Over-indebtedness: Striking the Right Balance

What has repeatedly astonished me about the discussion of over-indebtedness during the last couple of months is that people tend to treat the topic as if we only discovered it most recently.

To say so may reveal me as a microfinance dinosaur.

But didn’t we discuss over-indebtedness from every angle already back in 1998/99, when the Bolivia crisis loomed? Didn’t we conclude to strengthen information sharing significantly, to force all major players to participate and to even build in financial incentives to make MFIs take a more cautious approach? Didn’t we also set strong incentives for MFIs to transform into formal entities, with strong supervision from the superintendency and also forcing them to be as transparent as possible?

I say “we” as I have been involved as a consultant to the superintendency for many years, during which many of these steps have been implemented. Did this deliver the expected result? It did. That’s why the Bolivian microfinance market although certainly showing in many regions a high level of penetration does not seem to show dramatic overshooting.

What about Peru, which also has implemented all of those measures, doesn’t it show signs of over-indebtedness? If we take an elevated portfolio at risk (PAR), high rescheduling and write-off levels as indicators, I would say it does. But is there anything fundamentally wrong? No. To the contrary, all the necessary mechanisms are in place to counterbalance the risk of over indebtedness and those mechanism show results.

The basic recipe to counterbalance the risk of over indebtedness is known. It is made with the following ingredients: formalisation of MFIs, strong supervision, high financial incentives not to overshoot through strict provisioning requirements, full compulsory information sharing, broad product range with more and more individual lenders who can much more easily fine tune their reaction in case of problems and who carry out a more detailed cash flow analysis compared to group lenders, and strong supervision of internal control mechanism–to name the most essential ones.

Unfortunately, if we compare our basic recipe with the current regulation frameworks in many countries, we find that too small a number of countries use the basic ingredients described above. Regulators, only too often influenced by politicians and sometimes lacking specific know-how or experience, cook by their own recipes. Most countries barely support the core principles of a sound financial sector development policy, which is by far the most efficient tool to at least adequately control the risk of over-indebtedness.

Moreover, there is a real danger that politicians and regulators, alarmed by media coverage of over-indebtedness, become over ambitious chefs, i.e. they undertake measures that are ineffective or outright harmful. Instead of building a regulatory framework that fosters development of the market while including elements that counterbalance overheating, instead they constrain market development. The inevitable result is reduced services, and poor people have less choice, or lose access to finance completely. The Malegam recommendations in India are a case in point.

Over-indebtedness is as old as lending itself. A growing credit market will always bring about cases of client over-indebtedness. To put consumer protection measures in place is an essential part of good practice. However, this protection must not stifle market development itself. Avoiding over-indebtedness at any price is not desirable, as the overriding goal of building inclusive financial markets will not be achieved.

Rich brought up the question in his post: “how do we know if sacrifices without loans wouldn’t have been even worse?” And – I hope I understand correctly – this is a question that has to be asked on an individual level but also on an aggregated level. Whatever the answer might be, to justify the restriction of choice for the poor would not be an acceptable outcome. Access to finance is part of people’s economic freedom. To restrict it on grounds of consumer protection and thus exclude thousands of people from the opportunities credit markets offer is patronizing the poor, not helping them.

What we can and must do is learn from past crises that have caused wide-spread over-indebtedness. We can identify the signals that appeared prior to breaking out of crises. This can help us anticipate and prevent future crises and their repercussions. An important step in this regard is the research project we have undertaken together with the University of Zurich and in partnership with Triodos and CMEF in order to develop an over-indebtedness early warning index and discuss preliminary results.