The experiment was conducted in three waves: July, September, and October 2003. In each wave clients were randomly assigned three interest rates conditional on their observable risk category. Rate ranged from an upper bound of the prior interest rate for each individual to a lower bound of 3.25% per month. The offer rate was featured on the direct mailer. The contract and future rates were only revealed to clients and loan officers if the client took up the offer (i.e., applied), and after the loan officer completed her initial underwriting. Our design contains built-in integrity checks for whether the contract and future rate were indeed surprises: both client take-up and loan officer approve/reject decisions were uncorrelated with the surprise rates. Nor were there any instances of clients applying for the loan, being approved, and then not taking out the loan. This fact further corroborates that the contract rate and dynamic repayment incentive were surprises; i.e., that borrowers made take-up decisions with reference to the offer rate only.
5028 (8.7%) clients took up the offer by applying for a loan. Clients applied by entering a branch office and filling out an application in person with a loan officer. Loan applications were taken and assessed as per the lender’s normal underwriting procedures. The loan application process took at most one hour, typically less. Loan officers first updated observable information (current debt load, external credit report, and employment information) and decide whether to offer any loan based on their updated risk assessment. 4348 (86.5%) of applicants were approved. Next loan officers decided the maximum loan size and maturity for which applicants qualified. Each loan supply decision was made “blind” to the experimental rates; i.e., the credit, loan amount, and maturity length decisions were made as if the individual were applying to borrow at the normal rate dictated by her observable risk class.
After clients choose an allowable loan size and maturity, special software revealed the contract rate in the 41% cases that it was lower than the offer rate (otherwise no mention was made of a potentially lower rate). Loan officers were instructed to present the lower contract rate as simply what the computer dictated, not as part of a special promotion or anything particular to the client. Due to operational constraints, clients were then permitted to adjust their desired loan size following the revelation of the contract rate. In theory, endogenizing loan size in this fashion can work against identifying moral hazard on the contract rate (since a lower contract rate strengthens repayment incentives ceteris paribus, but might induce choice of a higher loan size that weakens repayment incentives). In practice, however, only about 3% of borrowers who received a lower contract than offer rate changed their loan demand after the contract rate was revealed.
Last, 47% of clients were randomly assigned and informed of a dynamic incentive future rate in which clients received the same low contract interest rate on all future loans for one year as long as they remained in good standing with the lender. This explicitly raised the benefits of repaying the initial loan on time (or equivalently the cost of defaulting) in the 98% of cases where the contract rate was less than the lender’s normal rate. The average discount embodied in the contract rate, and hence future rate, was substantial: an average of 350 basis points off the monthly rate. Moreover, the lender’s prior data suggested that, conditional on borrowing once, a client would borrow again within a year more than half the time. Clients not receiving the dynamic incentive obtained a contract rate for just the first loan (which had only a 4-month maturity in 80% of the cases). Clients were informed of the future rate by the branch manager only after all paperwork had been completed and all other terms of the loan were finalised.