Laboratory Experiments to Evaluate Policies: An Example from Islamic Microfinance

Laboratory Experiments to Evaluate Policies: An Example from Islamic Microfinance Mohamed El-Komi University of Texas at Dallas Cairo conference: Perspectives on Impact Evaluation 31st March – 2nd April, 2009

Islamic Microfinance

Microfinance Can Alleviate Poverty • Small loans to disadvantaged individuals (or groups). • State of Microfinance: • High rates of interest (some reached APR 100%). • Receive Subsidies (95% of microfinance institutions, UNCDF 2005). • Primarely rural environments (e.g. Grameenbank and BRAC in Bangladesh, TriBanco in Brazil, Prodem in Bolivia and FINCA International). • Challenges: • Monitoring: Focus on group lending (less appropriate for urban settings). • Lack of tracking individuals + Increasing number of MFIs. Islamic Microfinance

Islamic Finance • Islamic commercial banking: • Assets exceed $700 billion ($160 billion in 1997). • Market growing 10-15% per year (The Economist 4 September 2008). • Relatively protected from current economic crisis (Financial Times Advisor 10 November 2008). • Main principles: Ban on interest + Equitable risk sharing. • Mechanisms: • Cost-plus sales (the most widely used). • Profit-sharing. • Joint venture financing. Islamic Microfinance

Islamic Microfinance? • Can expand potential clientele. • Increase take-up rates. • Enrich contractual settings. • New field (HSBC currently establishing an Islamic microfinance project in Pakistan). • Our project: • Experimental investigation of Islamic microfinance products. • Possible field implementation and evaluation. Islamic Microfinance

Controlled Experiments • Controlled environment to mimic the decisions of interest (avoid confounds). • Wind-tunnel (Plott 1979). • Induced valuation: paying experimental participants based on their decisions (Smith 1976). • Random assignment (unlike observational data or traditional interventions). • Inexpensive pre-tests. Islamic Microfinance

Previous Work • Group vs. individual lending: • Same repayment rates (Philippines) (Gine and Karlan 2008) (Karlan and Harigaya 2006). • Risk taking (Gineet al. 2006). • Group size irrelevant - information central (Carpenter 2002). • Interest rates: • Same repayments for consumer microcredit (South Africa) (Karlan and Zinman 2008). • Lower repayment for individuals, higher repayment for groups (Abbinket al. 2006). • Tracking borrowers: • Reduces moral hazard (microfinance) (Gineet al. 2006), (microcredit) (Karlan and Zinman 2008). • Islamic-compliant contracts – not previously examined experimentally. Islamic Microfinance

Our Setting • Entrepreneurial individual lending. • Focus: moral hazard (vs. adverse selection) (see, e.g., Cason et al. 2008, Cull et al. 2008, De Aghion and Morduch 2005, Gine et al. 2006, and Stiglitz 1990). • Compare ex post moral hazard in interest-based vs. Islamic contracts. • Used to design field experimentation. Islamic Microfinance

Our Experiments • Get loan, invest in risky project, learn outcome (lender does not), pay back or not (moral hazard). • Interest-based (10%) – no risk sharing. • Profit-sharing (80%) – complete risk sharing. • Joint Venture (40%, 60%) – partial risk sharing. • Hypothesis: More default risk sharing does not significantly decrease repayment rates. Islamic Microfinance

Interest-based Islamic Microfinance

Profit-Sharing Islamic Microfinance

Joint-Venture Islamic Microfinance

Summary of Future Work • Evaluate effectiveness of contractual types in the lab: • Different participants: Students, Muslim students, disadvantaged Muslims, microfinance clientele. • Design field implementation (Bangladesh). • Choice of contract and its impact on sustainability. • Evaluate full implementation. Islamic Microfinance

THANK YOU m.elkomi@utdallas.edu

Laboratory Experiments to Evaluate Policies: An Example from Islamic Microfinance