Perplexed about Overindebtedness, Part 2

The previous post in this series ticked off some reasons why we ought to be looking more closely at overindebtedness in microfinance. But what do we mean when we use that term? This question, like most others about overindebtedness, gets annoyingly complicated.

There is no uniform definition of overindebtedness. The term is sometimes associated with loans that don’t get repaid, or with loans whose repayment ties up more than X percent of household income, or with loans whose repayment becomes stressful for the borrower, or with clients taking loans from too many sources at once. Can we find a unifying concept at some deeper level?

“Indebtedness” refers to loan obligations—that’s easy enough. And the “over” part means too much. But too much from whose perspective? If we’re analyzing from the lender’s point of view, then things are still pretty straightforward. Too much debt = debt that doesn’t (or isn’t likely to) get repaid. Looking backwards at least, determining whether there’s been an overindebtedness problem is a simple matter of tracking default indicators.

But for many of us in microfinance, the ultimate objective is the welfare not of the bank but of the borrower. From this perspective, it seems natural to say that overindebtedness occurs when borrowers owe so much that their loans (or at least their last loan) have made them worse off than they would have been without the loan(s).

[Hmmm…is the overindebtedness question any different from the impact question? Aren’t they both about figuring out what would have happened to the borrower’s welfare in the counterfactual event of not receiving—or having access to—a microloan? More on this later. In the meantime….]

In a borrower-welfare frame of analysis, we can no longer equate overindebtedness with nonrepayment. A borrower may repay a loan but still have been hurt by taking it. Conversely, default leaves more, not less, money in the borrower’s pocket, at least for the short term.

Once more: when we say that we don’t want overindebtedness, we mean that by and large we don’t want clients to borrow so much that they’re making themselves worse off. Why do we need to stick “by and large” in that formulation? To illustrate, let’s assume that a woman wants to buy a sewing machine to expand her little tailoring business. There’s no absolute guarantee that she’ll be able to grow sales enough to pay for the machine, but the woman and her loan officer think the risk is a prudent one, based on her talks with potential customers. Let’s also assume that she doesn’t have enough cash or another source of credit, so she is able to buy the machine only because the local MFI gives her a loan for it. No microloan, no machine (and no risk). Now let’s assume that the woman buys the machine but the expected demand doesn’t materialize. And while we’re at it, let’s further assume that someone steals her machine, leaving her with an extra debt to repay but no extra income or asset to help repay it. Without the loan, none of this would have happened, so the loan obviously made her worse off.

I’m hesitant to regard this loan as a case of “overindebtedness,” because I associate that term with a kind of lending that MFIs shouldn’t be doing. But there was nothing wrong with this loan: we certainly want MFIs and their borrowers to continue taking prudent risks. In this hypothetical case there has been no irresponsible lending, just some bad luck. And there will always be some borrowers hit by bad luck. The only way an MFI can make sure that it is never leaving borrowers worse off is to do no lending at all.

Maybe it’s more useful to think in terms of larger groups of borrowers. Provisionally, let’s end for now with this formulation: “MFIs are contributing to over-indebtedness when an unacceptably high percentage of their borrowers are made worse off because of the loans the MFI gives them.”

What’s an unacceptably high percentage? I think most readers would find 2% acceptable and 25% unacceptable. Narrowing the band more than that would be complicated, and there are enough complications to deal with for the moment.

Next time: various proxy indicators for overindebtedness and what’s problematic about each of them.

PS: I’m far from sure that I’ve got the definitional issues sorted out properly (or usefully) here. Further suggestions from readers much appreciated.


10 September 2012 Submitted by Subrata Bhattac... (not verified)

think the over-indebtedness can be better understood by the repayment-ability of an individual. Repayment-ability is easy to understand and easy to measure. The following indicators might help to understand the ability:

* Total income of the household.
* Total expenditure for necessary consumption.
* Disposable income after necessary consumption.
* Irregularities in income flow.
* Productivity of the loans taken (how much additional income do they generate).
* Total amount of loans taken.

Obviously, this list is just indicative and not exhaustive. But repayment capacity would add value to understand over-indebtedness better.

10 September 2012 Submitted by Dr V.Rengarajan (not verified)

Thanks Rich! An interesting second part on the subject. I share some of my knowledge on the subject gained while working in the formal banking sector for 3 decades
The dynamics of ‘over indebtedness’ in public and private financial system
. In the formal system , the over indebtedness( ‘over due’ in banking parlance from supply side perspective) is very much associated with the repayment schedule fixed for the loan product concerned. .Here the size of the loan/debt and the repayment schedule are planned associating with the factor ‘income generation (IG)of the activity for which the loan/debt is provided. Besides, for ensuring the purchase of intended income generating asset without fungible one ( a borrower welfare oriented concern ) at client level, some time the loan is disbursed directly to the supplier of the asset and post supervised credit is also carried out to overlook the IG process.
Particularly in the case of the rural clients including the poor, the economics of the proposed activity to be financed in the given area are assessed based on the potential of economic activity suited to them and market demand for their output, (potential linked service area credit plan under lead bank scheme in India) Based on the above assessment, the micro credit product is designed for the poor. More ethically the quantum of loan (scale of finance/unit cost), the size of loan installment and periodicity for repayment are planned depending on the level of ‘income generation’ of the each activity in the given area.. In some cases the repayment schedule with provision of some initial holidays for repayment till the income is generated as in the case of crop loan where the repayment starts only in harvesting period- depending on the crop production pattern.. In the case of dairy animal loan repayment holiday is allowed during non lactation period as there is no income generation.. That is to say repayment schedule and the quantum of installment may vary for each loan product . No second loan is sanctioned if first loan becomes over due.
Here the repayment schedule assumes importance, because when the installment (principal and interest)which is due to paid on the scheduled date, is not paid, then it will become over due and if over due continues, it leads to over indebtedness attracting penalty fees at client house hold level. .The accounting for due collection starts only from the date indicated in the repayment schedule and not necessarily during holiday period. If the income generation process is choked either due to internal factors or external factors, then shoe starts pinching .leading to over indebtedness.

Where as in MFIs, there is ‘one size fits for all’ approach for the quantum of loan product and repayment schedule as well with rigorous collection procedure, starting from the immediate month of loan sanction without taking cognizance of income generation from the particular activity or the capability of the poor client to honor the loan contractual terms. During post sanction of credit, no body knows the functioning of the loan at client household level. All these environ coupled with peer pressure ( SHG system) push the poor clients to seek asylum of loan sharks. Otherwise some MFIs give another loan for closing the previous loan fallen over due. Hence while the poor remains indebted and over indebted, MFIs is safe with glittering collection rate.

10 September 2012 Submitted by Dr V.Rengarajan (not verified)

Two more points Rich pl. here instead of over loading in my previous posting.
1. In the case of your sewing machine illustration, the indebtedness problem emerges due to some other reasons too besides lack of demand for marketing her product for the tailor.
• Assumingly in case MFI sanctions loan uniformly fixed amount without product differentiation disproportionately to the value of sewing machine ( no other choice also for the client in this case), debt burden and the level of indebtedness eventually is bound to increase.
• Lack of demand for her product due to competition from her counter parts who are also likely financed by the same MFI or other institution in the given area.
It is therefore that correct size of the loan for the sewing machine and flexible repayment schedule suited to ‘little business’ in the given area , are needed.
• In the case of theft of the machine, as cited, it leads certainly to ‘an extra debt burden’. But here, why isn’t that risk covered under micro insurance? Borrower welfare oriented institution (MFI) /loan officer , I trust, could very much help avoid ‘too much’ or ‘over’ indebtedness. by prudently covering the risk with insurance and thereby facilitating for a insurance claim and revival/continuance of the tailoring business and income generation followed by good repayment /recovery .as well.
2. I agree with you Rich on absence of uniform definition of over indebtedness. An attempt has been made to initiate towards a unifying concept at some deeper level subject to changes
The ‘indebtedness’ of the household could be conceptualized as one where the household’s inability to repay the total due debt amount (both principal + interest) as per contract/s by means of borrower household’s income, expected from the utilization of debt/s availed (here indebtedness is related to Income generation (economic)activity created from the debt/s)
The ‘over indebtedness’ household could be defined as one where the household in debt with total amount of loan/s utilized for non income generating purpose /activity/s like health care, social ceremony, remaining over dues as per contract/s with no adequate main and supplementary household income for repaying the debt/s requiring debt relief ( by government) or debt swap or otherwise submerged in debt trap.( here indebtedness related to non IG(social) activity and the higher debt amount relatively with the one for IG activity )

10 September 2012 Submitted by Beth Rhyne (not verified)

Rich — I think you are trying to go deeper than is practical in defining overindebtness by whether a borrower is better or worse off. The definition of overindebtedness I like is still rough, but I think it gets at the heart of the problem: “Overindebtedness refers to a state in which a borrower has to make sacrifices to his or her basic standard of living (or, for businesses, productive capacity) in order to repay debts.” Using that definition, which is from the client not provider side, overindebtedness could be temporary or chronic, and it could be the result of “overlending” or of bad luck.
In order to determine whether they are overlending, then, lenders would not worry too much about individual cases of overindebtedness, but about getting a lot of people in trouble. I still think this should show up in the default rate, but given reports coming out about microlenders placing undue pressure on borrowers, maybe this indicator needs to be supplemented by routine client surveys that ask questions like, “In the past month, have you borrowed in order to repay a loan?” and “In the past month, have you gone without meals in order to repay a loan?” We wouldn’t know how to interpret the answers to this, and would expect the answers to be consistently different for different populations, but repeated use of questions like this should reveal trends. What do you think?

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