayment rates. Most of this gain is lost, however, when successful individuals can renege on commitments to revenue share after learning individual business outcomes.