My comments below are made in the context of the steps which we took in South Africa over the last 10 years to implement a regulatory framework in which protection against over-indebtedness was one of our primary objectives. South Africa’s Micro Finance Regulatory Council (MFRC) did extensive research on debt stress, based on samples from loan portfolios and on national surveys.
Based on samples from loan data for both MFIs and commercial lenders, we were able to estimate the debt levels of clients and to evaluate the lending practices of different lenders. We identified various market practices that created incentives to increase the levels of debt stress. The analysis of national survey data also confirmed that, even if the general level of access to finance may be low, there may well be pockets of extreme over-indebtedness.
FIGURE 1 HERE
High debt stress holds serious risk for both consumers and for the lending industry. Reckless credit follows a similar cycle as a pyramid scheme – while it grows it generates cash which hides the problems. When it unravels it has a devastating effect on the clients and the lenders alike and can easily spill over to the main stream banking sector, as it has done in South Africa and elsewhere. It also implies that the poor remain stigmatized as ‘unreliable clients’.
It is not only the direct impact of debt stress that is of concern, but also the fact that debt stress increases a household’s vulnerability to changes in their socio-economic environment. This could be a domestic event such as a divorce or illness, or regional events such as a drought or job losses. High debt levels undermine households’ ability to deal with the impact of such events.
The question has to be asked: how does a lender remain in business when their clients are over-indebted and cannot repay the loans? Would the defaults not push these lenders out of the market? Firstly, the higher the interest rates, the greater the capacity of a lender to transfer the cost of defaults to the performing clients. There are also a variety of mechanisms through which the ‘reckless lender’ can transfer the cost of default to its competitors. For instance, by applying coercive collection mechanisms it ensures that its payment get prioritized (and that the client default elsewhere, or cut back on household expenditure, school fees etc). Penalty fees and penalty interest similarly create an incentive to extend further loans to clients who may already be debt stressed. It can cause a dramatic increase in income for a lender on clients who pay irregularly and is earned on top of an already high base interest rate.
FIGURE 2 HERE
Below, I have summarized some of primary interventions which were implemented in South Africa between 1999 and 2002 to curb over-indebtedness. These regulations applied to the ‘micro-lending industry’ which consisted of approximately 1,500 lenders, including both MFIs and commercial lenders:-
- A national database of micro-loans was established, operated by commercial credit bureaus. The cost was recovered from the fees on lender enquiries and involved only minimal cost to government “
- Reckless lending rules” were introduced, requiring an assessment of a client’s repayment capacity, as well as standardized disclosure requirements
- The MFRC performed more than 200 inspections per year and had the power to deregister lenders and to impose fines
- In 2007 South Africa introduced national consumer credit legislation which expanded the regulations and also applied to retailers and on the banking sector. This was an important development, given that debt stress is normally the result of multiple lending from different sources.
Our assessment has generally been that improved disclosure would not be a sufficient intervention to curb over-indebtedness and that regulations which modify lender behavior are required. One has to consider the implications of low levels of literacy and the reality that clients often rely on the guidance of a loan officer. Yet, loan officers get commissions on extending more loans and bigger loans. Given these factors and the desperate choices faced by poor households, improved disclosure is unlikely to be a sufficient remedy. However, it is preferable to avoid placing limits on the number of loans to a single client, or on the number of lenders from whom a client may borrow. Such interventions undermine competition and client choice.
It is always important to remember that South Africa has a large employed work force and that lending is dominated by banks and commercial finance companies. However, interventions which create an obligation to consider a client’s repayment capacity and which promote increased information sharing may well have merit in most countries, and definitely in high growth markets.
Does this create a danger of over-regulation? I fear that, without appropriate regulation, increased commercialization and the incentive structures within the lending industry may result in further fall-out, similar to what we have seen in South Africa in 2002/3, in the U.S. as result of the sub-prime crisis, or in Bolivia at the end of the 90’s.
It is worthwhile also to refer to the cycles of debt stress and regulation that have played out in Japan in the early 80’s and again 20 years later. In both instances there were hundreds of debt related suicides, a public outcry and pressure for a clamp down on loan sharks. These involved “genuine loan sharks,” but the micro-finance sector has great risk of being painted by the same brush, and is currently living through the same history.
Microfinance with a package of pro poor financial services( micro savings, micro credit, micro insurance, transfer of money etc ), has emerged as a panacea for poverty reduction. The financial institutions both in formal(banks ) and informal sectors ( loan sharks) have been providing these services in piecemeal following different norms and conditions to the poor if not holistically all the services as a package.
Over a period of time, in the financial landscape, MFIs surfaced but unfortunately confining to micro credit service only to the poor and attracted global attention ignoring the basic facts that ‘credit alone’ is inadequate for the said purpose/mission and credit ‘per se’ cannot function in vacuum unless supported by other services .Consequent to negligence of the above basic facts and mishandling of the micro credit services by both the lender (MFI) and the borrower as well recklessly (as discussed in the earlier blog postings in over indebtedness series ) in the given (unregulated ) market environment, the debt stress has become very much concern to all in MF industry. Eventually, it is unfair and injustice in pushing it into ‘greater risk of being painted by the same (loan shark) brush’ .In this context, regulatory intervention for protecting the clients from over indebtedness assumes importance universally . Although suggested regulatory interventions are specific to micro lending industry in South Africa for the said objectives in the post, I would like to share some points from consumer protection perspectives for reducing the debt stress with the particular focus on ‘lending norms’ as it has more causal relation to debt issues.
1. Lending principles/norms for each of the micro credit products depending on productivity of the credit /scheme need to be clearly spelt out by commercial lenders and MFIs and approved by authorities. The latter, besides monitoring, may provide counseling and guidance in this regard to the lenders for facilitating uniformly in their respective service area. The basic idea behind is to eschew ‘one size fits for all’ formula for all credit products (one dimension of reckless lending) and ensure effective monitoring the level of debt for the both macro and micro level in the country.( In India, the banking system have been advised to follow uniformly the lending guidelines issued by the regulator (RBI/NABARD) for priority sector/weaker sector lending which includes micro credit for the poor )
2. Among the various lending norms for micro credit product, ‘repayment schedule and ‘grace period’ for each product assume importance and need to be designed depending on the income generation of the product in the given area. as both the factors influence the level of the indebtedness and over indebtedness ( details of ‘grace period for some credit products discussed in CGAP MF blog – my response to Jessica ‘Microfinance –over indebtedness, naming the beast and nailing the concept.’ January 31, 2011 )
3. Linking micro credit product with micro insurance need to be mandated for financial institutions in coordination with insurance companies ( In Indian banking system for various farm and animal husbandry based credit products, insurance is mandatory requirement ) The risk coverage by insurance to micro credit product benefits both lender and client as well in term of revival of livelihood, continued repayment, and less debt stress
4. Loan for livelihood activities with the focus on income generation need to be more encouraged than to consumption loan accounting at least 80% of the total credit portfolio.
5. Constitution of committee of financial institutions including MFRC may be insisted by the regulators at region/district/division/block level represented by the officials from the respective financial institutions ( banks, commercial finance companies, ) functioning there for the purpose of credit information exchange, level of over indebtedness, service area related issues, uniform application of lending norms, repayment capacity of clients of the area, market saturation for certain credit products, other operational issues etc. This coordination meeting among the players periodically will help in better appreciation of filed level problems, reduction in multiple financing and reckless lending healthy competition.( In India as directed by RBI under lead bank scheme, these coordination meetings viz., SLC at state level ,DCC at district level and BLBC at block level with the participation of the representative from regulators (RBI/NABARD ) and government officials are periodically conducted.)