Savings-and-credit contracts

Summary

Focus

We examine a novel financial contract design called the savings-and-credit contract (SCC), which uses mandatory savings periods and default penalties as a screening mechanism in credit markets. Unlike traditional spot loan contracts where borrowers make an immediate down payment, SCCs require borrowers to demonstrate their creditworthiness through regular savings payments over a specified period before receiving credit. We specifically analyse both theoretical and empirical aspects of this contract design, using Brazil's consórcio system as a real-world application of the SCC concept.

Contribution

We contribute to multiple strands of literature by introducing a new mechanism for addressing information asymmetry in credit markets. We extend existing work on signalling and screening in credit markets by showing how SCCs can be more effective than traditional spot loans, especially when borrowers face liquidity constraints. We provide a theoretical framework demonstrating why SCCs might outperform conventional contracts in separating good borrowers from bad. This can be particularly effective in environments with higher interest rates, higher discount rates or more unobservable information. This work complements existing literature on rotating savings and credit associations, household finance and contract design in credit markets.

Findings

We present both theoretical and empirical evidence supporting the effectiveness of SCCs. The theoretical model shows that SCCs can expand access to credit by better separating good from bad borrowers through the costly savings requirement. Empirically, data from Brazil's consórcio system show that despite appearing riskier on observable characteristics (including 15% lower formal employment rates and worse credit scores), consórcio participants show approximately 5% lower default rates than traditional bank borrowers when controlling for observable characteristics. A 2009 regulatory reform that reduced penalties for early default provides additional evidence supporting the model's predictions: when the penalty was reduced, adverse selection increased and default rates rose. This confirms the screening role of the savings period and penalty structure.

Abstract

In this paper, we present a savings-and-credit contract (SCC) design that mandates a savings period with a default penalty before providing credit. We demonstrate that SCCs mitigate adverse selection and can outperform traditional loan contracts amidst information frictions, thereby expanding access to credit. Empirical evidence from a financial product incorporating an SCC design supports our theory. While appearing riskier on observables, we observe lower realised default rates for product participants than for bank borrowers. Further consistent with the theory, a reform that reduces the default penalty during the savings period induces worse selection and higher realised default rates.

JEL classification: D47, G21, G23, G51, J61

Keywords: access to credit, contract design, information asymmetry, signaling