All’s Well That Repays Well? Not Necessarily.

The past year has seen many commentaries on the rapid expansion of microfinance in India warning of the imminent consequences of unbalanced growth. The most striking statistic in this context — that the average client’s dues more than doubled in just four years (between 2012 and 2016), far outpacing only moderate growth in numbers of branches, employees or clients, and surely clients’ incomes — was estimated from data that, at best, captures only a large proportion of the microfinance market. While this has triggered ruminations of an emergent repayment crisis, these fears have been tempered on two grounds. First, the enforcement of new regulations since 2012 limit the risk of client over-indebtedness. Second, delinquencies have consistently remained low over the expansionary period, and wherever reports of distress have surfaced, they seem mostly uncorrelated with the sector’s growth rate.

But do these arguments show us the full picture? Considered against primary evidence from the financial diaries of low-income households in India, we find that often they do not. The data, collected by IFMR Finance Foundation during a study supported by the CGAP Customers at the Center Financial Inclusion Research Fund, provides rich detail on the financial lives of borrowers in a competitive and mature microfinance market. It reveals that the indicators cited by both arguments above are poorly correlated with the incidence of over-indebtedness and with the ways in which borrowers experience and cope with repayment distress.

Timely repayments and borrower distress are not mutually exclusive

Aggregated data from lenders’ administrative records, such as delinquency estimates published by credit bureaus, have traditionally served to indicate portfolio quality. When delinquencies are low, it is interpreted as a signal of positive borrower outcomes. However, the repayment record may not fairly represent borrowers’ experiences if lending practices emphasize timely collection above all else.

The financial diaries of over-indebted borrowers illustrate this fact. Of the 400 households we studied, nearly one of every five borrowers reported repayment obligations higher than they could reasonably afford, given their incomes and minimum living expenses. Yet, as many as 85 percent of those over-indebted borrowers never missed a repayment on formal loans, arguably since they had strong incentives (both institutional and social) to do so.

Further, the records submitted to bureaus seldom distinguish between repayments made by the client and payments made by group members on her behalf. Thus, perhaps as an unintended consequence of the design of joint liability, the administrative data reveal few meaningful insights at a sector-level on borrowers’ distress or well-being.

Not consumption smoothing but repayment smoothing

How is it possible for so many borrowers to consistently avoid delinquency while carrying multiple, unaffordable loans? The data suggest they are using several coping mechanisms, such as lowering consumption or postponing essential expenses; raising resources from friends and social networks; and using large formal loans when available to settle old debts, including smaller informal ones accrued in past months. This use of coping mechanisms in the face of shocks is not unlike previously documented evidence. Low-income households use a variety of strategies to insulate their consumption and standard of living from the risk of volatile incomes; alternatively, they try to minimize the impact of income volatility by diversifying their occupations and resources. These strategies have a limited ability to protect households from poverty, and it has been shown that severe or persistent shocks are a major cause for chronic poverty.

The use of coping mechanisms by over-indebted borrowers differed from these practices in one regard — the incidence of coping behavior was highly correlated with the unaffordability of household debt and appeared to revolve around insulating repayments rather than consumption. Borrowers with more unaffordable debt used negative coping mechanisms more often and to a greater degree than others. Their financial behavior was not unlike the expected response to an income or health shock. But in this case, the shock came in the form of multiple non-negotiable loan repayments. Unlike a random occurrence, these “repayment shocks” persisted month after month.

Additionally, not only was the level of debt correlated with distress, but also with certain product features embedded in the loan contract. For example, a subset of borrowers experiencing highly volatile cash flows might have more trouble meeting repayments at certain times of the year. We found that these borrowers, for whom repayments were occasionally unaffordable (when calculated against a given month’s income instead of the average), experienced higher levels of distress, almost on par with those for whom the repayments were almost always unaffordable.

The implication for microlending is that poorly matched repayment schedules and other product features could be just as harmful as too much debt — and more harmful if combined with high levels of debt. This is a critical dimension of the experience of over-indebtedness, yet it is often overlooked.

New lending rules to prevent unsuitable loans

It is evident from the observed level of financial distress that current practices to prevent over-indebtedness are not effective. In fact, critical fault lines in their implementation have created an environment where unsuitable credit remains the primary coping mechanism even for over-indebted borrowers. It is also concerning that they focus heavily on limiting the amount of client debt while ignoring other aspects of borrowers’ cash flows that are significant in mediating financial distress. These include large seasonal or cyclical effects for specific lines of income or, even more generally, total income volatility (the median household in our sample experienced monthly income swings as high as plus or minus 45 percent) as well as large and significant uninsured (but insurable) risks.

Beyond better repayment assessments

Microfinance in India is no longer dominated by monopolistic or mono-product markets. With the licensing of several large lenders as small finance banks, the expectation is now that low-income households will have access to better financial services. This means not only easier access to a wider set of services, but services provided by institutions that are better equipped to respond to low-income households’ primary needs and vulnerabilities.

Many have argued that the continued success of lending to low-income households will require the evolution of robust mechanisms to assess clients’ capacity to deploy credit and manage repayments. By itself, this will not be enough to prevent borrower distress since repayments alone do not signal that a loan is suitable.

Lenders must also adequately detect clients’ cash-flow vulnerabilities and respond to them with appropriate design and service improvements, complementary savings and insurance products, flexible repayment schedules where appropriate, and best practices for delinquency management.