Randomized Controlled Trials in Rural Finance: An Example from India

Randomized Controlled Trials in Rural Finance: An Example from India Michael Faye and Sendhil Mullainathan Harvard University March 2007 mfaye@fas.harvard.edu

Agenda • Randomized Controlled Trials in Finance • Example from India: Jewelry Loans Experiment • Background on Jewelry Loans • Research questions & Results • Summary

RCTS ARE APPLICABLE TO MANY FINANCE QUESTIONS Bank • Can loan to value ratios be increased without inducing additional default? • What is the interest rate that maximizes profits? Int’l Org. • What is the social impact of a given finance program? • Which intervention is more effective? MFI • Can microfinance programs be made less rigid without inducing more default? • Is group lending necessary to ensure low default rates?

WHAT IS A RANDOMIZED CONTROLED TRIAL (RCT)? • Different interventions randomly tested in different places/people. • Example: interest rate randomized • Individuals randomly assigned to treatment and control groups • Treatment group receives intervention • Control group is not allowed to receive treatment (during evaluation period) • Allows us to interpret results as causal • What would have happened if individual did not receive treatment

WHY USE RCTs? • Not subject to psychological biases: • We are all bad statisticians  RCT eliminates this bias • More precise and not subject to selection bias: • RCTs can give precise numerical estimates of program effect • Avoids conflict: • Well-designed RCTs provide precise answers that avoid impasses • Relatively cheap: • While RCTs can be labor intensive and costly, it is more expensive to make a large-scale mistake WHEN RCTs ARE APPLIED TO THE RIGHT PROBLEMS, THEY PROVIDE A POWERFUL AND PRECISE METHOD TO GET ACCURATE ANSWERS FOR MANY BUSINESS AND POLICY DECISIONS

BACKGROUND ON JEWELRY LOANS What? Who? Area studied? Jewelry loans are loans that are collateralized by gold jewelry. • Bank grants loans to • Individual consumers Tamil Nadu, India

HOW ARE JEWELRY LOANS DISBURSED? • Customer shows jewelry to appraiser in bank • Appraiser weighs jewelry and subtracts non gold weight • Customer chooses loan amount and interest rate • Bank teller disburses loan to customer

WHY ARE JEWELRY LOANS INTERESTING? Question Observation • Individuals did not want to borrow at a higher LTV at the same interest rate • Why wouldn’t customers want to borrow more if they are credit constrained? • Why not save for these expenses? • Individuals are borrowing for predictable expenses (e.g., school fees) consistently • Why don’t customers borrow directly from • bank? • Pawnbrokers play a large part in the market • Can the lack of default be attributed to a • sentimental value of the jewelry? • Default is very low (<1%)

OUR INITIAL RESEARCH QUESTIONS Credit Constraints • Do people want to borrow more? • Is bank being too cautious on its term structure Individual Consumption • What do individuals spend additional credit on (e.g., consumption, investment)? Mental Accounting • Why aren’t individuals refinancing outside loans? Is mental accounting an important part of the story?

EXPERIMENTAL DESIGN IS ON 3 DIMENSIONS PRESENTATION LOAN TO VALUE TIMING • Increase LTV by 50 Rs/g • Offer higher LTV at time of initial transaction • Suggest other uses of loan including loan consolidation • Increase LTV by 100 Rs/g • Offer higher LTV at time of initial transaction but allow customer to come back for loan within a week • Ask if they need additional money for stated purpose of borrowing • Send letter to random individuals with offer of higher LTV

Results • Individuals do not appear to be credit constrained: • 40% of those offered an additional amount do not take more than they would have been eligible for without increase • Statistically insignificant difference in loan taken of those offered extra and those not • Individuals who are offered extra borrow at lower interest rates • Mental accounting plays a role in refinancing decisions • Small sample size still prevents accurate inference, but initial results suggest when prompted on outside uses of loan, individuals borrow more • Default rates have not increased • Despite the increase in credit limits, there does not seem to be any affect on default • Social effects • Survey still ongoing • Anecdotal evidence suggests that many people are using loans to smooth consumption

Summary • Significant increases in credit limits might be possible without increasing risk • Psychological biases may prevent individuals from optimal refinancing: minor interventions might help overcome these biases • Credit constraints might not be as severe as commonly assumed in some rural areas - before assuming demand for credit, we should understand the specific area • RCTs can be a powerful tool for both business and policy decisions: they transformed medicine in the 20th century - perhaps they can transform development programs in the 21st • Organizations can help you test. If you are having trouble finding one, please contact me or Sendhil and we can direct you to one. (mfaye@fas.harvard.edu)

Randomized Controlled Trials in Rural Finance: An Example from India