Over-Indebtedness in Microfinance – Who Should Bear the Risk?
Over the four decades since the development of the original microcredit methodology, the poor have been declared bankable – and increasingly even profitable bank clients. While microfinance products and lending methodologies vary significantly on the ground, two main features of microfinance have made this enormous expansion of access to finance possible: microlending has become scalable due to cost efficient operating models and due to risk management methodologies that ensured high repayment rates.
Recently, several microfinance markets have undergone crises of delinquency and over-indebtedness. To a certain extent this may be due to changed competitive environments where the typical lending methodology of microfinance works less well, to deviations from the principles of sound microlending, and to an interplay of industry dynamics with macroeconomic and political developments. However, these crises can also enhance our understanding of the general weaknesses of the microfinance risk management model.
Every lending activity faces on the one hand a risk of moral hazard, of borrowers who are unwilling to repay.
It faces on the other hand the risk of borrowers who are unable to repay. In microfinance, for a long time, both these risks seemed to have largely disappeared: clients were repaying extremely well. The mechanisms that enabled this reduction in risk are many and are well known:
- Selection mechanisms of borrowers that reduced the risk of adverse selection, for example, peer selection and close relationships between borrowers and loan officers
- Incentive mechanisms to prevent moral hazard, for example, group liability or guarantors, increasing loan sizes over cycles, collateral based on the subjective value of assets to borrowers rather than on market value, and small frequent instalments combined with a zero-tolerance policy.
Preventing loans to dishonest borrowers and giving borrowers strong reason to repay, these mechanisms are safeguards against strategic default by borrowers who are unwilling to repay. Most of the risk of strategic default has disappeared as a result. To a certain extent, the same mechanisms are also effective against risks of borrowers unable to repay. Small and regular instalments can make repayment discipline easier than large lump sums and in severe cases of difficulty, peers or guarantors may step in. However the risk of shocks to the expenses or income of borrowers, and the risk of microenterprise investments that fail have not disappeared. Instead of eliminating this part of repayment risk that relates to borrowers unable to repay, the microfinance lending methodology has to a large extent pushed this risk out of the portfolios of lenders and onto borrowers.
The strong repayment incentives of the microlending methodology often make microborrowers in repayment difficulties go to extreme lengths to avoid delinquency. Our over-indebtedness study in Ghana shows that many borrowers only manage to repay their loans on time because they go through unacceptably high personal sacrifices. Instead of delaying or stopping repayments when idiosyncratic shocks hit and debt service becomes unmanageable, borrowers absorb these shocks with personal suffering. In this case, what looks as a success from a risk management point of view because it keeps portfolio quality high is a serious concern from a social point of view.
For a long time, this part of repayment risk had become almost invisible in microfinance. But recent efforts to protect customers from over-indebtedness have brought the difficulties that microborrowers face in repaying back into light. Moreover, the markets that have experienced open repayment crises show that even from a risk management point of view, risk that seemed to have been reduced by a strong lending methodology, had only been shifted.
The moment that the borrowers’ maximum risk absorption capacity (including unacceptable sacrifices from a social point of view) is over-extended, the risk spins back into MFI portfolios.
From a customer protection point of view, the ideal risk management methodology would incentivize borrowers just strong enough to avoid moral hazard and strategic default. But there would be limits to shifting the risk of idiosyncratic shocks to borrowers. In line with insolvency laws in industrial countries, when repayments become unbearable with an acceptable level of effort, a borrower should be able to delay or default. The microfinance industry can hardly replace a regulator’s legal insolvency system or a government’s safety net – but for purposes of customer protection it will need to develop solutions for borrowers in difficulty that may imply an increase in risk for lending institutions.
Repayment incentives need to be strong but remain humane. Risk management should recognize to what extent it is making risk disappear and to what extent it is shifting who bears the risk. The industry may need to develop consensus on what amount of risk borrowers should bear for microlending to be responsible finance.
 Notwithstanding the benefits of flexible instalment schedules in the face of volatile incomes and of instalments that fit business cash flows.
A bit more on the “shifting” of risk. What this approach does is change how credit risk is experienced: while it reduces the probability of default, it increases the loss severity when default finally happens.
Thus, under most market conditions, repayment rates can stay unnaturally high. But when market conditions deteriorate beyond a given threshold, repayment rates can collapse entirely, sometimes with little warning. On its own, this means a more volatile market, which brings with it other dangers (political interference, reputation risk, etc.) But this approach is actually even less stable still, because by obscuring the normal signals of market stress — higher delinquencies — it allows credit to build up to levels that are completely unsustainable.
To put this in perspective, a handful of microfinance markets have experienced default rates HIGHER than even those for subprime mortgages in the US, and this after just a 3-4 years of growth. It’s not unreasonable to assume that were it not for the worship of unrealistically low delinquencies, growth in those markets would’ve crested earlier, mitigating much of the damage to both institutions and their clients.
This approach to managing credit risk has an interesting cousin — the credit default swap (CDS), or in the words of Warren Buffet, the financial weapon of mass destruction. During most market scenarios, the lower risk purchased via CDS reduces an institution’s exposure to credit losses. But during times of severe crisis, the sellers of credit protection are themselves are pushed into insolvency (think AIG), further propagating the stress in the market. Just as in microfinance, the ability to hide risk with CDS allowed the mortgage bubble to grow larger than it otherwise could have.
It’s a shame so few in the microfinance sector paid heed to these critical lessons from the 2007-08 mortgage crisis (lessons that I repeatedly wrote about back in 2009). For what it’s worth, it seems that these lessons have now finally been learned, and I hope that they will stay around in institutional memories for more than a few years…
thanks a lot for closing the circle and pointing out once more to what extent good customer protection ultimately contributes to sound risk management.
The short cuts that risk managers may have taken in the past because they focused on the institutional perspective of risk too much and overlooked what that meant for borrowers, have proven quite dangerous to MFI portfolios in the long run. I quite like the idea of pointing out the parallels with the global financial crisis where a lack of customer protection also played an important role in the build up of unsustainable risks.
The point is that even in industries without a social mission, markets are like ecosystems where no real short cuts exist. The sustainable financial success of lenders depends on the success of their services in providing real benefits to their customers.
For more on the social costs of repayment, see Karim “Microfinance and Its Discontents.” The book is has many flaws ( I have a review of the book forthcoming in Enterprise Development and Microfinance, Volume 23
Number 2), but her description of the social cost of repayment, what she labeled as “the economy of shame” is gripping.
One of major flaws of joint liability contract is the complete neglect of covariance risk. When the borrowers face such risk, even other group members cannot help. This makes the cost of repayment unbearable.
You wrote “for purposes of customer protection it (MFI) will need to develop solutions for borrowers in difficulty that may imply an increase in risk for lending institutions.
Grameen Bank has instituted such a solution already. It is known as flexible loan. A borrower in repayment difficulty can reschedule the loan by extending the time as well as reducing the installment payments. However, it is not costless; going into a flexible loan contract has embedded costs: lower loan ceiling etc. This is very similar to the proposed “continuous workout mortgage” by Robert Schiller for solving the housing crisis in the USA. You will find more about this in my book, “The Poor Always Pay Back: The Grameen II Story.”
It is very interesting article. The paper is also very interesting. Since 2014 I have been focusing on the sudden and massive delinquency issues in Eurasia. Since 2016 I have been training MFI collection officers directly. I have already trained 318 Collection Credit Officers, Collection Officers, and Collection Lawyers in Azerbaijan, Georgia and Tajikistan. Based on the rational client reasons that I heard either from clients or from collectors are in most, I would say 60% of cases, related to the over indebtedness. The clients are the same people who exhibited highest repayment behaviors just 4 years ago the problem is that they are faced with many priorities including the repayments beyond their economic capacity now. Overtime I have developed a special approach for debt collection for MFIs particularly for those who care about social impact. It is called Collaborative Negotiation for Debt Collection. It is more client centered and provides a second opportunity for MFIs to help the clients to manage their debt in a collaborative way. It is a capacity building intervention shifting the role of debt collector from somebody just demanding a payment to more debt advisor role. Client centered debt collection techniques help MFIs to go beyond the client classifications such as “wants to pay or not wants to pay” but goes deeper to the reason and needs. It is a great opportunity for socially motivated and responsible MFIs to offer adequate non-financial service and financial service in terms of repayment breaks, debt discounts, new loans or immense number of ways to assist clients to recover from the results of over indebtedness. I think it is also right opportunity for providing financial education for those who got over indebted.