Over-indebtedness – the flip side of financial inclusion
To help microfinance clients borrow the right amount, we need to improve their awareness and understanding of financial products.
For a number of years, microfinance industry players have been sharing a common concern: how to avoid over-indebtedness among micro borrowers. Some low-income borrowers take on too much micro debt, and struggle with repayment.
Discussions about the risks of saturated markets have taken place at country, donor, and microfinance institution (MFI) levels. Studies and empirical evidence have helped to define the term and report on over-indebtedness. The process of capturing client credit data through credit bureaus is improving; clients have been educated; and consumer protection has become a key focus.
Why, then, are we still talking about over-indebtedness?
Some markets in developing Asia have noted rising levels of loan saturation among certain targeted customer segments. Cambodia for instance has a high score in market saturation according to a MIMOSA study, with strong competition and the fastest-growing loan sizes among its peers. In a 2016 study on Indonesia, close to 60% of respondents (who had between 2-4 loans) seemed to be falling into a debt trap by getting a new loan to repay the old ones, or by borrowing from informal sources at exorbitant rates.
Low-income people often lack steady incomes, so they need multiple funding sources to smooth out their irregular income patterns and to cope with unexpected expenses, for example, due to the death or sickness of a breadwinner, or the loss of a crop due to bad weather.
Most low-income people are less financially literate. To help them avoid over-indebtedness, we need to improve their awareness and understanding of financial products. Even more so given that clients often shift suddenly from no access to finance or a bank account to having to use a digital device to operate an account and conduct transactions.
To address this concern, MFIs and practitioner associations are advocating consumer protection initiatives, such as the SMART campaign, a global effort to work with microfinance clients so they do not borrow excessively or use products they don’t need.
Some financial sector regulators have also contributed by issuing industry-specific fair practice codes that MFIs need to follow. Finally, government-run programs and MFIs alike have promoted financial education.
While clients are being educated and responsible lending practices are being implemented across the microfinance industry, the question remains how many loans or what total loan size will cause a client’s over-indebtedness and whether this should be capped in any way or form. These are variables nobody readily has an answer for, as it will be dependent on many factors, including country and client specifics.
Historically, loan officers have not relied greatly on a client’s cash income or cash flow projections due to information asymmetry and issues with data reliability. Loan amounts are typically standardized according to loan cycles rather than on the real demand of the client (hence also the need for multiple borrowing). This has been done partly to create cost efficiencies through standardization, and reflects MFIs’ own experience in the market and assumptions about the level of poverty.
So, how then can this problem be addressed?
With the onset of digitization which supports automation of operational processes in MFIs, including larger numbers of loan officers using tablets in the field, the need for standardized loan offerings will decline going forward.
The rapid rise of digital client credit scoring systems, often also based on client behavior and spending habits, will make it easier for an MFI to assess the appropriate loan size for a client. This is beneficial for both the customer and the MFI.
In the meantime, one can also look at India’s experience at promoting financial inclusion.
As one of the most advanced microfinance markets in Asia, India has learned from experiences such as the Andhra Pradesh microfinance crisis of 2010 and the impacts of demonetization in 2016. India has a well-regulated market, and the regulator has financial inclusion at the forefront of its agenda.
Several government-run programs promote financial inclusion, among them the Pradhan Mantri Jan Dhan Yojana or Prime Minister’s People Money Scheme, which facilitated more than 310 million account openings so far (January 2018). The national identification card, Aadhaar, is the world’s largest biometric ID system. In March 2016 the Aadhaar (Targeted delivery of financial and other subsidies, benefits and services) Act was passed in the Lok Sabha.
The Reserve Bank of India also issued directives that cap loan sizes and multiple borrowings, so no MFI could become a third lender to a client. To monitor this, MFIs must report their client credit data to four Indian credit bureaus, but in return can also search the credit data of clients they want to provide a loan to.
This is all done electronically, and has helped to curb excessive borrowing. It has also helped to educate clients, especially post-demonetization, as a client will not receive loans if he or she has a bad track record in the database.
Data is still being tested and some of it, for example from borrowers from self-help groups, are not yet recorded. Also, the jury is still out on whether there is an appropriate number for loans. Nevertheless, it is a step in the right direction.
Practical solutions will need all stakeholders—including regulators, MFIs, associations, clients and technology providers—to work together to establish a sustainable and responsible lending climate for low-income borrowers.