Debt Stress – A Harmless Cold or a Deadly Virus?

My comments below are made in the context of the steps which we took in South Africa over the last 10 years to implement a regulatory framework in which protection against over-indebtedness was one of our primary objectives. South Africa’s Micro Finance Regulatory Council (MFRC) did extensive research on debt stress, based on samples from loan portfolios and on national surveys.

Based on samples from loan data for both MFIs and commercial lenders, we were able to estimate the debt levels of clients and to evaluate the lending practices of different lenders. We identified various market practices that created incentives to increase the levels of debt stress. The analysis of national survey data also confirmed that, even if the general level of access to finance may be low, there may well be pockets of extreme over-indebtedness.

FIGURE 1 HERE

High debt stress holds serious risk for both consumers and for the lending industry. Reckless credit follows a similar cycle as a pyramid scheme – while it grows it generates cash which hides the problems. When it unravels it has a devastating effect on the clients and the lenders alike and can easily spill over to the main stream banking sector, as it has done in South Africa and elsewhere. It also implies that the poor remain stigmatized as ‘unreliable clients’.

It is not only the direct impact of debt stress that is of concern, but also the fact that debt stress increases a household’s vulnerability to changes in their socio-economic environment. This could be a domestic event such as a divorce or illness, or regional events such as a drought or job losses. High debt levels undermine households’ ability to deal with the impact of such events.

The question has to be asked: how does a lender remain in business when their clients are over-indebted and cannot repay the loans? Would the defaults not push these lenders out of the market? Firstly, the higher the interest rates, the greater the capacity of a lender to transfer the cost of defaults to the performing clients. There are also a variety of mechanisms through which the ‘reckless lender’ can transfer the cost of default to its competitors. For instance, by applying coercive collection mechanisms it ensures that its payment get prioritized (and that the client default elsewhere, or cut back on household expenditure, school fees etc). Penalty fees and penalty interest similarly create an incentive to extend further loans to clients who may already be debt stressed. It can cause a dramatic increase in income for a lender on clients who pay irregularly and is earned on top of an already high base interest rate.

FIGURE 2 HERE

Below, I have summarized some of primary interventions which were implemented in South Africa between 1999 and 2002 to curb over-indebtedness. These regulations applied to the ‘micro-lending industry’ which consisted of approximately 1,500 lenders, including both MFIs and commercial lenders:-

• A national database of micro-loans was established, operated by commercial credit bureaus. The cost was recovered from the fees on lender enquiries and involved only minimal cost to government “
• Reckless lending rules” were introduced, requiring an assessment of a client’s repayment capacity, as well as standardized disclosure requirements
• The MFRC performed more than 200 inspections per year and had the power to deregister lenders and to impose fines
• In 2007 South Africa introduced national consumer credit legislation which expanded the regulations and also applied to retailers and on the banking sector. This was an important development, given that debt stress is normally the result of multiple lending from different sources.

Our assessment has generally been that improved disclosure would not be a sufficient intervention to curb over-indebtedness and that regulations which modify lender behavior are required. One has to consider the implications of low levels of literacy and the reality that clients often rely on the guidance of a loan officer. Yet, loan officers get commissions on extending more loans and bigger loans. Given these factors and the desperate choices faced by poor households, improved disclosure is unlikely to be a sufficient remedy. However, it is preferable to avoid placing limits on the number of loans to a single client, or on the number of lenders from whom a client may borrow. Such interventions undermine competition and client choice.

It is always important to remember that South Africa has a large employed work force and that lending is dominated by banks and commercial finance companies. However, interventions which create an obligation to consider a client’s repayment capacity and which promote increased information sharing may well have merit in most countries, and definitely in high growth markets.

Does this create a danger of over-regulation? I fear that, without appropriate regulation, increased commercialization and the incentive structures within the lending industry may result in further fall-out, similar to what we have seen in South Africa in 2002/3, in the U.S. as result of the sub-prime crisis, or in Bolivia at the end of the 90’s.

It is worthwhile also to refer to the cycles of debt stress and regulation that have played out in Japan in the early 80’s and again 20 years later. In both instances there were hundreds of debt related suicides, a public outcry and pressure for a clamp down on loan sharks. These involved “genuine loan sharks,” but the micro-finance sector has great risk of being painted by the same brush, and is currently living through the same history.