Understanding the Effect of Islamic Finance on Small Enterprises: Evidence from a Randomized Experiment (2015-16)

In many economies around the world, “Islamic finance” is an important and rapidly growing pillar of entrepreneurial finance. Especially in low-income countries with large Muslim populations, the use of Shari’a-compliant financial products has been booming and is currently estimated to be worth between $1 and $1.5 trillion globally. The sector has been attracting significant attention of policymakers interested in the potential of Shari’a compliant-financial services to spur financial inclusion among Muslim consumers and businesses (World Bank, 2014). However, the economic implications of the rapid proliferation of Islamic finance, as well as its effects on small and medium enterprises with limited access to the formal banking system, remain poorly understood. While some studies have shown that Islamic banks tend to be more stable than their non-Islamic counterparts, and that Islamic loans tend to have lower defaults than comparable conventional loans (Beck et al., 2013), little is known about the selection into Islamic finance and the impact this may have on small businesses. Understanding the demand for and use of Islamic finance is, however, important because Islamic finance can serve as a bridge into the formal financial sector and may have far-reaching effects on how small enterprises operate and perform. Hence, in order to design Islamic products that are useful for businesses’ growth, performance and formalization, a more detailed understanding of Islamic finance and its effect on financial behaviors is needed.

In late September 2014, Bank Indonesia introduced Leonardo Bursztyn and his research partners, Stefano Fiorin, a UCLA Anderson Ph.D. candidate, and Martin Kanz of the World Bank to four potential partner banks. They had meetings in Jakarta with the potential partners, as well as with experts on Islamic finance working at the central bank. The meetings were useful to understand the context in which Islamic banks operate in Indonesia, and to identify the best bank to partner with. Thanks to support provided by the Center for Global Management, Bursztyn and his co-authors were able to begin a collaboration with a local bank.

The project studied the role of morality in the decision to repay debts. Using a field experiment, they found that moral appeals strongly increase credit card repayments. In their setting, all of the banks’ late-paying credit card customers receive a basic reminder to repay their debt one day after they miss the payment due date. In addition, two days before the end of a 10-day grace period, clients in a treatment group also receive a text message that quotes an Islamic religious text stating that non-repayment of debts by someone who is able to repay is an injustice. This message increases the share of customers meeting their minimum payments by about 15 percent. By contrast, sending either a simple reminder or an Islamic quote that is unrelated to debt repayment has no effect on the share of customers making the minimum payment. They also found that clients respond more strongly to this moral appeal than to substantial financial incentives: receiving the religious message increases repayments by more than offering a cash rebate equivalent to 50 percent of the minimum repayment does. Finally, they found that removing religious aspects from the quote does not change its effectiveness, suggesting that the moral appeal of the message does not necessarily rely on its religious connotation.

This project is complete, and a paper titled “Moral Incentives: Experimental Evidence from Repayments of an Islamic Credit Card,” which discusses the results of this study, is already circulating in the World Bank and the NBER working papers series, and has been submitted for publication at a leading economic journal.