Regulatory Options to Curb Debt Stress
The U.S. subprime mortgage crisis in the mid-2000s brought new focus on the risk of unsustainable debt burdens to both the financial sector and the real economy. This resulted in extensive reforms to laws and regulations related to credit across both Organisation for Economic Co-operation and Development (OECD) countries and other developed countries. In a broad range of developing countries and emerging markets, the past decade has seen highly publicized cases of dramatic household-level credit growth and increasing debt stress followed by institutional failure and government intervention. South Africa represents an extreme case, where a cycle of increasingly aggressive lending and over-indebtedness in the consumer credit sector led to the failure of a number of banks and contagion, which affected the entire banking sector.
Increased debt stress can result in social unrest and serious political repercussions. In Bolivia, protesters with dynamite strapped to their bodies held central bank staff hostage (Rhyne 2001). In Nicaragua, the No Pago movement instigated violent street protests, with the president labelling microlenders “usurers” (Pachico 2009). Such actions can threaten financial sector development. The recent debt-related fall-out in India captured international headlines and highlighted the extent to which debt stress can serve as a political rallying point. It led, for instance, to political support for repayment boycotts and to extreme regulatory interventions by one state government, and it undermined microlenders’ support from governments, donors, and social investors.
This Focus Note argues that it is preferable to implement appropriate monitoring mechanisms and regulatory interventions at an early stage in credit market development, to detect potential debt stress and prevent reckless lending practices, thereby avoiding risks to financial markets, consumers, and the regulator’s credibility.
It is based on the proposition that debt stress and over-indebtedness pose risks to credit market development as well as to consumer protection—risks that require a specific regulatory and policy approach. Consumers in developing countries are gaining more access to different forms of finance, from bank loans and consumer credit to loans from microfinance institutions (MFIs) and nonbank money lenders. Rapid growth in lending from these different subsectors may result in a rapid increase in debt stress, with defaults affecting both bank and nonbank lenders. The paperaims to offer practical guidance to regulators and policy makers who face such challenges.
As background for the policy and regulatory proposals discussed in this paper, Section I offers a brief overview of the dynamics of credit market cycles and describes how the factors driving the growth of a credit market may result in a credit bubble, followed by increasing defaults and eventual contraction. Understanding these dynamics is essential to grasping the limitations of traditional prudential supervision risk indicators and interventions in identifying and dealing with the risks of debt stress and over-indebtedness. We point out that when a credit market is growing rapidly, the increased supply of loans and high household liquidity may disguise actual levels of debt stress: defaults may be relatively low for a time, even when debt stress may be reaching unsustainable levels. Regulators are often unaware of the extent of debt stress until it is too late to take preventative measures.