Flexible Contract, Flexible Morale? Microcredit Design and Repayment Discipline

Flexible repayment benefits borrowers, but practitioners fear increased moral hazard. Investigating their concerns requires disentangling repayment choices from repayment capacity, which is typically infeasible in field studies. We use a lab-in-the-field experiment with 645 microcredit borrowers to cleanly identify the effect of repayment flexibility on moral hazard. We also quantify social pressure. Payoff maximization predicts low repayment in our rigid benchmark contract, and increased repayment with flexibility. Results suggest the opposite: Repayment in the rigid contract is high, and drops substantially under flexible repayment. Social pressure decreases. Our results are consistent with a strong social norm for repayment, which is weakened by introducing flexibility. Norms, which may be inculcated by the lender, may help explain several recent puzzles in microfinance research, including high and equal repayment rates across individual- and joint-liability contracts, and excessive peer pressure. Importantly, norm-driven behavior may erode with the introduction of flexibility.