Research & Analysis

When is Microcredit Unsuitable?

Rapid expansion in the microfinance sector has been credited with advancing financial inclusion in India, even as much of this growth has focused exclusively on simple group loans and credit-linked insurance. Both central bank regulations and self-regulations address the risk of over-indebtedness often associated with rapid credit expansion through the implementation of lending caps and mandatory credit reporting, while recent regulatory developments emphasize the need for lending institutions to detect and prevent mis-sale. This paper addresses what might constitute a loan mis-sale and seeks to inform the use of suitability guidelines for lending to low-income households by microfinance institutions (MFIs), self-help groups (SHGs), and various banks.

We reviewed a diverse body of evidence on microfinance and address specific evidence gaps with a year-long financial diaries survey of 400 active borrowers in rural southern India. We found that certain features of borrowers’ cash flows as they relate to lending practices and the nature of market sector development greatly influenced how credit was used and whether it resulted in borrower distress. We observed high levels of over-indebtedness (21 percent sample households), financial distress, and debt-dependence in the sample.

Critical fault lines in credit bureau reports may cause even fully compliant lenders to mis-sell to at least 33 percent of MFI clients in the sample. To ensure responsible sale, there is an urgent need to integrate credit information about all institutional lending into a single report, and once this is done, the data suggest that it would no longer be appropriate to apply over-indebtedness regulations in their current form. Doing so could prove too restrictive for 20 percent or more borrowers, and may greatly limit the ability of formal finance to serve clients’ needs. The focus must shift away from limiting consumer choice and instead toward building institutions’ ability to use integrated credit information and conduct independent assessments of borrowers’ repayment capacity. Specifically, suitable lending to low-income households will require lenders to review all outstanding debt, assess income, and respond to critical vulnerabilities, including unusual income flows and uninsured cashflow risk.

However, successful implementation of suitability in lending depends on expanding commensurate access to savings, insurance, and investment markets. Given the lack of market-based incentives to implement suitability and regulatory barriers to multi-product origination, we conclude with recommendations for regulators, financial institutions, and future research.