1 Expanding Credit Access: Using Randomized Supply Decisions to Estimate the Impacts May 2008 Dean Karlan Yale University Jonathan Zinman Dartmouth College

2 What we do: Our Main Research Question… Does More Expensive Credit Do More Harm Than Good? To Lender –Do financial intermediaries have the right model for assessing/pricing credit risk? To Borrowers (focus of this paper) –Do borrowers know what’s good for them?

3 What we do: Field Experiment on Consumer Credit Access First Randomized-Control Trial on credit access Finance company randomly assigned loans to below-bar, first-time applicants for consumer credit in South Africa –Treatment = standard product: 4-month installment loan, 200% APR, unsecured, individual liability –Control = rejected per usual –Sample frame: working poor (Table 1) We then measure impacts of expanded access: –On borrowers –On Lender

4 What we do: Measuring Impacts of Expanded Access Lender: profits from marginal loans Applicants –Household survey: wide range of economic and subjective well-being measures 6-12 months out Borrowing Investments, wealth, (mental) health –These are the ultimate impacts of interest –Credit scores 15 and 27 months out

5 Why is this Important? Methods, Findings Inform Policy Large policy and programmatic investments with schizophrenic approaches to credit access “Subprime” lending: make an expensive loan in the USA and you’re a: –“usurer” –“predator” Particularly if your loan is for “consumption” Prescription: restrict access “Microcredit” make an expensive loan in the developing world an you’re a: –“poverty alleviation charity” –Nobel Peace Prize winner Particularly if your loan is for “production” Prescription: expand access

6 False Dichotomy » Flawed Policy? False dichotomy: credit is credit (in subprime markets) –Money is fungible –Closely-held businesses –“Consumption” can yield higher “returns” than “production” Flawed prescriptions –Don’t necessarily want to restrict access even if consumers don’t know what’s good for them –Don’t necessarily want to subsidize access even if consumers do know what’s good for them (and markets fail)

7 Why is this Important? Consumer Decision Making More Generally Why might consumers harm themselves by borrowing at 200% APR? –(No hidden fees here, so why do we worry about consumers over-borrowing but not about under-borrowing?) –Present-biased preferences (Laibson, etc; Skiba and Tobacman) –Present-biased price perceptions (Stango and Zinman) –Over-confidence/optimism (?) Why might consumers benefit? –If consumers suffer from biases above, but their outside options are even worse (loan sharks, pawn shops, etc.) –If consumers are “rational” (homo economicus) Investments in health, education, work, financial management yield “returns” that offset the high interest rate –High rate does necessarily translate into high total interest payments on short-term loans

8 More Harm than Good? Existing Evidence Limited –Few studies (especially on consumer credit) relative to importance of question Mixed

9 More Harm Than Good? How do we Answer the Question? Naïve social science methods likely to fail –Lots of unobserved variables that might drive both access/borrowing and later outcomes –(E.g., low fit in credit scoring or revenue models) Solution: randomize access –This study take observationally identical people who would normally be rejected per the Lender’s risk assessment model randomly give some a loan –“Gold standard” method, following clinical (drug) trials –Then follow-up data collection on “subjects”

10 How do you Randomize? Lender’s normal method a combination of centralized credit scoring and branch personnel discretion –Add two extra steps to normal underwriting process What’s in it for Lender? –Senior management thought branches too conservative –Reluctant to tweak performance pay –Common for retail scoring models to not be fully optimized (Allen et al 2004)

11 What Did We Find? First some descriptive statistics on how borrowers use their loans Then a summary of our main results on borrower economic status, well-being

12 Table 4. Loan Uses in our Sample All loans since application Microlender loans since application Pay other debts28.3%31.7% Transportation19.4%12.7% Events16.9%15.5% School/university13.7%15.5% Improve/build house11.5%6.3% Buy/improve food9.9%23.2% Bills7.3%7.0%

13 Analysis Is simple: Treatment: additional loan(s) to marginal consumer credit applicants, at 200% APR –Treatment did increase overall (formal sector) access and borrowing Compare outcomes for treated (randomly assigned loan) v. control (still rejected) –Severally –Jointly

14 Main Results Tables 5-8 in paper: Overall 6-12 month effects on applicants positive –Economic well-being measures from household surveys –Subjective well-being measures from household surveys Mechanisms: –Job retention –Wealth effect of cheaper credit access No ill effects on credit scores months out –And positive effects on having a score Marginal loans were profitable Results consistent with welfare gains from expansion of high-risk, high-cost consumer credit

15 What Have we Learned? Within sample: key is ruling out negative effects on borrowers –No subsidies for consumer credit External validity: who knows. –One implementation only –But….

16 Implications: External Validity? Findings here provocative: arguably decked was stacked against finding positive impacts in this implementation –For-profit Lender –Expensive credit –Somewhat competitive market –No mandated APR disclosure

17 What Should We Do? Good science requires replication Good policy requires an understanding of mechanisms –Who benefits and who does not? –When Macro conditions and aggregate shocks –Why? “Behavioral” (psychological) biases Outside options (access to even more expensive credit)

18 Next Steps: Replications and Extensions “More research” should resonate here Testing financial innovations –Risk assessment, pricing, and access –Marketing –Product Development Systematic testing a win-win-win –Firms get a competitive advantage: profits through innovation –Policymakers and funders learn what works and what does not –Researchers learn why Good research is cheaper than bad decisions Even with pessimistic view of external validity, we can proceed market-by-market and get answers we need –with tiny fraction of resources devoted to microfinance programming

19 To be continued…. Thanks for listening!