Insights from Behavioral Economics to Small Business Banking Antoinette Schoar Michael Koerner '49 Professor of Entrepreneurial Finance MIT Sloan School of Management CEPR-EBRD: “Understanding Bank in Emerging Markets” September 5-6, 2013

What is Behavioral Economics?

What is Behavioral Economics?

The Marshmallow Experiment

The Marshmallow Experiment

Giving in …

Traditional – Mapping Intention to Action

A

C

Yes

No

Yes

No

B

D

Decision Actions Outcome

Behavioral – Obstacles to the Translation

Decision Actions Outcome

People misjudge how the will behave

Ex post need to justify actions (or just confused)

A

B

Yes

No

Yes

No

• Small changes in how financial products are set up significantly affect customer outcomes – Credit risk is not a fixed type but endogenous to

the state of the credit market – The sophistication of financial institutions causally

affects the structure of credit risk in the economy

• Banks have embraced retail financial tools for SME banking to reduce transaction costs – But opportunities to use psychological insights to

improve repayment behavior

Why is this Relevant for Finance?

Getting to the top of mind: testing the effectiveness of reminders

• Banks in Bolivia, Peru, the Philippine and Uganda

• Customers with loans of savings accounts

• Monthly text message reminders – Estimate size of effect – Generic text message

reminder or highlight a particular goal

Source: Karlan, McConnell, Mullainathan, and Zinman (2010) and Cadenas and Schoar (2011).

Text message have similar effects as 20% reduction in interest rate

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

No reminder Generic reminder Goal-specific reminder

% re

duct

ion

in la

te p

aym

ent

SMS Reminder Cash incentives for on time payments

* Heterogeneity who responds to each treatment: the young are more like to respond to SMS

Text message reminders increase savings

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

No reminder Generic reminder Goal-specific reminder

Perc

enta

ge in

crea

se in

savi

ngs

Information Avoidance: Foreclosure Resolution

Mullainathan, Schoar and Shafir (2011) 13

• Distress homeowners do not return calls and mailing about mortgage reduction offers

• >85% of borrowers in distress do not call back

• Lack of information seeking to avoid dealing with pain

• Type of outreach matters • Highly distressed borrowers

respond only to “soft touch”, constructive messaging

• Casually distressed borrowers respond to harsh messages (strategic default)

Take Away

• People suffer from inattentiveness even toward

goals that are important to them – Not following through on goals results in sub-optimal

outcomes

• Reminders can help people stick to a plan – Text message reminders are very cost-effective – Content and type of message matters

Loyalty as Alternative Collateral

• Idea: Many SMEs do not have collateral to get a bank

loan even if they have cash flow to pay it. Test a collateral free loan product and use relationships as alternative collateral?

Different Hypotheses for Effectiveness of Outreach

• Challenge: Test if relation building can ensure repayment and increase client loyalty • Can the services that bank provides substitute for the

lack of financial infrastructure in the market?

• Depends on the reasons behind defaults • Strategic default: Reduction of moral hazard? • Loyalty: Build personal relationship between loan

officer and clients? • Behavioral factors: SMEs have poor planning skills

• Only uncollateralized lending facility to SMEs in India • Credit assessment is based on a score card model • Centralized risk team makes credit decisions based

on observable information, e.g. tax filing, bank statements

• Loans are structured as a one year overdraft facilities • Payment modality like a credit card: monthly interest

payments and 5% of balance has to be paid • Loan size between $10k-$50K • Penalty interest rate starts after 30 days late

Set Up

• Hire six relationship managers to follow up with clients in treatment groups A and B • Very clear separation from credit assessment team • Convey to borrowers that relationship managers will

not be involved in loan renewal

• Relationship managers have set scripts to call clients • Check in every two weeks independent of loan

status. Solve problems with accounts, remind customers of delays in payment if necessary etc

• No cross selling (!)

Implementation

Experiment Set-up

• Group A: No monitoring treatment – Control Group

• Group B: Reminder treatment

– Send SMS with interest and principal due every month. Follow up with phone call if clients have outstanding balances

• Group C: Medium touch treatment

– Random loan officers follow up with clients regularly to solve problems, understand the nature of the business

• Group D: Personal touch treatment – Assign individual loan officer to create “ongoing relationship”

with client. Treatment as in Group C.

Default Rates Differ Drastically by Treatment

6 %

9%

0 %

8%

10 % 9%

10 %

12%

3%

19%

11 %

15 %

6 %

14 %

0%

2 %

4 %

6%

8 %

10%

12 %

14%

16 %

18%

20%

SBL, Loans 5+ Lakh, CPA Cities [N=774]

SBL Power, Loans 5 + Lakh, CPA Cities

[N= 311 ]

SBL, Loans 5 + Lakh, Non - CPA Cities

[N= 158 ]

SBL Power, Loans < 5 Lakh, Non - CPA Cities

[N= 505 ]

Delinquent Customers per Treatment Group

High - Touch (Relationship) Medium - Touch (Monitoring) Low - Touch (Reminders) Control

-

Differences in Account Behavior

• Significant reduction in late payments for borrowers in groups A and B • Almost 20% reduction in late payments • Onset of late payment and number of late payment

spells are reduced for treatment groups A and B • Ultimate default seems to converge: Accounts in

default are handled by separate department

• Improved outcomes at renewal stage for borrowers in groups A and B

Results I

Reachability

Complaint Behavior

• Compare treatment groups A versus B • Other treatment groups did not have outreach data • Significant higher likelihood of reaching clients in A

group than B; especially on second follow up call • Likelihood of complaints are lower for treatment

group A but conditional on complaint the nature of the complaint seems more serious

• Find similar results for ability to reach customers for follow up calls by ICICI bank and cross selling

Results II

Take Away

• Personalized attention by loan officers matters for repayment behavior and loan renewal decisions • Groups A & B have significant change in repayment

• Relationship lending affects client’s willingness

to engage in moral hazard behavior and loyalty to the bank • Relationships constitute “alternative collateral”

• Rethink model of credit risk in loan markets • Default decisions are situation contingent • Screening versus moral hazard? • Stability of prediction models?

• Advances in lending products helps borrowers

improve their credit type • Virtuous cycle of credit access

• Need more work on equilibrium effects and

competitive responses of banks

Conclusion

What is Behavioral Economics?

Clocky helps you get out of bed. Hit the snooze button and it rolls off the nightstand, around the room and hides. Next time it goes off you must get up just to find it.