This blog series is just more evidence that the microfinance industry is currently united around a common concern: avoiding over-indebtedness. Whether to protect the social impact on customers or the institutional viability of MFIs, over-indebtedness is crucial to all parties involved.
Still the most fundamental questions on over-indebtedness remain unanswered – in his recent post Rich Rosenberg says “we’re flying blind.” We do not know if over-indebtedness is just a marginal phenomenon in a few crisis countries or if it is a fundamental challenge to the industry. And we hardly know how to find out: Before we can measure over-indebtedness and address it we will first need a fair idea of how over-indebtedness in microfinance is defined.
We can learn a lot from commercial banking and the academic disciplines that have researched over-indebtedness in developed markets:
* Most of us will agree with economists that someone who is no longer able to repay his loans is over-indebted. But then default is the final stage of over-indebtedness and we would like to recognize it much earlier. As soon as we start following the economists on thresholds such as a high debt-to-income ratio, we realize that these are very imprecise and the thresholds rather arbitrary. How should we be able to tell for each country, for each individual, how much debt is too much?
* From a legal perspective, a challenge with default is that only honest borrowers should be eligible for debt relief. We cannot include deliberate default into our over-indebtedness definition but expect each borrower to make the maximum acceptable effort to repay his debt. While most developed countries have defined a minimum existence level that provides a threshold for the maximum acceptable effort, most developing countries have not. And many microfinance customers are probably living below the minimum existence level already before debt problems kick in.
* From a behavioral perspective, microfinance faces specific challenges of informational asymmetries. In most countries there is little information exchange between MFIs, let alone a central credit bureau. It therefore seems an indicator of over-indebtedness if borrowers accumulate loans from several microlenders at the same time, taking a new loan when unable to pay an old one off. However, researchers like Isabelle Guérin have pointed out that multiple borrowing is a common feature in the informal borrowing systems of the poor. Keeping a range of borrowing options active at all times might even be a means to maintain creditworthiness as a personal safety net. Other reasons for cross-borrowing can be the limited loan sizes of MFIs or inappropriate terms and conditions.
On top, microfinance institutions need to make special efforts that their products do no harm. From a perspective of customer protection, over-indebtedness is therefore much more than an inability to repay: it starts when a borrower has to sacrifice too much to be able to repay on time. Some sacrifices may well be acceptable for the borrower for the purpose of the loan but when they’re not – when a borrower is going hungry and selling his last livestock to avoid default – then (s)he is over-indebted. This definition may or may not be in line with risk management. It may discard the idea that high repayment rates prove the absence of over-indebtedness.
It does not necessarily imply that every loan that leads to unacceptable sacrifices should not have been made! The risk of investments going bad always exists. But a responsible lending industry will have to design products and policies that ensure the share of customers making unacceptable sacrifices is very low.
In conclusion, it comes at no surprise. When we want to learn about customer protection we will have to listen to what clients say. The real definition of over-indebtedness needs to take into account cultural differences, the social implications of debt, individual expectations about future income and so on. Only microborrowers themselves will be able to tell to what extent they are suffering from their debt.
This detailed understanding of the struggles over-indebted borrowers face is also what we need to develop appropriate measures of customer protection. It might turn out that the amounts we are lending are not too high but inappropriate installment schedules are making it too difficult for borrowers to repay, leading to sacrifices and the risk of default. In a second step we can identify indicators – and why not from the list above? – that approximate over-indebtedness well enough for MFIs to track its development in the long run. In the mean time I believe we all have an awful lot to learn about this complex phenomenon of over-indebtedness by listening to those we want to protect from it: the clients of microfinance.
For more information check out Jessica’s full length working paper “Microfinance Over-Indebtedness: Understanding its drivers and challenging the common myths.”