Over-Indebtedness: Roles and Responsibilities of All Actors

02 March 2011
3 comments

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.

Comments

Submitted by Jacco Minnaar on
Dear Milford, You are asking the big question and rightly so. There are separate discussions on this topic, but here is my take on it. - There is some evidence, including in Peru, that suggest that microcredit can and has had positive impact (see for example this meta research that has often been cited: http://www.microfinancegateway.org/gm/document-1.9.28824/30153_file_30153.pdf. I am aware that there is a lot of debate about methodology. - Overall I think the debate is still on and the jury is still out. I am not aware of any large household level research in either Peru or Cambodia that proves or rejects the hypothesis that microfinace has a positive impact. More research is needed. My hypothesis would be that rolling out credit at very high growth rates without proper cash flow analysis and credit bureau information put borrowers at risk and may be irresponsible, potentially leading to negative development impact. At the same time, I have not doubt that cash flow based lending done responsbily is an important building block of economic growth. - It seems to me that much of the research focusses on credit and even more often on group lending. The positive impact of savings is much less debated then that of credit. Succesful microfinance banks in our portfolio have more savings then credit (e.g. ACLEDA Bank in Cambodia)and this can be even more pronounced when looked at in terms of number of clients (e.g. Centenary Bank in Uganda serving almost 1 million savers and just over 100,000 borrowers). - There is extensive empirical evidence which suggests a significant and robust relationship between financial depth and growth. Researchers have also shown that financial depth is particularly beneficial for the poor, reducing income inequality (Beck, Demirguc-Kunt and Levine, 2004; Honohan, 2004). These results are encouraging and support that what I see as our goal is the way to go: building sustainable financial sectors. - Financial depth and access to finance are not the same, although there is also evidence that they are correlated. Is your critique of microfinance mainly focussed on group lending? This is where I see the biggest risks. Jacco

Submitted by Milford Bateman on
Jacco Where is the evidence that, apart from there being ‘more microfinance’, Peru and Cambodia have beneitted thanks to commercialised microfinance, say, through reduced poverty or local economic development? I’ve been looking for quite a while and can’t find any evidence of this having happened. Milford

Submitted by Dr V.Rengarajan on
Dear Jacco A very good and refreshing post! For challenging the over indebtedness issues, we need to go for the approach ‘Prevention is better than approach. In this regard, clarity on the role and responsibilities of the players concerned, assumes importance. While I agree your points, I share some more points pertaining to the subject for further strengthening the means for addressing the overindebedness issue effectively. 1. Ability of borrowers’ to repay- In the absence of cash flow analysis in group lending model, there is a need for the same analysis at individual borrower’s household level by the group leaders/field level officers concerned. This analysis involves assessment of three kind of borrower’s abilities covering a) debt bearing capability taking into account existing number of loans liabilities , b) skill execution capability for income generation from the activity financed c) budget management capability for balancing household expenditure including the given debt obligations and income. However, for income generation from the activity financed, besides skill of the borrower, the potential for the said activity in terms of physical supporting facilities like accessible roads, transport, communication, power, marketing etc., assume vital. MFI/SHG are to be trained for designing their appropriate micro credit product based on the available physical potential of the respective area as it would help assess the extent of market saturation and credit absorption as well of the area concerned . Both these factors also influence the cash flow from the activity undertaken and level of over indebtedness at household level. It is therefore emphasized that factors such as Potential based micro credit product (schemes) in general for matching the absorbability of the area of the MFI/group and capability of the borrowers at individual household level in particular for matching their needs are to be considered during the pre sanctioning credit stage . So to say a micro credit planning is necessary for serving as useful warning index and also monitoring tool for reviewing the progress at borrowers’’ level. 2. Crafting incentive system – While carefully crating incentive system for the loan officers/group leaders it is important that technical skill of the loan officers need to be tuned towards realization of mission and vision goals. In this context, more weightage is to be given for the socially oriented quality of micro financing for mission goals in terms of the following variables. a) More coverage of the fresh eligible borrowers b) Sale of diversified MF products such as micro insurance (MFI need to diversify MF products without confining to micro credit only) c) Number of poor clients crossing poverty line (prescribed line) in their respective staff service area and become independent living with debt stress d) Growth of normal business without happening of the above incidence as stated or similar kind forcing the clients much against their wishes case studies. e) Avoidance of multiple finance in their respective service area f) Entrusted with discretionary power for considering moratorium or rescheduling for a shorter period in genuine case. 3. Credit information on all borrowers – Two points I share here. In the first, besides information on existing and new borrowers as pointed in the posting, details on the drop outs / push outs (commonly found in SHG system) clients are necessary in the context of financial inclusion or inclusive micro financing and poverty reduction. Further practically it helps perceive the reason for the exclusion phenomenon and work out strategies for their re inclusion. Secondly, for collecting reasonably correct information in the non formal sector with the given level of literacy and skill at group level, there is a need for adoption of uniformity or standardization in the following for avoiding duplication , ghost data ( clients) wrong misinformation a) reporting format /schedule b) clarity on the column heads and c) units referred d) reporting periodicity e) local language Cross checking at different levels also is useful. 4. Defining role and responsibilities of all players- It is good to have the roles clearly defined for the all the actors in MF field. Besides the various role &responsibilities posted I wish to highlight three points. a) The role of clients also assumes importance in terms of their proper utilization of loan as per their actual need and purpose, avoidance of multiple loans from different sources accessible, willingness to repay dues in time, etc., In this regard MFI/NGO/SHG need to give counseling and guidance to the poor clients. b) The other invisible actor is government (local/centre) should have the responsibility in creating conducive environment and arranging physical supporting system in and around the service areas of MFI/SHG in a manner facilitating the functioning of micro credit more productively in terms of smooth income generation at house hold level. All said and done, it is equally important to have a well coordinated approach by the actors for the common goal. c) Both the investors and practitioners (MFIs) need to take the responsibilities to ensure credit planning and loan norms with the provision for suitable grace period/moratorium in repayment schedule (this point highlighted in Jessica’s posting in this blog- over indebtedness and impact Dated Feb 4, 2010) and integration of other microfinance services like micro insurance and micro savings with their micro credit products. All these purpose oriented factors reflect responsible micro lending without much debt stress in the poverty sector. 5. While defining commercial and ethical banking, one should note certain basics in Micro financing. Micro financing is package of pro poor financial services such as micro savings, micro credit, micro insurance, transfer services, capacity building etc., It should not confine to micro credit only and this service alone is inadequate for the said mission and vision. Indebtedness problems is liked only with the micro credit among other MF services.. Here commercialization of all micro financial services together instead of micro credit only, may not invite any controversies as access to all services with the reasonable coast to the poor, would meet the needs of various financial services of all segments of the poor in poverty pyramid and eventually facilitate poverty reduction . While providing all these pro poor services tailored to their needs, in an integrated manner to the poor clients, there is a hidden synergy of both commercial elements and ethical values as well. Where as under the brand name of Micro finance, mere commercial money lending (micro credit alone) with the inevitable focus on profit maximization may not help in any way positively on social front. What is emphasized here is an imperative need to have diversified micro financial services besides micro credit or micro credit integrated with other MF services as it would help MFI balancing their income/profit from different sources instead of single source micro lending at the cost of the clients’ sacrifices on one hand and ensuring the most vulnerable poor borrowers too (the poorest), endowed with well protected, risk free and secured livelihood on the other. . By this way candid micro finance platform provides an opportunity for synthesizing both the commercial elements and ethical values as well there by leading to a sustainable development of financial inclusion. For this, one has to avoid too much of credit and need to go much beyond micro credit as this would go a long way for challenging the over indebtedness problem Thanks Dr.V.Rengarajan

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