Over-Indebtedness and Market Forces

The issue of individual over-indebtedness has been around for a long time in microfinance, but the depth and extent of over-indebtedness that has recently emerged in Andhra Pradesh is quite unprecedented. Something is clearly rotten in the state of microfinance.

It is vital that we recognise right away – however painful this will be for some – that over-indebtedness is the almost inevitable outgrowth of the international development community’s preferred model of microfinance; the commercialised model. Even before the sub-prime-driven global financial crisis, financial history showed the potential for huge damage if opportunistic individuals are allowed (thanks to extensive deregulation) and encouraged (thanks to free market ideology) to effectively take control of the financial institution that employs them. Senior managers begin to act like private entrepreneurs and impose upon their institution a new operative goal — their own private enrichment. The long-term benefits that might accrue to the shareholders/owners and/or to other important stakeholders (clients, employees, suppliers, and the community) are effectively abandoned as the primary strategic goals.

This negative ‘institutional capture’ phenomenon is exactly – and quite predictably – what is behind the over-indebtedness crisis that has befallen microfinance. As microfinance was increasingly commercialised from the mid-1990s onwards, ‘best practice’ for an MFI was simply to pump out as much microcredit as possible, in order to grow fast, grab market share, hike up profits, and so grow even faster.

It was simply assumed that what a country, region, or locality needed and wanted was always ‘more microfinance.’ Carefully hidden behind this focus upon extending outreach, however, was the awkward fact that a MFI’s senior managers were quietly turning these institutional gains into private gains taken out in the form of spectacular salaries, bonuses, dividends and, eventually, the windfall profits arising from an IPO.

Under such circumstances, raising the possibility of client over-indebtedness and the damage it might cause to the poor, was deemed completely off-message. Such loose talk would undermine the central justification for the rapid growth of an MFI, which was in turn the central pillar upon which private enrichment was made possible.

But as many observers began to appreciate from the Bolivian microfinance crisis of 1999-2000 onwards, and now fully accept as a result of events in Andhra Pradesh, ‘more microfinance’ and over-indebtedness are actually fundamental problems in poor communities and have been deeply damaging to the poor.

By the same token, over-indebtedness is not generally related to insufficient information about clients, which is why support for the public or private credit bureau model is often so wide of the mark. Consider the situation in Bosnia. The main MFIs, as well as most members of the public, knew as early as 2005-2006 that the microfinance sector was heading in the direction of massive client over-indebtedness. But the MFIs individually and collectively appeared to be able to do nothing to halt their own expansion plans. Present in Bosnia since at least the early 2000s, private credit bureaux were completely ignored, as was a public credit bureau established quite recently.

From first hand experience, I learnt that the desire to grow fast and build market share was paramount. No matter how deep potential clients were already in debt, the pressure was on to obtain as many new clients as possible, and also to get existing clients to top-up their microloan.

It greatly helped here that the risk of default was initially seen as minimal (the Bosnian economy was growing and remittance income flows were massive) and anyway default costs were pretty much factored into the high interest rates charged. There was also the hugely important ‘two guarantor’ system, which meant that friends and family of the client could be chastised to get a potential defaulter to repay, and then – as happened from late 2009 onwards to around 100, 000 of them- chased up themselves to repay a microloan they had guaranteed and which had gone all the way through to default. So, as I heard on many occasions as both an academic researcher and consultant, why pay for data on indebted clients if in general you had no problem whatsoever in working with them?

Moreover, if one MFI refused to work with these indebted individuals, it was unlikely that its competitors were all going to be equally as cautious (or ethical). And those MFIs that willingly accepted clients already in possession of one or more microloans, no matter the risk, would quickly outgrow the competitors: that what was counted. Crucially, that MFIs senior managers would be in a better position to individually profit when their now larger MFI was sold off to a western European bank or investment fund, as was every Bosnian MFI’s plan pretty much right from the start.

The inevitable result of this unrestrained competition, however, was the ‘microcredit meltdown’ that exploded in late 2009. Some of Bosnia’s MFIs will no doubt recover, and most financial analysts expect that the senior managers’ private enrichment goals will eventually be turned into reality once the law is changed. But with no evidence whatsoever to confirm that Bosnia’s poor actually benefitted from expensive microfinance in the run up to 2009’s meltdown, it’s pretty much been all pain and no gain for them.

One of the most worrying aspects of the over-indebtedness problem today is the way that even non-profit MFIs have tried to ensure their own financial sustainability by wilfully assisting poor individuals into over-indebtedness. Haiti is the obvious example here. Far too many poor individuals were all too easily convinced into believing that if they keep on trying they will eventually hit upon a microbusiness idea that can be a success, an outcome that would then clear all their accumulated debts and allow them to return to something like a normal life.

But hope is all too often an unsatisfactory substitute for the lack of basic business opportunities in post-earthquake Haiti. Most of the poor accessing a microcredit have used it to buy simple household goods to sell to others equally poor. This is not a real solution to poverty anywhere.

Those in Haiti simply tapping into a microcredit to purchase desperately needed consumption goods have done so in the hope that some other business opportunity, or cash windfall, would come along in the meantime that would help them repay their steadily mounting debts. This way of engaging with microfinance in Haiti is culturally not that different to playing the ‘Borlette’, the traditional numbers game that very many poor Haitians hope and dream will one day help them escape their poverty, but which in reality actually soaks up much of their already tiny incomes. Sadly in Haiti, as even the main MFIs working in Haiti now concede, notably Fonkoze, as have development organisations like Oxfam, that most of the hopes and dreams built up around microfinance have amounted to nothing more than a destructive wave of individual over-indebtedness.

The over-indebtedness crisis that is bringing down the microfinance industry is not some plague that arrived from space. Nor is it a result of government intervention, as some market fundamentalists contend. It is a phenomenon that is quite intrinsic to the preferred commercialised microfinance model. Until we first accept this unpalatable fact, most of the solutions proffered so far are simply papering over ever-widening cracks.

–Milford Bateman

The views reflected in this post are those of the author, and not of CGAP.