Over-Indebtedness in Microcredit

This post kicks-off a new series in preparation for the XIV Inter-American Forum on Microenterprise (Foromic) in Costa Rica from 10-12 October. CGAP and the MIF are joining forces to argue about the key challenges in microfinance and distill the game-changing solutions for greater financial inclusion and stronger micro and small enterprises in Latin America and the Caribbean. These posts will also be featured on MIF’s Microfinance Blog in Spanish.

Recently, MIX has explored portfolio quality problems around the world, a common proxy to measure overindebtedness, and various relevant patterns emerge for the discussion of over-indebtedness in Latin America and around the world:

• Market saturation is an important early warning indicator of over-indebtedness: Research indicates that the risk of portfolio quality problems increases when the total number of accounts per country is more than 10% of the total population.
• The 10% threshold is an average, and further refinements are necessary to account for additional factors such as within-country geographical variation, demand for microcredit (including size of the formal economy and poverty levels), and supply of financial services by non-specialized microfinance providers (like state-owned banks) that may compete for the same type of clients than MFIs.
• In order to mitigate the effects of market saturation, it is necessary to improve financial sector infrastructure, including regulation and credit bureaus. MFIs can expand into new under-served markets, and design new products beyond credit, including savings and insurance.
• All parties involved in saturated markets should lower growth expectations before overheating the market.
• Credit policies are the most important process that MFIs could improve in order to prevent over-indebtedness. These policies are particularly effective preventing portfolio quality problems for MFIs that are experiencing portfolio contractions, but of limited effect in saturated markets. This implies that saturated markets are more challenging than we think, and extra caution is necessary.
• In particular, we found that Planet Rating’s GIRAFE scores can predict portfolio quality problems twelve months in advance, demonstrating that similar indicators could be part of an early warning system.
• At the level of policies and processes, the first action that MFIs can take to reduce over-indebtedness is to strengthen lending methodologies and train credit officers accordingly.
• Moving into more formalized market segments can lead to more portfolio quality problems, especially during economic slowdowns like the recent financial crisis.
  • Microfinance portfolios have been more resilient to local macroeconomic shocks than those of traditional lenders because the typical microfinance clients are used to dealing with shocks, are expert micro-diversifiers, and have had greater flexibility to move from one economic activity to another. However, in recent years, the microfinance sector has been moving away from these types of clients by increasing the share of non-microenterprise loans in their portfolios, and by expanding into regions with less informal microentrepreneurs. Our recent research indicates that the portfolio quality of MFIs with a larger share of non-microenterprise loans or those operating in countries where most of labor market consists of salaried workers suffers more in relation to contractions in GDP.
• Extensive growth into new and less-saturated markets is less prone to over-indebtedness than intensive growth into the same markets where other MFIs are already operating. In addition, extensive growth is positive because it increases geographical diversification, and access to exclude populations, including rural areas.

Lessons for the microfinance industry:

• Overcoming the challenges of market saturation. As the sector matures, high penetration markets have become saturated and overheated. As a new stage of evolution for microfinance, we are realizing that conventional wisdom and well-established tools do not work as well in saturated markets. Learning the new rules of the game in saturated markets is a new challenge for all microfinance players, including MFIs, regulators, donors, funders, and raters.
• What is microcredit? More than semantics. Microfinance was born from a successful lending methodology to reach informal microentrepreneurs in economies with high degrees of informality. However, the expansion of MFIs into more formal economies and non-microenterprise clients may imply additional risks. This does not imply that we should pause expansion into new products and populations, but rather that we should have more awareness of the potential implications of new products.
• At the MFI level, strengthening lending technologies is the first step to reduce over-indebtedness. Microcredit became successful by appropriate screening of potential borrowers and design of appropriate incentive mechanisms for repayment. Evidence suggest that today, this is still one of the most important areas of attentions for MFIs concerned about over-indebtedness
• Overindebtedness is a serious issue, but under-indebtedness is as serious. Both occur at the same time in different markets. Therefore, policies designed to avoid over-indebtedness should not limit the expansion of microfinance in areas where under-indebtedness is the most serious problem, including remote and rural markets.
• Multi-indebtedness, good or bad? Multiple loans per client are common in various countries, including Ecuador and Peru, but until now there is no definite evidence indicating that multi-indebtedness causes over-indebtedness. Instead of focusing on number of loans per client, the focus should be on total repayment capacity of the client with respect total debt, including additional sources of repayment, and incentives to repay.
• Over-indebtedness has multiple causes, and their proper identification is crucial for effective policy making. Knowing how many clients are over-indebted is not useful if we don’t know why.