The Social Impact Credit Trap in Asset Finance

Imagine you are a socially minded innovator. You’ve just invented a product that somehow cuts the amount of time spent on housework in half. You want to make it widely accessible and have decided that starting a for-profit business is the best way to do that. But a couple things stand in your way.

First, in the areas where you want to sell your product, the average household can only afford to spend $20 per month on it. Your asset costs $200. Second, you can’t find a bank or microfinance institution willing to help customers finance your asset. Either they are unfamiliar with the product or uncomfortable taking the risk of lending to low-income households.

You know your device will improve people’s lives, but only if they can afford it. So you start to finance your own sales and allow customers to pay for the asset over 12 or 18 months. Suddenly, 10 times as many people are purchasing your asset because it only costs $20 down.

Long before those 12 to 18 months are up, development finance institutions and social impact investors start to answer your calls. They see your initial growth, ability to manage credit risk at a small scale, and potential impact, and they are prepared to fund you — but only if you can grow rapidly and create widespread impact.

Trusting in yourself and your company, you agree. Suddenly, you need to double your staff and increase your sales (and loan book) by an order of magnitude, all while still (ostensibly) managing credit risk.

You’ve entered the social impact credit trap.

What is the social impact credit trap?

The development sector is filled with capital seeking impact and impatient optimists who want to allocate it. When an innovation demonstrates both commercial viability and impact, the pressure to fund it, to scale its benefits and to not miss out on its success is immense.

In many sectors and scenarios, this impatience is appropriate. But credit businesses that lend money or finance assets for poor households have different risks and requirements. Rapid growth in credit sectors, whether driven by a desire for profit or a desire for progress, can overwhelm institutions’ risk management capacity and lead to overindebted customers, non-performing assets and insolvent lenders.

Rapid growth in credit sectors, whether driven by a desire for profit or a desire for progress, can overwhelm institutions’ risk management capacity and lead to overindebted customers, non-performing assets and insolvent lenders.

History has shown that those effects can be even more severe among lenders serving low-income clients.

Microfinance

Take microfinance, for example. The early 2000s was a time of breakneck growth in the sector, as evidence (later disputed) of impact on poverty alleviation led to a spike in public and private investment. A 2010 CGAP report stated that loan books more than tripled in size between 2004 and 2008, and international investments in microfinance institutions (MFIs) increased by a factor of seven from 2003 to 2008.

The top MFIs had strong incentives to keep growing, as “funding, national influence, and international recognition all flowed to the largest players.” An industry survey from 2008 showed that few stakeholders were worried about credit risk at the time (it ranked only #10 on list of concerns) but cautioned that “too much capital is probably a bigger problem than too little in that it may drive standards down.”

Indeed, the rapid growth came at a cost.

MFIs were forced to double and triple their staff quickly, which meant that standards for evaluation and training began to slip. One MFI in Pakistan had regional managers overseeing as many as 75 branches. An MFI in Morocco increased its staff five-fold in three years but only doubled its internal auditors.

The lack of experience and push for growth, combined with commission incentives that rewarded loan officers who originated greater volumes, caused credit standards to slip. When the 2008 financial crisis hit, it revealed that many clients were overindebted and that MFIs lacked the credit risk management structures to effectively originate and manage their portfolios.

By 2009, the same industry survey referenced above showed that credit risk had become the #1 concern. Repayment crises sprang up in Nicaragua, Pakistan, Morocco and elsewhere, followed by the Andhra Pradesh crisis of 2010.

Digital credit

Digital credit offers another example, albeit without as much of a social impact focus.

M-Shwari, the first large-scale digital loan product that used non-financial data to underwrite loans, launched in late 2012 to great success. Within two years, the company had opened over 9 million savings accounts and disbursed 20 million loans. A CGAP report from 2015 lauded CBA’s and Safaricom’s efforts to manage risks and protect clients but worried that “inferior copycat digital lenders” could create a “a race to the bottom or widespread over-indebtedness.”

This proved prescient. By 2016, at least 17 digital credit services were active in Kenya, as domestic banks and foreign investors began putting money and resources into the sector. By 2017, surveys showed that one in four Kenyans had taken a digital loan. Similar to what happened in microfinance, customers who had never had access to formal credit were suddenly awash in options.

The results of this digital credit boom have been well-documented by CGAP and others: high default rates, exorbitant late fees, juggling multiple debts, inappropriate collections by lenders, and negative credit bureau reports. One in five Kenyan borrowers reported reducing food purchases to repay a digital loan.

Is asset finance next?

Credit bubbles, even when driven by good intentions, hurt poor people. They squeeze household budgets, discourage future investment and make responsible credit harder to access. They should be avoided at all costs.

The hypothetical example at the beginning of this post is playing out with increasing frequency. Asset finance companies in Sub-Saharan Africa and elsewhere have raised huge amounts of capital and are growing their loan portfolios rapidly.

In many ways, this is welcome: more people are accessing life-changing assets. But risk management capacity, already stretched for some companies, has not always grown commensurately with their loan books. Without a major emphasis on risk management, accompanied by money and resources, asset finance runs the risk of repeating the above cycle.

How should social investors approach credit businesses?

The solution to the social impact credit trap is not to stop lending to poor households or to stop investing in businesses that do. Rather, it’s to recognize that investing in credit businesses means investing in risk management.

The solution to the social impact credit trap is not to stop lending to poor households or to stop investing in businesses that do. Rather, it’s to recognize that investing in credit businesses means investing in risk management.

Investors in asset finance companies and other credit-based businesses serving poor customers need to be cautious in how fast they expect lending businesses to grow. And they need to exercise due diligence to verify that businesses have the core elements of risk management in place:

• Frontline risk management, a dedicated risk team and an internal audit function (the ‘three lines of defense’)
• Cleary articulated risk appetite and portfolio limits
• Demonstrated ability to hit growth targets while staying within risk tolerances
• Culture of risk management that starts at the top and goes all the way to frontline staff

When these are not present, organizations may be able to scale quickly and generate high ‘sales’ numbers, but they may struggle to turn their loan/lease receivables into actual cash.

The good news is that these things can be built. Investors can provide short-term technical assistance to help companies develop their risk management capabilities. A little bit of money spent on risk management now, combined with a bit of patience, can lead to slower, more sustainable growth.

And that is where the impact actually comes from.

Want to learn more about how to manage credit risk in asset finance? Check the technical guide for credit risk managers and senior executives at asset finance companies, and the recording of our recent webinar on this topic.