Randomized Controlled Trials in Rural Finance: An Example from India

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

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

3. 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?

4. 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

5. 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

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

7. 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

8. 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

9. 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%)

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

11. 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?

12. 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

13. 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

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

15. 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)