Over-Indebtedness: Roles and Responsibilities of All Actors
The study referred to in my post yesterday, defines over-indebtedness as the inability to repay all debts fully and on time. Over-indebtedness only occurs if this situation occurs chronically, i.e. several periods in a row and against the borrowers will. I agree with Rich Rosenberg and Jessica Schicks who argue that over-indebtedness can start before a default is reached.
Still one of the keys to addressing over-indebtedness is analyzing the ability of the borrower to repay. A weakness of many group lending models is that no cash flow analysis is done, hence the debt service burden cannot be compared with net disposable income and the risk of over-indebting a client is not appropriately addressed. Some MFI’s that offer group loans have introduced cash flow analysis in the group lending methodology.
MFI’s should not rely on guarantees only and defaults that are covered by guarantees should be tracked in the management information system (as they often go unnoticed and loans are reported as current even if repayment is through a guarantor). There should be specific guidelines for the ratio of debt service as a percentage of net disposable income. Good practice is that credit officers visit borrowers after disbursement to monitor the use of the loan.
MFIs should also carefully craft incentive systems. These should of course not only be based on volume and disbursements but mainly on the quality of the loan portfolio. Too high levels of variable pay introduce undue pressures to disburse. As a consequence the use of incentives to motivate loan officers is limited. When recruiting loan officers, finding people who have affinity with the mission and vision of the institution is as important as technical skills.
When comparing debt service levels to repayment capacity, MFIs face the issue of multiple lending. As borrowers will not always voluntarily disclose other loans, credit information on all borrowers in the sector is important. Improving the effectiveness of existing credit bureaus and building new ones where they do not exist is necessary, though not easy. A legal framework is needed which enforces participation of all relevant lenders, while protecting borrowers. Credit bureaus should be designed to be able to collect information correctly, comprehensively and in a timely fashion, while at the same time transaction costs should not become a burden.
Even countries with strong MFIs and a good credit bureau are not immune to the issue of over-indebtedness. The sector has to define what is reckless and what is responsible lending. It seems to make sense to define a maximum debt service level compared to net disposable income, with mechanisms in place to enforce this (either through self regulation or where needed supervised by regulators). How to tackle over-indebtedness is complex, but who is responsible? Over-indebtedness cannot be tackled by any actor alone; a concerted effort of all stakeholders in the sector is needed.
Microfinance clients are not just victims. Client education is important and they should be encouraged to use credit responsibly. Microfinance institutions can play an important role in getting this message across. They should be consistent in applying best practice in terms of evaluating repayment capacity, offering transparent terms and conditions and using credit bureau information. Under the umbrella of microfinance and banking associations, they should encourage debate on the definition of what is responsible lending in their market and set specific guidelines. Regulators can promote disclosure and transparency on lending practices, encourage or enforce the use of credit bureaus and supervise guidelines. Appointing an ombudsman can be a way to get warning signals and a part of an effort to protect microfinance clients.
Investors cannot leave the burden of tackling over-indebtedness solely to MFIs. The profile of microfinance investors has changed and become more commercial. In order to counterbalance this development, several investors have developed and signed up to the Principles for Investors in Inclusive Finance. All investors should be encouraged to do the same. As equity investors they should seek a reasonable return, play an active role in the governance of their investees and directly influence the policies of MFIs. As providers of debt they can integrate the way MFI’s are trying to tackle over-indebtedness in the investor’s credit decision making process, while influencing MFI’s when discussing with them during due diligence.
At its core, the discussion is about what defines commercial and ethical banking. In his blog, Milford Bateman suggests that over-indebtedness is intrinsic to the preferred model of commercial microfinance. I agree that with the arrival of new purely commercial investors, there is a risk that profit maximization becomes more important than the mission of MFIs and their social objectives. But Milford Bateman’s view ignores the fact that commercialization has also had positive impacts. In many countries the growth and larger scale which was reached after transformation into a commercial entity, has led to a more diverse product offering and lower rates and as a result a better services to clients. Many countries, including Cambodia and Peru are examples of this development.
What is needed is balanced growth and balanced returns. Efficiency gains and lower cost ratios should be translated not only in higher profits, but also in lower interest rates. This does not mean that we should abandon the commercial model altogether. It does mean that we need to take into account all stakeholders in order to grow the sector sustainably.
Ultimately the microfinance client has to become the key focus again. This is about more than client satisfaction. It involves really understanding the needs of clients and delivering products that cater for these needs. Microfinance has come some way, but there is still too much focus on credit, while what is needed is a broader variety of services (savings, remittances, payments, insurance, etc.). A diversified credit product offering is also needed; enabling MFIs to tailor products to customers’ needs and situations.
Over-indebtedness cannot be avoided by any of the parties involved alone. This is an important difference compared to other issues. While MFI’s are often pointing to other players when discussing pricing transparency, each player can improve its performance in this respect independently of other actors in the sector.
An MFI that adopts all best practices on over-indebtedness can still be confronted with the issue, as long as the rest of the sector is not moving in the same direction. Therefore all stakeholders (including investors, regulators, microfinance associations, MFI’s and microfinance clients) should take the necessary steps to protect clients, reduce risks and work towards a sustainable development of the inclusive finance sector.