Consumer Lending and Overindebtedness in Latin America
In Latin America household debt levels have been rising in recent years. This has been driven in part by the growth in consumer lending that has coincided with rising incomes of many low-income households in countries such as Chile, Peru, Brazil, Mexico and Colombia. This growing consumer base has attracted new providers from international and national-level retail chains to local consumer lenders, eager to capture market share in a population often underserved by traditional financial institutions in the past.
Increased consumer debt level can in part be expected with growing economies. However, in several markets these debt levels may be leading large groups of consumers towards overindebtedness, and could pose a risk to economic growth, household well-being, and financial institutions with significant levels of consumer debt in their portfolios. In Brazil, for example, household debt-to-income levels nearly doubled in five years from 2006 to 2011, from 22% to 40%. We have already seen a consumer lending scandal at major retail chain La Polar Chile that impacted more than 400,000 of their customers, and dropped their stock price by 42% in a single day. While in Mexico information on consumer lending for many microfinance and credit-only institutions shows portfolios with arrears levels of 20-30%.
We view consumer lending to low-to middle-class consumers as one of the biggest consumer protection challenges facing the region. Fortunately there are many promising interventions underway by both policymakers and the private sector to better understand the phenomenon of consumer lending and its implications for households and retail finance, and hopefully be better prepared to address bubbles before they burst. To share some of these experiences, we would like to highlight here three particularly promising approaches.
Institutional-level risk assessment. This approach includes incorporating specific measurement of consumer lending portfolios into review of financial statements, risk and affordability assessment requirements for lending operations, and consideration of staff incentive structures that encourage reckless lending. One of the best examples of this approach to rising consumer debt levels is Peru. The Superintendent of Banks and Insurance in Peru recognized several years ago the growing presence of consumer credit amongst low to low-middle income consumers, with consumer loan growth increasing at approximately four times the rate of GDP growth from 2006-2011, with more than half of all new credits during this period at amounts less than $5,000. To address the potential for overindebtedness in the consumer credit sector, the SBS has enacted a series of supply-side measures, including
- Best practices and risk mitigation strategies that financial institutions dealing with consumer and small business loans should follow or at least take into account.
- Evaluation of financial institutions’ portfolios that focuses on the portion of their portfolio that includes small-value loans, including portfolio in arrears and rate of growth of this portion of their overall lending operations.
- Sanctions in the case that the SBS determines the financial institution does not monitor small-scale borrowers’ overindebtedness risk properly, including the requirement of additional loan loss provision requirements for the financial institution if their portfolio is deemed to be too risky or growing at an unsustainable rate.
Household debt surveys. Demand-side data can help providers and policymakers to understand gaps in our knowledge of consumer lending and debt levels across markets:
- Measurement of actual debt levels across different population segments and product types;
- Why household debt levels are increasing, and the primary uses of this debt in households; and
- The consequences of rising debt levels to a household (i.e. sacrifices in education, health, nutrition and other basic necessities as a result of rising debt levels.)
Another interesting use of this survey data is linking it with demographic and behavioral information, so that these surveys not only measure current household debt levels, but also explore the characteristics and behaviors that lead to high consumer debt.
For example, a household debt survey by the Banco de la República in Colombia examined household debt and financial literacy in a single survey. This led to an important observation that financial literacy performance actually does not correlate very strongly with high or low debt levels amongst the lower-income participants in the survey. This observation raises questions about the effectiveness of traditional curriculum-based financial education as a tool to drive consumers towards better financial management, and may speak to the need for interventions that seek more to influence behavior than increase financial knowledge.
Credit reporting systems. Credit bureau coverage has expanded considerably in Latin America in the past decade, and there are several new pilots in the region that seek to build on these advances in credit reporting by focusing on the issues of consumer lending and overindebtedness. In Mexico, an ongoing study is examining credit bureau data on borrowers from microfinance institutions and consumer lenders, both to measure debt levels amongst low-income populations, as well as better understand the patterns that lead to overindebtedness. This study builds on the credit bureau data by conducting follow-up surveys with a sampling of the households in the bureau with high debt levels, to try and identify personal and financial traits or habits amongst these consumers that may indicate a propensity towards excessive debt. Another credit bureau pilot project in development in Panama is using psycho-metric information to measure traits such as honesty and responsibility to help identify credit-worthy individuals without any existing credit history, so that they are not excluded from access to financial products solely because they lack a credit history. MIF is also testing the use psycho-metric tools for credit assessments by individual institutions in Mexico, Peru, and Costa Rica.
Latin America is a region with significant opportunity and urgency to take a global lead on financial consumer protection. The high supervisory capacity coupled with mature and innovative financial service providers make the region a perfect laboratory to further develop the above efforts to better understand the risks of base-of-the-pyramid consumer lending, and pilot other approaches as opportunities arise. In addition, the rapid growth in access to financial services amongst the lower and middle-class in Latin America create an urgent need for better understanding of both the benefits and the current and future risks that this expansion in consumer lending carries for high-growth countries across the region.
Dear Rafe, dear Sergio
Thanks a lot for this very interesting and important post! Especially your reference to household surveys and the links between indebtedness and financial literacy attracted my attention.
In our over-indebtedness study in Ghana, with the cooperation of KfW and the Smart Campaign, we have correlated financial literacy directly to our sacrifice-based measurement of over-indebtedness and find the results from Columbia confirmed: mere numeracy and general financial literacy have no or even negative effects on over-indebtedness. However, we find that a lack of debt-specific literacy with regards to how credit contracts work is strongly correlated to over-indebtedness.
For those who are interested, the paper can be found here: http://ideas.repec.org/p/sol/wpaper/2013-116700.html In line with the questions you raise around demographic characteristics and their relationship to indebtedness, our control variables (full table in the Appendix) shed a lot more light on the characteristics of over-indebted microborrowers in Ghana.
All the best for a fruitful discussion at Foromic!
So glad you weighed in--of course your work in Ghana was in the back of our minds while discussing the use of surveys (I will certainly go back and read the Appendix again). Moving beyond credit, a financial education challenge I have been struggling with lately is fees on savings accounts. The work we are doing in Mexico shows quite nasty fees on savings accounts that can wipe out your balance in a very short time. Part of the problem for first-time savers is they are not really watching out for this when they open a savings account, since it is assumed to be a safe place to store their money. So, extending your observations on debt-specific literacy, do you have any thoughts on what we could do to understand how to measure and improve savings-specific literacy?
Thanks for the great comments and link to your study, I really encourage everyone interested in this topic to look at Jessica's work in Ghana if they have not done so already.
Dear Jessica, thank you for your post. I agree with you and at the same time with all the field visits I take to Latin America and elsewhere, I continue to be shocked at the number of MFIs who do not give clients a copy of their contract. Also, the contracts that are given out are often in legalese and small print that is sometimes difficult to understand for someone with a university degree, less so for someone with a primary education. There are plenty of other issues I could raise, but I wanted to hear your thoughts on that.
Hi Sergio and Rafe
Totally! While recognizing potential risk factors among borrowers is an important step towards avoiding over-indebtedness, client protection strategies obviously need to be about MFI behaviors. We are hardly going to change the socio-demographics of potential borrowers, but we can change the way we interact with them.
Reminds me of Malcom Harper who recently said that "responsible marketing is about learning 'to dance to your customers' tunes', that is, addressing them in terms which they will understand and with products from which they will benefit. It is not about trying to teach your customers to dance to your tune [by means of literacy trainings]". Giving borrowers an understandable contract and avoiding hidden fees seem like an absolute minimum standard to me.
At the same time, introducing a new product implies explaining it to customers if needed. Knowledge is a scarce good for many microfinance clients and advising them on dealing with their finances may be very valuable to them (as much as they often have sophisticated informal systems for money management in place). I therefore do believe in financial literacy training - training that treats clients as intelligent counterparts who can make their own decisions but provides simple guidelines and rules of thumb that clients can put to use in their daily lives.
With regards to both your examples, the lack of understandable contracts and the fees on savings accounts, training in my opinion is less about financial literacy and more about literacy in the world of formal transactions that MFIs are introducing many customers to. It is training about the rights of customers, about entering and dealing with contractual obligations, about understanding one's information needs and (getting closer to financial literacy here) being equipped to deal with the relevant information.
I wish that responsible MFI behavior would automatically teach clients what such transactions should look like. An industry where this kind of literacy is not necessary will end up creating it among its clients over time. In the mean time it makes sense to continue down the road of research into effective training approaches that take the insights of behavioral economics into account.