Over-indebtedness: Striking the Right Policy Balance
There are increasing concerns in many parts of the world on over-indebtedness, even in countries where the level of access to finance is very low. Over-indebtedness has extremely negative social consequences, as households divert an increasing amount of income from basic household expenditure to debt servicing. The recent CGAP Focus Note explores policy and regulatory options to deal with the ubiquitous rise in retail credit and debt levels and the regulatory challenges which this poses.
Photo Credit: Darcy Kiefl
Debt stress is an inherent phase in the evolution of credit markets and in credit cycles. It is natural that the success of pioneering lenders in a growing market will attract other participants, increasing the supply of credit and leading to further growth. These factors are positive, reflective of a developing and maturing market. However, it is also natural that many of these new entrants will target the same client segments as the pioneers, possibly with weaker loan methodologies. These new entrants may equally well include a few sharks who spotted an opportunity for quick growth and quick profit. Debt stress is the inevitable result.
The political consequences of ignoring debt stress are serious. Even when only a small section of the population is affected by excessive debt or aggressive debt collectors, such cases can result in headline news. We have seen how this can lead politicians to question the competence of financial regulators and the adequacy of credit regulations.
Urban residents and government civil servants are often the first target when credit providers set up shop in emerging markets. Unfortunately, these are also the most politically sensitive target markets. Any evidence of debt stress in these segments can trigger parliamentary discussion and the call for new regulations. Such action may very well be justified in the light of debt stress amongst salaried workers in urban areas . . . but they may equally well make it much more difficult to extend finance to rural populations, SMEs, or even informally-employed city residents.
The risk of over-reaction is most acute in middle income and high growth markets. This would include countries such as Mexico, Brazil, Thailand and many more. My home country, South Africa, is firmly on this list. In the early 2000s lending excesses by both bank and non-bank lenders instigated huge instability in the financial sector. This included bank failures. In response, a ‘national loans register’ was established and a comprehensive National Credit Act was passed, which included penalties on ‘reckless lending.’
In such circumstances regulators have to monitor growth in the market so they can detect signs of stress early.
Increased credit market regulation, including detailed disclosure rules, compulsory affordability assessments, mandated credit bureau enquiries and increased regulation of debt collectors usually form part of the response in high growth and high risk credit markets. However, such an extensive response may not be appropriate in an early stage market, when the majority of the population still has little or no access to credit.
There is always a risk that a few isolated cases of over-indebtedness in politically sensitive client segments can result in a national outcry, leading to regulatory interventions that are damaging to financial inclusion. Without convincing statistics, it is very difficult for regulators to take the lead in pro-active and balanced policy formulation.
The pace of growth in credit markets demonstrates the importance of early establishment of credit bureaus (and of inclusive information sharing between bank and non-bank lenders), introduction of affordability requirements and close scrutiny to high risk lending practices, such as lending based on payroll deduction.