We Need to Keep Learning about Overindebtedness

It is my privilege to close out this blog series which has been a wonderfully rich exploration of one of the most complex and consequential topics in microfinance. I’m tempted just to sit back and say – I like what Rich wrote about the challenge of definitions and how Jessica illustrated the difficulty of drawing the line of “acceptable sacrifice” and the way Jacco laid out the responsibilities of various stakeholders. In fact, that’s largely what I propose to do, while taking up the overall theme of learning from research.

This series demonstrates the wide field of research emerging on overindebtedness. Several of the contributors to the series are the first movers who have established tentative hypotheses and tested research methodologies. We need more such studies to inform product design and policy making. Milton is skeptical that more knowledge will lead to better outcomes, and he does have a point. It’s quite possible that the only way to learn and take the steps necessary to produce a better outcome is to plunge a market into a crisis. Even better, however, would be to use the results of research. Although the studies profiled here are a huge step forward, it is still early to use them for making decisions: it is not yet clear how their findings will hold up in other countries and different settings.

We need to know more about clients. In the absence of microfinance, or in addition to microfinance, how much debt and what kind of debt do people have? What sacrifices come up in their lives, how often, and what do they think about them? As Sarah asks, what are the consequences of default for clients? Does the picture Jessica drew from interviews in Ghana hold up in Ecuador, Morocco, or Nepal? This kind of understanding is fundamental.

We need to look more carefully at the interactions between microfinance institutions and their clients, examining how MFI practices play out in lives of clients on an everyday basis. Stuart posed two specific hypotheses: if a lender needs clients to borrow continually, it incentivizes overselling and overindebtedness, and that insistence on immediate, in-full repayment drives some clients to begin bicycling loans. These hypotheses deserve to be tested in many circumstances. Another hypothesis I would like to see examined is that clients with both savings and credit are less likely to become overindebted than those with only credit.

These are the kinds of explorations that should shape microfinance methodology and product design. They may lead to very significant rethinking of both. I worry when practices like the ones Stuart cites are considered business as usual by a large swath of providers in a given country. In Bangladesh and India it is difficult to identify specific bad players, since a number of bad practices have been used by many. His examples signal that a solution that’s good for clients will require the difficult task of changing the practices of many providers across a short time. As Rochus points out, such change can happen quickly when regulators respond vigorously to a crisis as they did in Bolivia in 2000 and (as Gabriel notes) in South Africa in 2002. Both those countries were blessed with exceptionally competent regulators.

Getting more operational, a study of Bosnia study carried out for the European Fund for Southern Europe by the Microfinance Center in Warsaw helped give empirical backing to what is probably the number one rule of thumb (and time-tested MFI experience) regarding overindebtedness: the debt service to household income ratio. Since this ratio is often the backbone of both credit underwriting methodologies and client protection regulation in many countries, the more we understand it, the better. A deep body of data would help develop the ability to answer questions such as these: How does the debt service ratio correspond with default? Or with clients perceptions about acceptable sacrifice? What is the best cut-off for credit approvals? What about the cutoff for reckless lending?

The Bosnia study provided strong evidence about another number – cross-indebtedness, or the number of loans from different institutions per customer. In Bosnia, indebtedness across two providers was fine; defaults jumped noticeably with three, but not to a level that would be hard for lenders to handle. At four loans, however, the likelihood of default jumped up steeply and it was astronomical from five on. Data from credit bureaus in Peru shows an identical pattern. Could this be the start of an iron law? It would be terribly convenient, because number of multiple loans is such a straightforward indicator, and currently microlenders are not very secure about the rules they use regarding cross-indebtedness. Where credit bureaus exist and cover microfinance, this kind of data is easily assembled, and it would be a great service to the industry for someone to examine the data across a number of countries. One caveat: the figures from both Bosnia and Peru mainly represent individual loans. Things may look different with group loans, especially those with highly constrained loan sizes, as Sanjay has pointed out regarding South Asia.

At the most aggregated level, the University of Zurich study Jacco, Sarah and Rochus reported on began to test market-level indicators to provide an early warning about overheating. The model has been built using data from the past, but it remains to be seen whether it can provide useful predictive value. If so, it can be especially useful for investors and regulators.

I have been examining all this information from the perspective of the Smart Campaign, which is developing methods to certify financial institutions on whether they apply the Client Protection Principles, including the first principle on preventing overindebtedness. I want to know whether the lender policies and procedures the Smart Campaign’s assessors look at accurately reveal whether a lender is pushing its clients into too much debt. The Smart Campaign’s assessment procedures already use most of the indicators that have just been mentioned, especially the debt service ratio, the policies regarding cross-borrowing, and the loan officer incentive package.

The assessments also check that lenders are not doing some of the things Gabriel warns about, like abusive collections and excessive penalty fees. Assessors also consider the enabling environment (presence of unique I.D.s, credit bureaus) and market conditions (level of competition, market penetration). If conditions press lenders toward disbursement of more and more loans while providing little borrower information or regulatory oversight, responsible practices by the provider will be trumped by the market-based incentives to lend more. Renso and Scott indicate that Smart Campaign endorsers are not significantly stricter than non-endorsers about cross-indebtedness; I hope and expect that to change as the Campaign deepens from awareness raising to implementation and finally to certification.

To end, a call to action. As Jacco says, everyone has a role to play in preventing overindebtedness: researchers in discovering the most valuable indicators of overindebtedness, providers in using research to inform policy and being willing to change practices, investors in rewarding good providers and avoiding bad ones, and regulators in prescribing safe market conduct and prudent lending rules.

Finally, clients. It is only right to close this series by turning to clients and their literacy, as Shameran highlighted. Karuna reports that in a sample of clients in Karnataka, higher financial literacy was associated with less repayment stress. No client can fully trust the advice a lender gives about how much debt is sustainable. Clients have a responsibility to make their own realistic judgments about how much debt they can sustain, and lenders have a responsibility to assist clients to understand their limits.




07 September 2012 Submitted by Juan Vega (not verified)

Hola Elizabeth,

We have seen so many overindebtedness crisis all over the world (even in quite well developed countries), that are convinced that the only sustainable way to solve it is trough massive and effective financial education.

At the end of this demand side development savings and productive investment will growth leading income,employment and living conditions to improve.

On the supply side, the missing link between financial and social performance is corporate governance. A lot of work to be done, not only in microfinance institutions…


Juan Vega
Director Regional
Central America

07 September 2012 Submitted by Balbir Jain (not verified)

Dear Elisabeth,
You have concluded the blog series on over-indebtedness with the statement, “Clients have a responsibility to make their own realistic judgments about how much debt they can sustain and lenders have a responsibility to assist clients to understand their limits.” But how can it be done? You have asked for constraints on both borrowing and lending. Are the borrowers and lenders likely to constraint themselves?
Over-indebtedness is not a new problem. It was a major problem in India before independence. The intensity of the problem had been reduced to a considerable extent owing to changes in the legal and political regimes. After independence, money lending particularly informal money lending was no longer an easy job due to lack of legal sanctions. However, the low income households had to face hardships due to lack of access to credit.
With the emergence of microfinance, many low income households have gained access to credit. But all of them do not borrow in a constrained manner. In a number of cases, borrowings are for consumer durables like TV and fridge or for social ceremonies and festivals. Over-indebtedness occurs in many such cases due to the tendency to borrow regardless of their repayment capacity. They end up in a debt trap by borrowing from other sources including informal moneylenders to repay the existing loans.
Over-indebtedness also occurs in case of borrowings for investments particularly in case of newly set-up micro-enterprises. Established micro-entrepreneurs, on the other hand, do not usually borrow. Probability of failure of a new business is not insubstantial.
With the given set of uses of microloans, the trade-off between access to credit among the poor and over-indebtedness is quite obvious. It would be naïve to expect that borrowers particularly poor households would constraint themselves. It is, therefore, imperative to ask: how can the supply of credit to the poor be controlled so as to avoid over-indebtedness? Can the MFI’s do it?
Balbir Jain

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

Dear Elesabath
I would like to share some of my views on the series on over indebtedness
1. The final post on the subject –over indebtedness, reviews extensively on all the postings of the writers only in the series. It could have been more useful for further learning comprehensively, had all the valid points from the comments received for each one of the posts also been incorporated.
2. I feel we have enough lessons already and learnt adequately on the subject. Now it is time for action in the context of urgent need to reach MDG? The crux of the problem exists in the process of adoption and implementation by multiple players from supply front according to the lessons learned. After all over indebtedness issue is as old as lending itself (Rochus Mommartz) and we have enough ‘warning index’ (Jacco Minnaar).Any over indebtedness crisis witnessed, is therefore nothing but ‘a crisis by invitation’(N. Srinivasan-previous series on AP crisis) and not due to absence of warning signals more particularly after the advent of MFIs.
3. The ‘basics’ for the said issue as anguished by Rich is worthy for in-depth analysis and the comment by Rengarajan portrays a detailed account on the ‘basics’ both from supply and demand side perspectives.
4. For inclusive growth and development , primarily ‘inclusive microfinance’ is a ‘sine quo non’ with the inclusion of all micro financial services viz., micro savings , micro insurance, transfer services micro credit and other pro poor support services. Mere institutionalizing the micro credit for money lending activity using the brand name ‘ MFI ‘ only warns us that inclusiveness is not inclusive enough resulting the inevitabilities such as over indebtedness and not adequate enough for challenging the poverty issue. This calls for an effective integrated Micro financial services as correctly diagnosed and highlighted in the post and the comments by Shahid Khandker and Rengarajan respectively. In this direction ‘the pilot project with graduated approach of CGAP in selected regions is worthy emulation with more focus on the poorest
5. In Asian context, the poor asserts that ‘being debt’ has become the way of life irrespective of its impact on their livelihood. There is an adage -‘ Indian farmer is born in debt, live in debt, dies in debt and bequeaths debt’.. Complexity due to multiple lending and multiple borrowing through multiple sources with varied norms and systems, prevail in MF game.. As against this socio economic profile, the discussion on subjective perception on sacrifices with or with out loan ( Rich and Jessica) in poverty sector and objective definition more with economic concepts(income-debt ratio)on over indebtedness, albeit useful for addition in development literature, begs a question?
6. In the context of multiple stake holders with different interests and varied (social & religious) value system among the poor clients representing both supply and demand sides in micro finance arena, the exercise for defining or conceptualizing uniformly on the subject for practicality may not helpful, unless a harmonious mind set for all the players is nurtured for the common goal at all level.
7. Most of the analyses on the subject in the series of postings pertain to the causative factor for over indebtedness. Surprisingly none of them made any attempt to focus on the values of micro insurance –another vital MF but remain neglected – as a curative factor from the poor man’s perspectives and to probe how ‘insurance inclusive microfinance’ could also positively influence the level of over indebtedness issue if integrated appropriately with micro credit product. This appears a positive way forward keeping the ultimate GOAL point of view.
8. In fine, having appreciated that age old issue -over indebtedness belongs to micro credit only and again micro credit alone will do more harm than good from the demand side perspectives particularly in poverty sector , would it be any worth in encouraging the institutions like MFI dealing with money lending only? or What type of changes required in the pattern or modalities being followed in the existing MFIs for achieving the desired ‘end’ result ? or do we need any alternative participatory institution indigenously nurtured by local people themselves and local sources for the said purpose? These are the moot questions, what I feel in present context, need to be addressed urgently for further action instead of harping over credit related institutional issues.
Thanks for sharing my views and comments in the series. Any response to this, I believe, would certainly widen the horizon of my knowledge on the subject.

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