Over-Indebtedness in Microfinance – Who Should Bear the Risk?
Over the four decades since the development of the original microcredit methodology, the poor have been declared bankable – and increasingly even profitable bank clients. While microfinance products and lending methodologies vary significantly on the ground, two main features of microfinance have made this enormous expansion of access to finance possible: microlending has become scalable due to cost efficient operating models and due to risk management methodologies that ensured high repayment rates.
Recently, several microfinance markets have undergone crises of delinquency and over-indebtedness. To a certain extent this may be due to changed competitive environments where the typical lending methodology of microfinance works less well, to deviations from the principles of sound microlending, and to an interplay of industry dynamics with macroeconomic and political developments. However, these crises can also enhance our understanding of the general weaknesses of the microfinance risk management model.
Every lending activity faces on the one hand a risk of moral hazard, of borrowers who are unwilling to repay.
It faces on the other hand the risk of borrowers who are unable to repay. In microfinance, for a long time, both these risks seemed to have largely disappeared: clients were repaying extremely well. The mechanisms that enabled this reduction in risk are many and are well known:
- Selection mechanisms of borrowers that reduced the risk of adverse selection, for example, peer selection and close relationships between borrowers and loan officers
- Incentive mechanisms to prevent moral hazard, for example, group liability or guarantors, increasing loan sizes over cycles, collateral based on the subjective value of assets to borrowers rather than on market value, and small frequent instalments combined with a zero-tolerance policy.
Preventing loans to dishonest borrowers and giving borrowers strong reason to repay, these mechanisms are safeguards against strategic default by borrowers who are unwilling to repay. Most of the risk of strategic default has disappeared as a result. To a certain extent, the same mechanisms are also effective against risks of borrowers unable to repay. Small and regular instalments can make repayment discipline easier than large lump sums and in severe cases of difficulty, peers or guarantors may step in. However the risk of shocks to the expenses or income of borrowers, and the risk of microenterprise investments that fail have not disappeared. Instead of eliminating this part of repayment risk that relates to borrowers unable to repay, the microfinance lending methodology has to a large extent pushed this risk out of the portfolios of lenders and onto borrowers.
The strong repayment incentives of the microlending methodology often make microborrowers in repayment difficulties go to extreme lengths to avoid delinquency. Our over-indebtedness study in Ghana shows that many borrowers only manage to repay their loans on time because they go through unacceptably high personal sacrifices. Instead of delaying or stopping repayments when idiosyncratic shocks hit and debt service becomes unmanageable, borrowers absorb these shocks with personal suffering. In this case, what looks as a success from a risk management point of view because it keeps portfolio quality high is a serious concern from a social point of view.
For a long time, this part of repayment risk had become almost invisible in microfinance. But recent efforts to protect customers from over-indebtedness have brought the difficulties that microborrowers face in repaying back into light. Moreover, the markets that have experienced open repayment crises show that even from a risk management point of view, risk that seemed to have been reduced by a strong lending methodology, had only been shifted.
The moment that the borrowers’ maximum risk absorption capacity (including unacceptable sacrifices from a social point of view) is over-extended, the risk spins back into MFI portfolios.
From a customer protection point of view, the ideal risk management methodology would incentivize borrowers just strong enough to avoid moral hazard and strategic default. But there would be limits to shifting the risk of idiosyncratic shocks to borrowers. In line with insolvency laws in industrial countries, when repayments become unbearable with an acceptable level of effort, a borrower should be able to delay or default. The microfinance industry can hardly replace a regulator’s legal insolvency system or a government’s safety net – but for purposes of customer protection it will need to develop solutions for borrowers in difficulty that may imply an increase in risk for lending institutions.
Repayment incentives need to be strong but remain humane. Risk management should recognize to what extent it is making risk disappear and to what extent it is shifting who bears the risk. The industry may need to develop consensus on what amount of risk borrowers should bear for microlending to be responsible finance.
 Notwithstanding the benefits of flexible instalment schedules in the face of volatile incomes and of instalments that fit business cash flows.