As nations begin to restore economic activity following COVID-19 lockdowns, one thing is certain: credit will be an essential tool as people rebuild their lives. However, with lockdowns leaving consumers in need and providers under stress, the stage is set for consumer protection challenges around the provision of credit. At this unpredictable time, the usual risks to borrowers may be heightened and new risks may emerge.
Consider that during the lockdowns this spring, an enormous number of small businesses and farms depleted their reserves and tapped out social networks. Some may have even sold productive assets. Households also used up their reserves simply to survive. With no working capital to purchase inventory, materials or seeds, business and farms will need to borrow. Households will seek credit for basic needs when other possibilities have run out. With government and humanitarian aid reaching only a small fraction of those in need, these factors could contribute to a widespread demand for credit in the coming months.
Yet financial services providers (FSPs) are under the greatest stress they’ve experienced since the global financial crisis in 2008. Many are facing challenges that reduce revenue and liquidity: high arrears, loan moratoria, withdrawals of deposits or the inability to conduct branch operations. CGAP’s Global Pulse Survey of Microfinance Institutions showed that 30-day portfolio-at-risk among microfinance institutions (MFIs) at the end of April was on its way to doubling. At an average of 7.2 percent, it was substantially elevated, though not yet at crisis proportions. However, an ADA survey showed higher levels. Some regulated financial institutions have received relief from policy makers in the form of liquidity facilities and relaxed reserve or provisioning requirements, but the nonregulated institutions to which lower-income people often turn have received little or no support.
In markets with high demand and institutions under strain, we can expect consumer protection problems to emerge. Let’s examine three risk scenarios related to credit.
1. Over-indebtedness among current borrowers
Moratoria extended during the initial lockdowns are expiring soon, and FSPs will begin calling for resumption of debt service payments, even though borrowers may not yet have the means to comply, particularly if the terms of their moratoria were not favorable.
The MFIs that responded to CGAP’s pulse survey report that, on average, 18 percent of their portfolios have been placed under moratoria or rescheduled. In some cases, regulators mandated moratoria. In others, they encouraged moratoria by enabling FSPs to treat paused loans on their balance sheets as though they were still performing. The degree of prescriptiveness varied widely across regulators, but often lenders retained great discretion over when to offer and how to structure moratoria. Nonregulated FSPs generally were on their own in determining their response. Some FSPs offered moratoria to all borrowers, such as group lenders that simply stopped collecting repayments while group meetings were suspended.
As Isabelle Barres, former vice president at the Center for Financial Inclusion at Accion, suggests, some moratoria are fairer than others. If penalty fees are imposed, if the loan term is not extended or if the delayed principal is due in a lump sum, a heavy burden falls on borrowers. Evidence suggests that many borrowers will be unable to resume repayments when moratoria are lifted, which will require many loans to be rescheduled. How lenders handle these cases will depend on their financial condition and regulatory guidance, such as rules governing provisioning.
As arrears rise, FSPs may attempt to step up their loan collection activities. Early evidence from Pakistan reveals that many microfinance loan officers continued to pressure borrowers for repayments, even after moratoria were declared. There are reports that domestic workers in Hong Kong from the Philippines and Indonesia are falling into debt traps with aggressive lenders. FSPs that rely on collections agencies may turn a blind eye to high-pressure tactics.
If FSPs report participation in moratoria to credit reporting agencies, it may create a lasting impact on borrowers’ ability to qualify for new loans. Some credit bureaus have requested that lenders not report borrowers in moratoria as delinquent, and some have agreed not to use participation in moratoria in determining credit scores. Controversies are arising, however. In South Africa and the United States, concerns have been raised about whether lenders submit information correctly. It is not yet clear how favorable treatment in credit bureaus will last once moratoria end.
2. Inability of households and small businesses to obtain loans
Fresh infusions of credit could be an important stimulus to economic recovery. More people than usual may seek credit because people who previously relied on savings or social networks can no longer do so. With depleted reserves and assets, many otherwise good borrowers will not meet standard creditworthiness criteria or collateral requirements.
At the same time, many FSPs suspended new lending during the shutdown, and it is not yet clear how they will begin again. Some lenders have been affected by arrears and income losses, and many may be having trouble raising capital for on-lending. In response, they may tighten lending criteria or lend only to longstanding customers.
All these factors suggest the risk of a credit crunch affecting lower-income borrowers. There are already reports of loans becoming less available in the United States and in the Philippines. Fearing a credit squeeze, the Kenyan government announced that it would fine FSPs that reject loans only because of negative credit scores.
At this time, it is important for regulators and providers to define responsible guidelines for underwriting. One shift, for example, could prescribe greater emphasis on a customer’s repayment history, human capital and social capital, relative to collateral.
3. Aggressive and reckless lending
The third scenario is the flip side of the second and arises when responsible FSPs are constrained. Some lenders may aggressively market high-interest loans at a time when borrowers are more desperate for money and less able to pay off debt than in normal times. Aggressive and deceptive lending is most likely to appear among the nonregulated credit providers frequently used by lower-income borrowers.
A Need for Clarity
With these three scenarios likely to appear in many places, the credit market for lower-income customers is in for a difficult and possibly chaotic period. Regulatory guidance may be unclear or leave much to the discretion of FSPs. Moreover, not all FSPs are subject to regulatory guidance. FSPs that have not received categorial guidance may opt to treat customers on a case-by-case basis, which is both slow and likely to result in inconsistent treatment of customers. When rules change as the crisis evolves, regulators and FSPs may have to adapt on the fly, leaving their policies continually in flux. In many cases, FSPs and their staff will be confused. In this complex situation, FSPs will need to take extraordinary measures to communicate clearly with staff and customers.
By anticipating what can go wrong and communicating clear policies, FSPs, regulators, investors and credit bureaus can help ensure credit markets at the base of the pyramid treat borrowers fairly during these uncertain times.