Building Responsible Lending at the Base of the Economic Pyramid Through Credit Reporting

February 21, 2012    

Microfinance globally has brought first-time access to formal financial services to hundreds of millions of people. Much of the public’s attention has been focused on microcredit, which, in the past five years alone, has experienced unprecedentedly rapid growth, and new players have entered the market. Unfortunately, this growth is not always sustainable. Some iconic markets, such as India and Bosnia–Herzegovina, are experiencing large-scale credit crises and in some cases client over-indebtedness, and they are not alone. Credit reporting, covering both lenders and clients at the base of the economic pyramid, offers a critical tool to promote responsible microlending and avert harm to the very poor households microfinance intends to help.

But adapting credit reporting approaches that have revolutionized uncollateralized lending to more affluent customers around the world to incorporate the poor and those that lend to them presents unique challenges. A new paper by CGAP and IFC outlines the issues and identifies success factors that will help to ensure the growing ranks of lenders to this market segment behave responsibly.

“Credit reporting isn’t a cure-all,” said Tim Lyman, a lead author of the paper. “Alone, credit reporting cannot create credit discipline, nor can it compensate for inadequate underwriting standards. But it can help all types of lenders at the base of the pyramid to better manage credit risk, and it can create a powerful incentive for repayment among borrowers as they develop ‘reputational collateral’ in their positive histories.’”

The CGAP and IFC paper reviews the three main types of approaches to credit reporting that can serve the base-of-pyramid market segment – credit bureaus, credit registries, or MFI-specific client databases – noting that they can be exist in parallel and in various hybrid forms, depending on the market.

Credit bureaus are usually privately-owned or formed as nonprofits, and they typically collect the widest range of information on borrowers’ credit histories, which is packaged, analyzed, and sold to lenders in the form of credit reports. Credit registries differ in that they are usually established by regulators to collect data and information on the lenders they regulate to help better manage credit risk. A third model entails MFIs sharing the credit histories of their customers among themselves for the same purpose and in some cases can develop into a more elaborate and comprehensive forms of credit reporting. These MFI-specific client databases can start quite basic, and sometimes represent simple ‘blacklists’ of delinquent borrowers.

“All three approaches have their merits as do creative hybrids, and we’ve seen examples in specific countries where each approach has helped all types of base-of-the-pyramid lenders get better information on their customers, and helped their customers establish valuable ‘reputational collateral'" said Lyman.

These approaches are already effective in some countries. A credit bureau in Ecuador has developed excellent reach to customers outside the traditional banking framework thanks to a partnership with the country’s rural finance network, while in Bosnia-Herzegovina, the central bank broadened the reach of its Central Registry of Credits to include both bank and non-bank lenders, including all of the country’s MFIs.

Typical challenges to effective credit reporting at the base of the pyramid include:

• establishment of credit reporting systems that cover all types of base-of-the-pyramid lenders in a given market;
• regulatory or cost barriers that limit participation;
• comparatively high costs of obtaining and processing high-quality data on base-of-the-pyramid borrowers;
• establishing the identity of base-of-the-pyramid borrowers; and
• protection of data privacy and accuracy at a reasonable cost given high transaction volume and low loan sizes.

Policy makers, donors, and lenders serving those at the base of the pyramid all have roles to play in developing credit reporting systems that gather reasonably thorough and accurate data on base-of-the-pyramid borrowers and cover the full range of formal lenders from which these clients are borrowing. Policy makers can remove regulatory barriers to participation and fashion incentives—or even mandates, if removing the barriers proves insufficient to get reasonable market coverage. Donors have the means to support policy makers, credit reporting service providers, and base-of-the-pyramid lenders to understand the benefits of comprehensive credit reporting systems and to overcome obstacles—and they have the means to inform base-of-the-pyramid borrowers why this is in their best interest.

But base-of-the-pyramid lenders have perhaps the most important role to play: by supplying data and purchasing credit reports they provide the building blocks of credit reporting systems with the potential to foster responsible lending at the base of the pyramid and avert irresponsible lending that leads to over-indebtedness.