76207 FOCUS NOTE Regulatory Options to Curb Debt Stress T he U.S. subprime mortgage crisis in the mid-2000s brought new focus on the risk of unsustainable debt burdens to both the financial sector and the It is based on the proposition that debt stress and over-indebtedness (see Box 1 on terms used to describe these phenomena and different household real economy. This resulted in extensive reforms credit segments) pose risks to credit market to laws and regulations related to credit across development as well as to consumer protection—risks both Organisation for Economic Co-operation and that require a specific regulatory and policy approach. Development (OECD) countries and other developed Consumers in developing countries are gaining more countries. In a broad range of developing countries access to different forms of finance, from bank loans and emerging markets, the past decade has seen and consumer credit to loans from microfinance highly publicized cases of dramatic household-level institutions (MFIs) and nonbank money lenders. Rapid credit growth and increasing debt stress followed by growth in lending from these different subsectors may institutional failure and government intervention.1 result in a rapid increase in debt stress, with defaults South Africa represents an extreme case, where a affecting both bank and nonbank lenders. The paper cycle of increasingly aggressive lending and over- indebtedness in the consumer credit sector led to the failure of a number of banks and contagion, which Box 1. Terminology: Debt Stress, Over-Indebtedness, Microcredit, and affected the entire banking sector. Consumer Credit As used in this paper, the term “debt stress� Increased debt stress can result in social unrest and refers to a financial condition of an individual, serious political repercussions. In Bolivia, protesters household, or market segment that is on the road with dynamite strapped to their bodies held central to over-indebtedness. There is much debate over bank staff hostage (Rhyne 2001). In Nicaragua, the the definition of “over-indebtedness� and how it ought to be measured, especially where it implies No Pago movement instigated violent street protests, judgment about how much credit is too much with the president labelling microlenders “usurers� when the full range of individual circumstances (Pachico 2009). Such actions can threaten financial may be difficult to ascertain. Accordingly, the term sector development. The recent debt-related fall- “debt stress� is used broadly to refer to a range of situations that may indicate a threat of debt-related out in India captured international headlines and crisis at the individual or market level. highlighted the extent to which debt stress can serve as a political rallying point. It led, for instance, This paper refers frequently to both “microcredit� and “consumer credit.� As a rough generalization, to political support for repayment boycotts and microcredit usually involves small loans to nonsalaried to extreme regulatory interventions by one state workers who operate informal “microenterprises.� government, and it undermined microlenders’ support In contrast, most consumer credit (e.g., credit cards or retailer finance) goes to salaried employees of from governments, donors, and social investors.2 formal sector enterprises. However, these general descriptions have many exceptions, and in practice No. 83 This Focus Note argues that it is preferable to there may be considerable overlap among the March 2013 implement appropriate monitoring mechanisms and markets served by the different types of lenders. Consumer lenders may serve some unsalaried regulatory interventions at an early stage in credit borrowers, and MFIs sometimes lend to salaried Gabriel Davel market development, to detect potential debt stress workers. Because of such overlaps, it is essential and prevent reckless lending practices, thereby to look at the household lending market as a whole. Problems with consumer credit can affect avoiding risks to financial markets, consumers, and microlending, and nonbank lending can affect banks. the regulator’s credibility. 1 These include Bolivia (1998–1999), Colombia (1999–2000), South Africa (1999–2002), Bosnia–Herzegovina (2008), Nicaragua (2009–2010), India (2010), and Chile (2010–2011). 2 See, e.g., Micro-Credit Ratings International Limited (2011b) and CGAP (2011). 2 aims to offer practical guidance to regulators3 and • Expansion of credit information sharing and policy makers who face such challenges. establishment of credit bureaus As background for the policy and regulatory These and other measures (see Table 1) will proposals discussed in this paper, Section I offers a be discussed in further depth in this paper, brief overview of the dynamics of credit market cycles highlighting a few key country examples. Further and describes how the factors driving the growth of a country examples of each measure are provided credit market may result in a credit bubble, followed in Annex 1. by increasing defaults and eventual contraction. Understanding these dynamics is essential to In implementing any of these measures, it is grasping the limitations of traditional prudential essential to recognize that countries differ supervision risk indicators and interventions in substantially in their stage of credit market identifying and dealing with the risks of debt stress development, profile of credit providers and and over-indebtedness. We  point out that when products, level of credit penetration, and regulator a credit market is growing rapidly, the increased capacity. There may also be substantial differences supply of loans and high household liquidity may in credit market development within the country. disguise actual levels of debt stress: defaults may For example, a certain population segment (e.g., be relatively low for a time, even when debt stress civil servants or salaried workers) or geographic may be reaching unsustainable levels. Regulators are area (e.g., urban centers) may be saturated while often unaware of the extent of debt stress until it is others still struggle with basic financial access. too late to take preventative measures. These factors affect the risk of debt stress as well as the nature of the policy response. An overly Sections II and III propose a policy and regulatory restrictive or prescriptive regulatory environment approach for early-stage and high-growth credit may limit the ability of credit providers to introduce markets. This approach aims to address emerging innovative products or delivery channels. This in risks of debt stress without inhibiting the expansion turn can undermine credit market development of financial access. While there is a potential trade- and strategies to increase access to finance. Thus, off between these two policy goals, this paper argues the priority in early-stage markets should be on that a sensible strategy can find the right balance. monitoring early warning indicators; creating The main proposed measures, in general order of enabling infrastructure, such as credit bureaus; or importance, include the following: removing legislative obstacles to lending. • Implementation of specific measures to detect It is similarly important to consider differences in potential debt stress at an early stage (when countries’ regulatory structures and institutional monitoring defaults may not be sufficient) mandates, which may limit regulators’ ability to • Regulation of lending practices that may create cover all relevant segments of the credit market. incentives for reckless lending Such limitations may make it challenging for any • Rules requiring effective disclosure and complaints single regulator to effectively manage debt stress handling by lenders that results from activities in unregulated or under- • Measures to improve lending practices, potentially regulated segments of the market. Coordination including guidelines on affordability assessments among regulatory agencies and efforts on the or the oversight of agents or brokers policy front to close such gaps are essential. 3 For simplicity, this paper uses the term “regulator� to describe the authorities that regulate and supervise financial institutions in a particular country. 3 Table 1. Summary of Early-Stage Regulatory or Policy Interventions to Prevent and Address Debt Stress Monitor signs of potential Regulators can monitor trends in statistical indicators for potential debt debt stress stress and assess market practices that may aggravate the risk of debt stress. Early-warning indicators include rapid growth in individual institutions’ portfolios with a simultaneous rapid expansion in the number of lending institutions; concentration of lending to certain population segments (e.g., government servants/salaried workers); rapid growth in average loan size or loan term; increased loan rescheduling and refinancing; and increased arrears and default. Regulate high-risk market Regulators should address market practices that increase the risk of unsound practices or predatory lending.a For instance, payroll deduction facilities have led to debt stress in many countries, often among politically sensitive market segments such as government employees. Similarly, when collection methods are unregulated, the practices of predatory credit providers can become a political issue, even if only small numbers of people are affected. Unsolicited credit and automatic increases in credit limits are further examples of high-risk practices. Regulating such high-risk practices at an early stage can reduce the incentive for high-risk lending without unduly hindering responsible lenders. Support credit bureaus Effective and inclusive credit bureaus add value in nearly every environment. In low-inclusion environments, improved credit information lowers the cost of credit assessment and loan origination and creates an impetus for growth. In a high-risk environment, it can help credit providers identify debt-stressed individuals, reducing credit risk in the market. Credit bureaus should include both positive (full-file) and negative data, and include both bank and nonbank lenders. Support lender standards Regulators can require that industry codes contain guidelines for responsible and ombudsman schemes by lending, including affordability assessment requirements. Regulators can industry also require that financial institutions establish internal complaints and recourse mechanisms and report complaints data to the regulator. Further, an industry-funded ombudsman scheme could provide a mechanism to handle consumer complaints and offer accessible redress, without requiring regulatory resources. Foster consumer awareness Messages relating to household debt management and over-indebtedness risk should form part of any national consumer awareness and financial literacy campaign. There is no single definition of “predatory lending,� a term that can encompass a range of misleading, manipulative, or abusive lending practices. John a.  Hawke, Jr., defined this term and presented examples of a range of such practices in his statement to the U.S. House Committee on Banking and Financial Services in 2000. Morgan (2007) described predatory lending more generally as “a welfare-reducing provision of credit.� See Hawke (2000) and Morgan (2007). In the meantime, regulators should, at a minimum, contraction. These cycles have significant policy broaden their monitoring efforts to capture and regulatory implications: potential spill-over effects from other segments of the market that may increase overall debt stress. • Understanding this may help those involved move beyond the competing ideologies that I. Dynamics of Credit blame over-indebtedness either entirely on Cycles and Debt Stress indulgent and irresponsible consumers or on in Expanding Markets predatory and reckless credit providers. • Understanding these cycles helps regulators detect A systemic view of credit market cycles the level of debt stress relative to the level of credit market development. The inherent dynamics of credit market development • Perhaps most importantly, understanding these can lead to cycles of credit growth and consumer cycles is essential to crafting appropriate policy debt build-up followed by ­ large-­ scale default and and regulatory responses. 4 Figure 1. Credit Market Cycle: From Expansion to Meltdown PHASE 3 PHASE 4 High liquidity Low defaults Defaults PHASE 2 Debt build-up Debt collecƟon As se PHASE 5 DistribuƟon network → tp s ric PHASE 1 Commissions i ce es t pr → ContracƟon se Access to loan capital As EscalaƟng defaults CommodiƟze • CommodiƟzaƟon and commercializaƟon Commercialize drives strong growth • High liquidity disguises debt stress Bank → defaults low failures … ? • When stress reaches criƟcal levels, defaults commence, leading to contracƟon and escalaƟng stress Phases of expansion and The typical phases of expansion and contraction contraction in credit markets are as follows: Cycles of growth and contraction are quite • Phase 1—Preconditions for expansion. A few predictable and have been observed in many pioneer institutions develop cost-effective lending different market sectors. Recent cycles of debt 4 methodologies to reach underserved or lower stress in lower income credit markets have access customer segments. This includes low-cost been preceded by high growth rates among models for client selection, loan disbursement, existing institutions, fed by rapid increases in loan administration, information technology, and available commercial financing. Commercializing effective collection processes. microlenders have often scaled up (in both • Phase 2—Commercialization and expanded access overall portfolio and loan size) at the same time to funding. Demonstrated success attracts new as commercial banks have attempted to go entrants. Distribution networks develop further, down market by providing smaller loans to either often involving agent or broker networks and businesses or consumers. Aggressive competition aggressive incentive structures to drive growth.5 among lenders for the same client base can saturate High returns attract commercial investors and market segments quickly. See Figure 1. enable growth, which in turn requires rapid growth 4 This section applies to consumer credit markets and Minsky’s (1992) analyses of the swings in financial systems between robustness and fragility, with debt build-up followed by over-indebtedness and credit contraction, which in turn fuel extreme economic cycles. See also Kindleberger’s (2005) description of financial crises and credit cycles. Such credit cycles have received much attention since the global financial crisis, particularly as the basis for macroprudential (as opposed to microprudential) or counter-cyclical policies that operate to curb credit cycles. See, e.g., Bank of England (2009). 5 MFIs had access to relatively ample new sources of debt in Bosnia–Herzegovina, Pakistan, Nicaragua, and Morocco during the period ­ (2004–2008) before their default and repayment crises. See Chen, Rasmussen, and Reille (2010). Leading up to the U.S. subprime crisis, the linkage between mortgage brokers and securitization enabled a similar pace of expansion through new capital sources. 5 in loan portfolio and market share to achieve client base over time, through its selection of a target expected returns. market, growth targets, affordability assessment and • Phase 3—Debt build-up with high borrower liquidity credit criteria, and loan officer incentives structure. and low defaults. As the market enters a phase Certain lending methods, such as payroll-deducted of rapid growth, competition could undermine lending, unsolicited credit, or automatic/incremental lending standards and processes. Borrowers may re-advances, will cause an increase in debt build-up have access to multiple loans from different lenders, and can increase the risk of debt stress. (See Annex 2 enabling them to “borrow from Peter to pay Paul.� for more on microcredit methods and risks.) The high level of liquidity means that defaults may remain surprisingly low for an extended period Traditionally, regulators assume that the risk of even as overall debt levels increase. default should keep lenders from providing further • Phase 4—Escalating default and contraction . loans to clients who are at risk of becoming over- Defaults start escalating, triggered by unsustainable indebted. Unfortunately, several factors undermine household debt levels and sometimes by external this assumption. A high-interest-rate environment, shocks, such as economic slowdowns. Lenders or one that allows significant late payment penalties become alarmed, start cutting back on new credit, or debt collection charges, creates incentives for and prioritize debt collection. This contracts high-risk lending.6 As long as the return on increased household liquidity, leading to escalation of defaults. lending (including all interest, fees, and potential late • Phase 5—Institutional failure and potential for payment penalties on clients with irregular payment contagion. Default levels may affect several patterns) is sufficiently high to offset the capital losses lenders, including banks, whether as a result of on defaults, a lender can withstand a high level of their own lending or as a result of providing loan arrears while still maximizing its return across the total capital to retail lenders. Depending on the level portfolio. (See Annex 1 for variations in microcredit.) of bank exposure, this could result in bank failure. High late-payment interest and penalties or debt collection fees increase the profitability of lending Debt stress appears as a warning sign, but also as a to clients who have a high likelihood of going into sign of the success of previous strategies for credit arrears, creating an incentive to target borrowers with expansion and financial inclusion. The challenge weak repayment records. lies in developing appropriate regulatory strategies that deal proactively with the consequences of Obviously, the “financial imprudence� 7 of the increasing credit access, rather than trying to roll client base also plays a role in debt stress, as does back commercialization. “desperation borrowing� by clients who rely on loans to augment very low or unstable incomes. Causes of debt stress: Lender However, research indicates that factors such as practices and borrower behavior reckless borrowing or borrowing with the intention to default do not constitute a significant cause Regulations and policies must address the individual of over-indebtedness.8 Low-income or vulnerable behaviors that collectively contribute to the credit households are quite likely to face situations cycle. The lending strategies and specific loan policies that cause additional borrowing in response to a adopted by individual lenders play a determinative household crisis or external event (e.g., a reduction role in the credit cycle. Every lender effectively in remittance flows). A final factor is that lenders determines the amount of debt that will develop in its may exploit borrower vulnerabilities and behavioral 6 See, e.g., Gardner (2010). 7 In the United Kingdom, e.g., credit counselors point to factors such as low financial literacy levels and cognitive biases in consumer choices as underlying what may look like irresponsible behavior (over-borrowing, under-insurance); they cite such “financial imprudence� as a main factor in over-indebtedness (Disney, Bridges, and Gathergood 2008). 8 See, e.g., Disney, Bridges, and Gathergood (2008). 6 Table 2. Examples of Lender Practices That Increase the Risk of Debt Stress Unsolicited/pre-approved Unsolicited and pre-approved credit create a natural incentive for increasing credit debt levels among performing clients. This cycle terminates only when the client starts showing signs of debt stress. Automatic increases in loan sizes or credit limits have a similar effect. Payroll deductions Permitting loan repayments to be deducted directly from salaries undermines the lender’s incentive to assess the borrower’s total level of debt, including loans from lenders without payroll deduction facilities. Instead, it creates an incentive to lend to the maximum deduction allowable.a Penalties on arrears Excessive late payment penalties create an incentive to lend to clients with existing high debt levels. Hidden fees and charges/weak Hidden fees and charges and weak disclosure undermine clients’ ability to disclosure assess the repayment obligations and manage their own debt commitments. Loan officer, agent, or broker High agent or broker commissions create an incentive for aggressive loan commissions origination. The position is aggravated when commission structures do not penalize poor loan quality or subsequent default. Unregulated debt collection Unregulated debt collection enables predatory lenders to use coercive practices pressures to enforce repayment and avoid default, even when clients are over- indebted. No or inadequate credit In the absence of credit bureaus, lenders have insufficient information on the information sharing total debt levels of applicants. Negative-only bureausb or bureaus that cover only bank credit undermine the effectiveness of credit bureau information. Any mechanism that provides lenders a preference to collect directly from a borrower’s bank account for a specific category of lender would have the a.  same adverse outcome. Preferential deductions for credit insurance policies, either from salaries or from bank accounts, are similarly damaging. Negative-only information results in the lender not having access to information on all the loans that are outstanding and thus being unaware of an b.  increase in borrowing until the borrower starts defaulting. biases9 through misleading marketing or aggressive II. Early Warning Indicators sales techniques. Pre-existing high debt levels and Monitoring can make households or consumer credit markets much more vulnerable10 to adverse shocks, such Keeping these dynamics in mind, market monitoring as job loss, business or crop failure, a death or is the necessary first step in any proactive and illness in the family, or divorce, that cause a sudden integrated approach to curbing debt stress. reduction in household income or an unexpected In this section we provide an overview of early increase in expenses.11 The most damaging shocks warning indicators and mechanisms regulators are those that affect a whole region or population can use to monitor debt stress. (The next section segment, such as a drought or a regional decline explores regulatory mechanisms as well as market in remittance income. infrastructure, such as credit bureaus, to mitigate the risk of over-indebtedness. A complete list of Table 2 provides an overview of different lender the monitoring and regulatory options is included practices that create perverse incentives and increase in Annex 3.) the risk of unsustainable credit growth and unhealthy business models. The regulatory interventions that Market monitoring focuses on indicators that target these practices are discussed in detail in would help a regulator detect a risk of over- “Section III. Regulatory and Policy Interventions.� indebtedness at an institutional or sector level,   9 For a survey of some of this behavioral research, see Schicks and Rosenberg (2011) at 16–17. 10 E.g., already increased indebtedness in the microfinance markets in Bosnia–Herzegovina before the global financial crisis made the country vulnerable and exacerbated the impact of the financial crisis and contributed to the repayment crisis (Leshner and Frachaud 2010). 11 Research from the United Kingdom suggests that the three key factors that “expose households to the risk of excessive debt and other financial problems are loss of employment (including the failure of a business), marital breakdown, and poor financial management by the household� (Disney, Bridges, and Gathergood 2008). 7 rather than only at the individual household level a country or portfolio is shorter, a low debt-to- (U.K. Task Force on Tackling Over-Indebtedness income ratio will mask the true debt stress (the 2003). Traditional indicators, such as the aggregate debt servicing ratio is a better indicator). debt-to-income ratio or the level of arrears in individual institutions, are often misleading and A general weakness in traditional indicators is the may not provide an accurate indication of the extent to which aggregated indicators or national extent of over-indebtedness in the market. Early averages are used. Disaggregated statistics and warning indicators and other proactive monitoring the trends in these statistics for different income mechanisms can reduce both risk to the financial groups, different regions, or different employment system and risk to regulators’ credibility. categories can help to detect localized stress and prevent problems from being hidden in national Limitations of traditional indicators averages. Traditionally, a low level of arrears is seen as a Early warning indicators strong indicator of low debt stress. However, high household liquidity created during a phase of A range of potential indicators can complement expansion and growth and rapidly increasing loan traditional credit risk indicators and provide more portfolios and client numbers (often coinciding with effective early warning when the risk of debt stress new lenders entering the market) can disguise the 12 is increasing. The most generally applicable include level of debt stress. Furthermore, if a portfolio with the following: a mix of small and large loans is not disaggregated by loan size and client segment, household debt • Rapid growth—High growth of a lender’s portfolio problems will show up in regulatory reports only over several years,14 especially when concentrated when a very large number of clients are already in particular market segments, should be cause for over-indebted. 13 further investigation. The risk is increased when the growth takes place across several institutions There are similar weaknesses in other macro-level with a large number of new entrants targeting the indicators traditionally used by regulators. The same market segment. These risks are exacerbated aggregate debt-to-income ratio is often used as if there is no credit bureau system through which a measure of indebtedness, yet it may be quite credit providers can assess an applicant’s overall misleading. The profile of the underlying debt (the exposure to all lenders and no requirement to do mix between long- and short-term debt and mix affordability assessments. between small and large loans) in any particular • Increases in loan size/term and refinancing—A country has a huge impact on the interpretation of rapid increase in lenders’ average loan size and the debt-to-income ratio. The core of the problem loan term combined with increased refinancing is that the debt–to-income ratio is based on the and rescheduling indicate that client debt levels amount of debt, rather than the debt servicing are increasing. When the level of refinancing and commitment or the number of consumers affected. rescheduling starts increasing, it is likely that debt When the average repayment term of the loan in stress has reached an advanced stage. 12 Low-income households may make significant sacrifices to repay loans. For such borrowers, high levels of debt stress (measured by unacceptable sacrifices or compromises to welfare) would not show up in arrears. In such circumstances, household surveys may be an important way to measure debt stress (Schicks 2011a). 13 For further discussion of the weakness of arrears reports as an indicator of existing debt stress, see Schicks and Rosenberg (2011). 14 There is no rule of thumb to judge what rate of growth is too high without detailed understanding of context. Note that in the case of microcredit, Gonzalez (2010) finds that growth rates of individual lenders show little correlation with subsequent collection problems. However, risk appears to increase when either aggregate market growth or microcredit market penetration is very high. 8 • Increasing debt collection activity and abusive Different mechanisms that may be considered debt collection practices—These practices suggest include the following: a high level of debt stress, as does an increase in the volume of court cases related to debt.15 • Special indebtedness report—If there is a concern about debt stress but no clear statistical evidence, None of these signals alone is a certain sign of it may be appropriate to commission a special over-indebtedness. However, a sustained upward report by a research firm or task team to assess trend in more than one of these early-warning the level of debt stress based on a detailed review indicators may well signal that regulators should of relevant statistics, interviews with lenders, and gather additional information to assess the extent similar activities. Statistical analysis will help clarify of the problem. the extent of the problem and determine the level of action that may be required. Such a report has A common challenge in many early-stage credit the added value of alerting the industry to the markets is limited availability of national statistics regulator’s concern.18 and limited resources to commission further studies • Special lender reporting—The regulator can require or surveys. Even where this is the case, there are regulated entities to submit a special report on their often alternative sources of information, such as practices in assessing clients’ levels of indebtedness, financial statements from regulated entities, credit and on their views on the extent of debt stress in bureau reports, complaints records, 16 judgment each entity’s client base, trends in arrears, and statistics, or less formal sources, such as media causes thereof. This both informs the regulator and reports. Regulators should engage with the raises awareness among lenders, without placing national  statistics office, department of justice, high demands on regulatory capacity. and other authorities to ensure that appropriate • Onsite inspection reports—A specific section on information17 is collected that would help detect lending practices and on indicators of potential debt stress. debt stress can be included in onsite inspection reports prepared for prudentially regulated Monitoring mechanisms entities. • Test of a sample of lender files—The regulator could In countries at an early stage of credit market choose to evaluate a sample of client files at high- development or with limited formal credit activity, risk lenders19 to assess the extent of debt stress substantial investment in monitoring mechanisms in the lenders’ client base. Such an assessment is may not be warranted. However, when the level of demanding and would be justified only if there is credit activity increases or when the early-warning a high level of concern. It is most effective if there indicators raise alarms, deeper investigation and is an independent source of information on client more systematic monitoring may be justified. indebtedness, such as through a credit bureau 15 The volume of cases is a more significant indicator than the monetary value of debt-related judgments. Where debt collection happens primarily outside of courts, regulators can look to sources such as complaints reports or the media. 16 The next section describes two early-stage interventions that can be a source of early-warning indicators while serving other important purposes: (i) setting up systems to receive complaints or complaints reports and (ii) establishing or improving credit reporting infrastructure and participation. 17 Relevant information could include (i) information on the amount of monthly repayments on debt relative to income, (ii) the number of agreements, (iii) the types of agreements, and/or (iv) the name and type of the lenders involved. It is important that aggregated statistics specify the number of consumers and number of agreements that are involved, and not only the aggregate monetary values. Information on monthly debt-servicing commitments is more important than information on the total amount of debt outstanding. In addition, statistics on the components of the debt (differentiating among principal debt outstanding, accumulated interest, fees, and debt collection or legal charges) would be useful. 18 In South Africa, both a detailed credit bureau report and a credit provider report are published quarterly, and both reports include statistics that can serve as indicators of debt stress. 19 High-risk lenders typically would be identified by the appearance of the early-warning indicators in their portfolios, a large number of debt collection cases in the courts, high numbers of complaints filed against them, etc. 9 Box 2. Statutory Requirements to Consider Affordability The following are examples of the formulation of consumer despite the fact that the preponderance affordability assessment requirements. of information available to the credit provider indicated that— European Union, Consumer Credit Directive, (i) the consumer did not generally understand Article 8 or appreciate the consumer’s risks, costs or obligations under the proposed credit Obligation to assess the creditworthiness of the agreement; or consumer (ii) entering into that credit agreement would make the consumer over-indebted.� “1. Member States shall ensure that, before the [Over-indebtedness is defined elsewhere in conclusion of the credit agreement, the creditor the Act.] assesses the consumer’s creditworthiness on the basis of sufficient information, where appropriate obtained Australia, National Consumer Credit from the consumer and, where necessary, on the basis of a consultation of the relevant database.� Protection Act “131(2) The contract will be unsuitable for the consumer “2. Member States shall ensure that, if the parties agree if, at the time of the assessment, it is likely that: to change the total amount of credit after the conclusion of the credit agreement, the creditor updates the financial (a) the consumer will be unable to comply with the information at his disposal concerning the consumer and consumer’s financial obligations under the contract, assesses the consumer’s creditworthiness before any or could only comply with substantial hardship, significant increase in the total amount of credit.� if the contract is entered or the credit limit is increased in the period covered by the assessment� South Africa, National Credit Act “80. (1) A credit agreement is reckless if, at the time Mexico, Law on Transparency and that the agreement was made, or at the time when Ordering of Financial Services of 2007 the amount approved in terms of the agreement is (amended through 2010) (unofficial translation) increased, . . . Art. 18 Bis 1. Entities shall only issue credit, loans or (a) the credit provider failed to conduct an assessment revolving credit card financing upon an assessment . . . irrespective of what the outcome of such an of the viability of repayment by the applicants, assessment might have concluded at the time; or based on an analysis of quantitative and qualitative (b) the credit provider, having conducted an assessment information that enables the determination of their . . . , entered into the credit agreement with the credit worthiness and ability to repay. system. (South Africa’s Micro-Finance Regulatory special section in its annual reports that assesses Council regularly performed such assessments. and comments on the level of debt stress. See Box 2.) • Loan officer survey—Debt stress could be included • Debt stress task team—The regulator may consider as one of the topics in a periodic survey of senior establishing a task team that includes industry loan officers of banks and other lenders to assess representatives and economists, with a mandate and analyze loan officers’ views on key topics. This to assess debt stress and to develop proposals. is of most value if done annually, to reveal trends. In addition to raising industry’s awareness of the • Credit bureau reporting—Credit bureaus could regulator’s concerns, this high-profile step can help be required to analyze their data and produce the regulator develop an appropriate regulatory reports on trends in debt stress and other relevant response while managing political pressure. 20 information. • Annual debt-stress reviews—In high-growth • National survey—Where national surveys are markets, the regulator may consider including a conducted on more general information, the 20 Such task teams have been used in the United Kingdom, United States, and South Africa, among others. 10 regulator could advocate for a series of questions to exchange (article 9), and disclosure (articles 4–7, be included that gather information on household among others). The G-20 High-Level Principles on debt levels and indicators of debt stress. 21 Financial Consumer Protection and the companion report from the Financial Stability Board are likely III. Regulatory and to lead to further guidelines in this area.24 Policy Interventions A comprehensive regulatory strategy would also There is a potential trade-off between regulatory deal with a number of related matters, such as mechanisms aimed at curbing over-indebtedness disclosure, consumer complaints and redress, and the requirements of an effective financial limitations on unsolicited credit, and debt inclusion strategy. A strategy that aims to prevent enforcement rules or debt counseling. over-indebtedness, but sets such high standards that low-income people and people with irregular As a first regulatory priority, this paper proposes sources of income do not qualify for credit would be curbing market practices that can create an counterproductive. However, there is ample room 22 incentive for reckless lending. These are market for a sensible strategy that strikes a balance between practices that undermine a lender’s incentive to these policy goals. Such a strategy would curb the assess affordability or that increase the profitability practices of over-aggressive and predatory credit of irresponsible lending. This includes practices such providers, but should have little impact on lenders as direct deduction of loan repayments from salaries, that target clients who have limited access to finance excessive late payment penalties, or abusive debt or lenders that apply sensible procedures to prevent collection practices. A second priority is to limit their clients from becoming over-­ indebted. Such a practices that encourage unsustainable growth in strategy would simultaneously curtail unsustainable credit markets, such as unsolicited credit offers, growth in consumer debt and increase the stability negative option marketing,25 or automatic increases of the credit market. It is critical that regulators in credit limits. It is also important to improve have a solid understanding of the different lending market infrastructure through credit bureaus and methods and business models in the market. information sharing. Once these mechanisms are in place, compulsory affordability assessments could be The U.S. subprime crisis has given momentum viewed as a follow-on intervention in the event that to regulatory and policy reform in this area, with perverse incentives remain. However, as discussed several countries implementing specific measures below, it may be best not to prescribe quantitative to curb over-indebtedness. There is no “standard limits (i.e., specific debt service-to-income ratios). set of measures� to address over-indebtedness. The EU Consumer Credit Directive 2008/48/EC Several regulatory and nonregulatory measures (European Union 2008) 23 is a useful benchmark that promote consumer protection and improved and includes articles on affordability assessments market conduct more broadly can also contribute (article 8), credit bureaus and credit information to a comprehensive strategy for addressing debt 21 See footnote 19 for examples of relevant information. 22 E.g., strict collateralization requirements or absolute quantitative affordability assessment thresholds may serve as an unwarranted barrier to lower income consumers. Other policy interventions, such as interest rate caps or limits on multiple borrowing, can have similarly unwanted consequences. 23 See also Ramsay (2004). 24 The current G-20 High-Level Principles on Financial Consumer Protection do not deal with over-indebtedness explicitly, but do include disclosure, transparency, and affordability/suitability assessments (“financial service providers should assess the financial capabilities, situation and needs of their clients before agreeing to provide them with a product or service�). The Financial Stability Board’s consultation document on consumer finance protection deals extensively with both over-indebtedness and responsible lending. 25 Negative option marketing offers a product in such a way that the consumer’s failure to respond is treated as acceptance, thus requiring the consumer to affirmatively reject the offer. 11 stress. For example, debt stress can be reduced is still low. Such mechanisms bring attention to through mandatory disclosure of certain types of lending practices and standards, which is a useful information that will help prospective borrowers starting point in developing markets. better understand their repayment obligations and total loan costs so they can make informed decisions The following section provides an overview of on their level of debt and repayment commitments. different measures that could be considered in Similarly, rules that require and set standards for regulating over-indebtedness. Annex 1 offers more effective complaints handling can help with both detail that includes country examples. detection and monitoring of debt stress levels and provide relief for potentially debt-stressed clients. Incentive failures Effective disclosure and recourse are necessary for a comprehensive approach, but alone they are not The priority must be to identify and regulate market sufficient to address the risk of over-indebtedness. practices that create incentives that increase Interventions aimed at building consumer financial the risk of over-indebtedness. This includes capacity around debt management also are an practices that reduce a lender’s incentive to do an important complement, but only in combination affordability assessment, or elevate fees to a level with more robust measures targeting lender where they increase the profitability of lending to practices. 26 Mechanisms such as debt counseling consumers who are already, or are at immediate are unlikely to be justified except in fairly developed risk of becoming, highly indebted. Examples markets with significant debt stress. include payroll deduction facilities (of which public servants are often a primary target, increasing the Many countries have implemented interest risk of political backlash), preferences in debit order rate controls as part of a package of regulatory processing,27 coercive debt collection practices,28 interventions to curb debt stress, with the intention and excessive late payment penalties and debt to prevent borrower exploitation or to avoid a collection fees. high interest rate environment that can incentivize over-aggressive lending. However, a simplistic Potential regulatory interventions in these areas or misguided approach to interest-rate control may include the following: can do damage to credit supply and can limit access to finance. These disadvantages may well • Imposing limits and/or conditions on the collection outweigh its benefits in curbing over-indebtedness. of loan repayments through payroll deduction Limits on multiple loans or limits on loans from facilities (examples include Kenya, South Africa,29 multiple lenders similarly can do damage by stifling the Philippines, and Brazil). competition and market development. • Limiting late payment penalties or debt-collection charges, to avoid incentivizing high-risk lending Finally, industry codes of conduct and similar self- and to prevent predatory lenders from applying regulatory mechanisms may be a useful starting extreme penalties. point in early-stage markets, avoiding extensive • Rules on the conduct of debt collectors to regulatory prescription when the risk of debt stress curb abusive practices, such as were part of the 26 This paper does not address the broader topics of disclosure, complaints handling, and consumer awareness and financial capability interventions beyond noting their relevance in preventing debt stress. 27 Payroll deductions and debit orders can be convenient for customers and can lower the costs of lending/borrowing; however, experience has shown they can be subject to significant abuse. 28 For instance, the use of threats, harassment, or public shame, such as was seen in Andhra Pradesh, India, where there were allegations of a spate of suicides among microborrowers. 29 Treasury regulations passed in 2001 placed limits on payroll deductions from government employee salaries, as well as on the interest that may be charged on such loans. For more information, see Republic of South Africa Public Service Commission (2007). 12 regulatory response in India following the crisis in that commissions be linked to loan origination Andhra Pradesh. standards and loan performance33 • Introduce explicit accountability of lenders for the Market practices that encourage conduct of their agents34 unsustainable credit growth Compulsory affordability assessments Certain market practices, individually and in combination, lead to unsustainable credit growth An increasing number of countries have introduced and create an environment in which debt stress a statutory requirement to perform affordability is likely to increase over time. These include assessments in recent years.35 The EU Directive negative-option marketing, unsolicited credit, on Consumer Credit (2008) requires affordability automatic increases in credit limits, and automatic assessments on all consumer credit agreements and incremental re-advances or refinancing. 30 In (including increases in credit limits). Similar high-growth markets, loan officer commissions and requirements have been introduced in the United agent and broker commissions often play a part in States (in respect to mortgages through the Dodd- unsustainable credit growth. India, South Africa, Frank Act), in South Africa, Mexico, Australia, and and Nicaragua are some of the countries in which Uganda, among others. the aggressive lending practices of loan officers and sales agents contributed to increased debt Affordability definitions typically consist of the stress, leading to instability, political intervention, following components: or both (see Annex 2 for details). • A requirement to perform an affordability Potential regulatory measures include the following: assessment, with exemptions for cases where it is not considered appropriate or where different • Prohibit unsolicited credit and negative-option standards may be applied, e.g., for educational marketing 31 loans, 36 and standards that accommodate • Limit or regulate automatic increases in credit limits the specific characteristics of group-based (e.g., increases in overdrafts or credit facilities) or microcredit 37, 38 on incremental re-advances (e.g., by requiring • A definition of the sources of income and expenses demonstrated repayment capacity through a new that should be considered when doing the affordability assessment) 32 assessment • Review commission structures for loan officers and • An indication of minimum information to be agents, potentially imposing limits or requiring considered, i.e., payslips or credit bureau records 30 Many microcredit methodologies control risk by starting with very small loans, and then increasing loan sizes by a set amount as borrowers successfully repay each prior loan. However, in the absence of sound affordability assessment, this practice entails a high risk that clients will eventually take loans that exceed their comfortable repayment capacity. 31 See, e.g., South Africa’s National Credit Act (2005). 32 See, e.g., South Africa’s National Credit Act (2005); in Mexico, financial institutions may increase credit lines only for customers who have a good repayment history. 33 In Peru, e.g., financial institutions must ensure that performance incentive structures for personnel do not conflict with the management of over-indebtedness risk. SBS Resolution 6941-2008. 34 Problems in agent and broker behavior often result from limited oversight and accountability by the principal lender. If accountability is improved, direct regulation may not be required. This approach has been followed in Brazil, Colombia, and the European Union, among others (Dias and McKee 2010). The Basel Core Principles (revised 2012) also require that banks be accountable for outsourced services. 35 Ramsay (2004) describes a range of mechanisms that different countries either have introduced or are considering. 36 Note, however, that student loans are covered in some regulations, e.g., those issued by the U.S. Consumer Financial Protection Bureau. 37 In many group microlending models, group members play an important part in assessing an individual member’s repayment capacity. 38 For lenders making very short-term loans (e.g., three months or less), the requirement of an affordability assessment before every loan might be relaxed somewhat for loans to borrowers with a good repayment history. 13 Box 3. The Effect of Add-Ons and Penalty Interest on Loan Repayments Example: A $500 loan is repayable at 33% over 12 loan goes into arrears. Therefore, a loan that looks months. Lender charges the following additional fees: affordable based on the nominal repayment may be (a) 15% loan administration fee, (b) 10% credit life difficult to repay after additional charges. Penalty insurance, and (c) 10% penalty interest on late payments. interest means that the repayment will increase exactly when the client may be having financial Note: These add-ons are typically excluded from problems, making it even more difficult to recover. the advertised loan repayment amount, making it In practice the lenders with the worst standards resort impossible for the consumer to understand the impact to the most extreme fees and penalties. before taking on the product. Regulatory proposals: (a) A simple pre-agreement Monthly loan repayment without add-ons 49.48 disclosure form that includes total monthly Monthly loan repayment with add-ons 61.86 repayment, inclusive of all fees, charges, or add-ons; Monthly loan repayment with add-ons (b) advertisements, brochures, or leaflets must show and penalty interest 68.04 the repayment, including all add-on charges, and must show penalties; and (c) disclosure of and limits The installment amount thus increases by 25% on penalty interest, penalty fees, or debt collection as a result of add-ons, and by a further 10% if the charges. (such standards should be sufficiently flexible to Disclosure and transparency40 be applicable to people with informal sector or irregular sources of income) Effective disclosure requirements improve the borrower’s capacity to assess total loan costs and Box 2 summarizes the legal definitions that are the level of repayment commitments relative to applied in a few countries. expected income. A key requirement is disclosure of the aggregate periodic repayments, including Pressure is often put on regulators to define a all fees and charges. This should preferably be specific “affordability percentage� (e.g., a ceiling compulsory and standardized in advertisements, on the allowable borrower debt-service-to-income marketing leaflets, and pre-agreement disclosures.41 ratio). However, there are strong arguments against Box 3 illustrates the impact of add-ons and fees such an approach. The primary concern is that and the implications of weak disclosure.42 the level of affordability strongly depends on the target market of each lender, its credit risk policy, The method and timing of disclosure is of equal and the length of the repayment term. It is difficult importance. Regulators may prescribe the timing to define one specific percentage that would be of disclosures (i.e., sufficiently before a contract), appropriate for all types of lenders, all types of the provision of a clear summary sheet highlighting products, 39 and all the different segments of the the most important terms and conditions, and potential client base. In general, this should be left disclosure in advertisements and leaflets as to the discretion of each lender. well as oral explanations accompanying written 39 A long-term loan should, e.g., be subject to a lower limit than what may be tolerable for a short-term loan. 40 For more detailed discussion, see Chien (2012). 41 Clear disclosure of the full cost of credit in advertising and marketing material is critical. This allows the consumer to consider full cost of the repayment obligations before engaging with credit providers and to obtain independent advice if needed, avoiding being pressured to making decisions while in discussion with loan officers. 42 Research has shown that borrowers in some settings have found annual percentage rate less useful than other disclosure methods (e.g., total cost of credit, the cumulative amount to be paid over the life of the loan) (Chien 2012). 14 disclosures. For instance, Ghana’s Borrowers Figure 2. Advertisement from Consumer and Lenders Act of 2008 requires all lenders to Awareness Campaign Conducted by South use a prescribed disclosure sheet that presents Africa National Credit Regulator the annual percentage rate (APR), total cost of credit, and a repayment schedule and highlights 3. whether certain risky conditions apply. This form includes plain-language explanations. South Africa requires credit providers to disclose the cost of credit in advertisements and brochures and to provide consumers with a pre-agreement quote. Other regulators, such as the Superintendency of Banks and Insurance (SBS) in Peru, require lenders to regularly submit information about the pricing  of products, which SBS then publishes to allow for cost comparisons. Disclosures should also include  contact information for internal complaints mechanisms and external ombudsman schemes. the dti Financial literacy, debt advice, debt counselling, and debt restructuring www.ncr.org.za 0860 627 627 Increased consumer awareness and financial literacy and education interventions related to debt stress are designed to make borrowers more cautious service may be limited to debt advice or advice on when taking on loans. They also aim to help them budgeting and financial planning, or it can extend deal with the consequences of over-indebtedness into full debt counseling, assistance with debt and debt stress. This may be limited to general restructuring,43 and assistance with applications for warnings on over-indebtedness and the value personal insolvency. Countries such as Malaysia of good borrowing habits (for an example, see and South Africa have adopted slightly different Figure 2) or could extend to topics such as budgeting approaches, 44 largely informed by the extent and financial planning. As noted, such interventions of credit market development and the level of should be seen only as a complement to robust debt stress in each. In the management of debt regulations aimed at responsible lender behavior. stress, the United Kingdom has a rich institutional experience involving public-sector institutions Debt advice and debt counseling provide services as well as a large private-sector-funded debt to consumers who are already over-indebted. The mediation mechanism.45 43 In this context, debt counseling and debt restructuring refer to a service that would help consumers negotiate with all the different credit providers to restructure debt. This normally would involve a restructuring of all loan obligations, potentially including interest reduction, extension of payment terms, or capital reductions. Such interventions are typically possible only if the powers are created through specific legislation. 44 In Malaysia in 2006, Bank Negara Malaysia set up the Credit Counseling and Debt Management Agency (Agensi Kaunseling dan Pengurusan Kredit [AKPK]), which provides free services to individuals. With the 2005 National Credit Act, consumers in South Africa could seek debt counseling from a network of private debt counselors registered with and regulated by the National Credit Regulator. 45 The Consumer Credit Counseling Service (CCCS) is a world leader in the provision of debt counseling and debt restructuring services. It is a registered charity that functions as an umbrella debt counseling service in the United Kingdom. It is primarily industry-funded and provides a free national telephone service as well as face-to-face counseling through regional centers. In 2011, CCCS provided debt advice assistance to 350,000 consumers (CCCS Research 2012; CCCS Statistical Yearbook 2011). 15 Credit bureaus and credit include a much greater share of total lending to market infrastructure the “base of the pyramid� (Lyman et al. 2011). As a result of the reckless lending conditions in the A credit bureau adds significant value by giving South African legislation, South African bureaus credit providers information that may help to have developed specific indebtedness indicators detect existing over-indebtedness, guard against in addition to the more usual credit scores. future over-indebtedness, and promote financial Where informal lending is widespread, regulators inclusion.46,47 In addition, a credit bureau can lower may look for innovative ways to facilitate more the credit provider’s costs of doing an affordability comprehensive reporting, including by informal assessment, enable the lender to reduce defaults, lenders.50 and contribute to lower interest rates to consumers. Finally, a credit bureau can be a powerful market Codes of conduct, self-regulatory bodies, monitoring tool for the regulator. and industry ombudsman schemes To be effective, a credit bureau system should Self-regulation through an industry code of include banks as well as consumer lenders, conduct can be an important starting point in microlenders, and other nonbank lenders, thus introducing basic lending standards, guidelines ensuring that an inquiry would reflect all formal for affordability assessments, and similar measures sector debts. Furthermore, the system should to curb debt stress. The regulator may encourage enable collection of both negative and positive the establishment of a code of conduct through (full-file) information. 48 A negative-only register is its engagement with industry associations. In of limited value and is particularly weak in providing some jurisdictions, supervisors formally oversee an early warning indicator when the level of debt implementation of self-regulatory initiatives. The is increasing but default has not yet occurred. biggest challenge in a self-regulatory approach is Consensus is building that in a system where both to monitor and enforce compliance.51,52 In addition, bank and nonbank institutions share in “full file� even if self-regulation is implemented well, limited information, credit bureau reporting can make coverage might limit its effectiveness—for example, important contributions to financial inclusion.49 if a significant share of lending remains outside the boundaries of self-regulatory arrangements. For example, credit bureaus in Mexico and South Self-regulation could offer a pragmatic starting point Africa have expanded information collected to for an early-stage, developing market, but would 46 See, e.g., Chen, Rasmussen, and Reille (2010), at pp. 7–8. 47 Credit bureaus can enable credit providers to identify potential clients from client groups that are excluded from financial services, by using noncredit indicators, such as monthly bill payments or monthly rentals of a mobile telephone. 48 “Negative-only� reporting refers to a credit reporting system in which data furnishers selectively report only adverse account information to credit bureaus. This provides bureaus with a partial snapshot of account behavior, but fails to accurately depict the entire credit history. By contrast, “full-file reporting� includes this negative event information, along with many other indicators, such as “account balances, number of inquiries, debt ratios, on-time payments, credit limits, account type, loan type, lending institution, interest rates and public record data� allowing for a fuller and more accurate picture of credit risk (PERC 2009). 49 One study shows implementation of such a system correlating to increases in private-sector lending on the scale of 48–60 percent of a country’s gross domestic product (PERC 2009). Such growth, depending on its target markets, can improve access. 50 In Ghana, e.g., a proposal is being considered to have susu collectors report to a credit bureau via mobile phone. Susu collectors may be thought of as “mini mobile bankers� who circulate among villages and markets collecting deposits from women’s susu savings groups and individuals. Susu collectors have been regulated by the Bank of Ghana since 2011. In South Africa, a data category called “public domain data� enables broad participation in information sharing by both credit providers and other service providers. 51 The “responsible finance� movement, led by the Smart Campaign (www.smartcampaign.org) for the microfinance field, has given new impetus to voluntary adherence to a common set of lending standards; in addition, a third-party certification system to validate compliance was launched recently. Meanwhile, external reviews and assessments by social investors (e.g., microfinance equity funds) create strong incentives for compliance among institutions that depend on such funding. 52 In Senegal, e.g., the regulator mandates membership in the MFI industry association, which strengthens the incentive to comply with the code of conduct for that sector. South Africa offers an example of effective formalization of industry-specific ombudsman schemes through mandatory participation. 16 normally not be appropriate on its own in a highly 2. Structured to accommodate the reasonable cost commercialized, rapidly expanding, or aggressive of origination and servicing of small loans and lending environment. microenterprise loans 3. “Tiered� by criteria such as size, term, or security Introducing an industry-funded ombudsman scheme to accommodate the differences in cost and risk can compensate for some of the weaknesses of a among categories such as mortgages, credit self-regulatory approach to the extent that it offers cards, unsecured loans, and microenterprise loans accessible and effective mechanisms for customers to resolve misunderstandings and complaints Similar caution should be exercised regarding limits with some objectivity. The effectiveness of an on multiple lending. In the wake of various debt- ombudsman is enhanced if the mandate of the related crises in developing countries, considerable ombudsman is formalized and reinforced by law attention has been paid to the extent to which or regulation. over-indebtedness is caused by clients borrowing simultaneously from different lenders. The possibility Cautionary note on interest rate of multiple lending, however, is an inevitable controls and limits on multiple lending consequence of an expanding credit market and can benefit consumers by providing a choice The political reaction to over-indebtedness often among different credit providers. Furthermore, includes interest rate or margin controls, as was the any single lender might limit loan size well below case in India, Nicaragua, and other countries. There the borrower’s borrowing requirements and actual are arguments made for and against such a response. repayment capacity. Placing a limit on multiple On the one hand, a high-interest-rate environment loans or imposing a requirement that a borrower enables lenders to tolerate a higher level of default may borrow from only one lender would undermine and thereby creates an incentive to lend to clients competition and consumer choice. Finally, while who may already be over-indebted. Some argue some studies find a correlation between multiple that interest rate limits might discourage high-risk lending and over-indebtedness, other studies find or predatory lenders from entering the market and no correlation or even a negative correlation in one would thus reduce lending pressure. case (Schicks and Rosenberg 2012). However, there are also several strong arguments For these reasons, market-based regulations, against imposing interest rate limits. Primary among such as compulsory affordability assessments, these is the high risk of unintended consequences. establishment of credit bureaus, and mechanisms to Interest rate limits based on an all-inclusive APR address adverse incentives, should be implemented definition will always have a more negative impact before considering high-risk interventions, such as on small or short-terms loans.53 A blanket interest limits on interest rates or limits on loan sizes or rate cap could thus reduce the supply of small loan terms. and microenterprise loans—those that are most needed from a financial inclusion and small/ IV. Prioritization, Sequencing, microenterprise development perspective and and Tailoring Interventions that may offer better value-for-money than to Country Context their informal-sector alternatives. If considered, therefore, interest rate controls should be This Focus Note offers an overall policy and regulatory framework for preventing and managing 1. Based on extensive empirical research on the debt stress, with select country examples. The actual cost of lending selection of a particular set of regulatory or policy 53 This is due to the inclusion of origination and servicing fees that may be high relative to the size of the loan. 17 options must be determined by the specific Banco Central de Chile. 2010. “Endeudamiento de circumstances in each country. In early-stage credit los hogares en Chile: Análisis e implicancias para markets with a low risk of debt stress, it would la estabilidad financiera.� Informe de Estabilidad be inappropriate to allocate substantial regulatory Financiera, First Trimester. resources to over-indebtedness. 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Detailed Comparative Supervisory, Regulatory, and Policy Interventions Category of Examples of problems Examples of relevant response and concerns regulatory measures Country examples Detection and • Debt stress is often • Identify potential early- Peru: SBS Resolution 6941-2008 monitoring detected only warning indicators and requires financial institutions to by conventional monitor trends. regularly and annually test their microprudential • Produce an annual report small-scale borrower portfolio techniques when to assess the extent of for signs of debt stress and risk it is already at an debt stress and over- of over-indebtedness, report this advanced stage, indebtedness. analysis to directors, and take affecting large • Improve national corrective/preventive actions. ­ numbers of ­ clients statistical surveys by The Risk Unit in each financial and possibly including appropriate institution must report quarterly even threatening debt-related questions. to directors, and this report must institutions. ­ • Include specific checklists be made available to SBS. • Many of the monitor- and procedures in bank South Africa: The National ing mechanisms that supervision inspection Credit Regulator is responsible are normally part of programs. for monitoring and reporting on prudential supervi- • Conduct regular “loan levels of over-indebtedness and sion are ineffective. officer surveys.� socioeconomic consequences. • Conduct special research. Incentive structures • Payroll deduction • Impose limits on payroll India: 2011 NBFC-MFI Directions  Practices that facilities deduction facilities or (as amended) establish limits on undermine • Debit order limit types of transactions margins; forbid penalties charged incentive processing that may be deducted on late payments; and permit to assess preferences from pay. only noncoercive collection affordability • Excessive late • Implement minimum methods (cross-reference to  Practices payment penalties standards for debt Guidelines on Code of Fair that increase • Excessive debt collection conduct. Practices for NBFCs). profitability of collection fees Prohibit abusive conduct. Uganda: 2011 Financial reckless credit • Abusive debt • Impose maximum limits Consumer Protection Guidelines extension collection practices on late payment penalties prohibit charging of unreasonable • Easy access to court or debt collection fees. debt collection costs/expenses orders, without • Implement minimum (§ 6[9]). consideration of requirements for access lender behavior to court orders that force South Africa: The National court inquiry, e.g., lender Credit Act prohibits late payment affordability assessments. penalties and defines reckless • Implement maximum credit so that inadequate limits on court orders affordability assessments render the related to debt debt unenforceable, there is a code (maximum statutory of conduct for debt collectors, and deductions as percentage most types of payroll deduction of consumer income). facilities are prohibited. Market practices • Heavy reliance on • Prohibit unsolicited credit South Africa: The National Credit that encourage agents and brokers marketing. Act (inter alia) prohibits negative unsustainable credit in loan origination, • Place limits on automatic option marketing and limits growth with high commission increase in credit limits automatic credit line increases. structures and and re-advances, or Mexico: Financial institutions limited oversight by introduce a requirement may raise credit lines only for principal lender for prior affordability customers who have good • Unsolicited credit assessments. repayment history and then only and automatic • Introduce minimum based on the customer’s explicit increases in credit standards on a lender’s acceptance of the offer. All limits accountability for the overdraft fees are also prohibited. • Automatic and conduct of its agents. incremental • Impose limits on the Peru: Financial institutions must re-advances level and nature of ensure that the performance commissions payable to incentive structures for personnel agents and brokers. do not generate conflicts of interest with the management of risks of over-indebtedness. (continued) 24 Annex 1. Detailed Comparative Supervisory, Regulatory, and Policy Interventions (continued) Category of Examples of problems Examples of relevant response and concerns regulatory measures Country examples Compulsory • Extensive lending • Impose an obligation to Mexico: Financial institutions affordability without any prior perform an affordability may only issue credit based on assessments affordability assessment. an assessment of customer’s assessment ­ • Impose minimum creditworthiness and ability to standards for affordability repay. assessments. • Prescribe minimum Uganda: Providers are prohibited standards for external from engaging in “reckless documentation that must lending,� which is defined so as be considered in the to require (inter alia) some form course of an affordability of affordability assessment. assessment. Disclosure and • Consumers who • Prescribe information to South Africa: Standardized pre- transparency do not adequately be disclosed, including agreement disclosure. Required understand pricing standardized pricing disclosure in advertisements or other conditions terms, focusing on total and brochures. Plain language cost of credit. requirements. Regular • Disclosure rules to compliance audits and surveys. include advertising, brochures, and Ghana: All lenders must disclose pre-agreement certain information in advance of statements. entering a loan agreement, using • Impose plain language a statutory disclosure form. requirement in Peru: Information regarding agreements. pricing and other terms and conditions must be prominently displayed in branches and online. Providers must regularly report pricing information to regulator. Interest rate • Extreme interest ** Problem: Unrealistic South Africa: Credit providers controls rates that create limits based on APR make are subject to a range of  CAUTION: an incentive for small loans unprofitable and interest rate caps (depending HIGH RISK OF reckless lending and drive vulnerable clients to on credit type) that are pegged REDUCING attract unscrupulous loan sharks. ** to the bank reference rate, and ACCESS TO providers into the • Requirement to that were designed following FINANCE market perform an affordability extensive empirical market • No competitive assessment preferable research. pressure to curb to interest rate controls, interest rates as it directly addresses underlying affordability problems without the same unintended negative consequences. Limits on multiple • Excessive borrowing ** Problem: Limits India: Under the 2011 NBFC-MFI loans from different undermine competition, Directions, no more than two  NOT lenders, leading to undermine expansion NBFC-MFIs may lend to same RECOMMENDED over-indebtedness of options, undermine borrower. development of market. ** • Requirement to perform an affordability assess- ment is a preferable intervention and more effective. (continued) 25 Annex 1. Detailed Comparative Supervisory, Regulatory, and Policy Interventions (continued) Category of Examples of problems Examples of relevant response and concerns regulatory measures Country examples Debt counseling • Consumers who • Implement industry-level South Africa: National Credit have no access to complaints and mediation Act provided for registration of support or assistance mechanisms that a network of debt counselors to and who become borrowers can contact assess levels of indebtedness and desperate when they experience mediate between consumers and debt stress. financial institutions for voluntary • Implement government debt restructuring. Before debt or independent help-line enforcement, financial institutions to provide debt advice. must propose to consumers • Provide for advice or that they seek help from a debt assistance through pro counselor or another ADR body/ bono legal services or agent. NGOs. Bosnia: BiH Central Bank has supported and endorsed the work of the nonprofit Center for Financial and Credit Counseling. Codes of conduct • Weak lending • Work with industry India: RBI issued Guidelines and ombudsman practices to introduce code of on Code of Fair Practices for schemes • An increase in conduct. NBFCs and required each NBFC aggressive or • Ensure that code includes to adopt its own Code of Fair predatory practices appropriate minimum Practices. • No place where lending standards. consumers can • Code should include South Africa: The 2004 Financial complain about poor some monitoring and Services Ombud Schemes conduct enforcement mechanisms. Act provides requirements for • Support establishment industry ombudsmen to obtain of an ombudsman recognition under the Act. structure or other forms The National Debt Mediation of recourse. Association has also developed a Credit Industry Code of Conduct to Combat Over-indebtedness. Credit bureaus and • Growth in prevalence • Create regulatory Nicaragua: A new microfinance credit information of borrowing from structure for credit regulator (CONAMI) is sharing different lenders or bureaus. empowered to establish a credit multiple borrowing • Include both banks and bureau and all registered MFIs • No mechanism nonbanks in information are required to consult this or to assess total sharing. another bureau. borrowing • Share both positive and negative information. India: Under the 2011 NBFC-MFI Directions, no more than two NBFC-MFIs should lend to the same borrower (focused on outcome without clarifying how to obtain information necessary to assess). All loans must be approved and disbursed from central location. Azerbaijan: In 2011, the Central Bank expanded its Central Credit Registry to include NBFCs, including MFIs, and made reporting mandatory. 26 Annex 2. Debt-Related Crises and Political and Policy Reactions in Diverse Developing Credit Markets Bolivia (1998–1999) • Crisis: As the small-scale credit market heated up, poor credit discipline and underwriting led to excessive lending, including unsustainable multiple borrowing.a Following a sharp economic downturn, rising defaults became highly politicized, with consumer groups even holding a financial regulator hostage. As loan repayment deteriorated, a major MFI and a number of consumer lenders failed. • Response: The regulatory response included credit reporting and caps on maximum debt service for salaried workers (50% of salary). South Africa (1999–2006) • Crises: After 1992, moneylending and consumer finance expanded rapidly, often targeting salaried workers. Increasing defaults resulted in the failure of two of the banks that focused on low-income household lending. The contagion caused further banking stress, with a major mortgage lender being rescued. • Response: High levels of indebtedness and abusive lending practices first led to the establishment of the Micro- Finance Regulatory Council in 1999 and to the prohibition of the payroll deduction facilities. It subsequently led to the introduction of the National Credit Act in 2005, with reckless lending rules, strict disclosure requirements (advertising and pre-agreement), regulation of credit bureaus, debt counselling, and regulation of interest and fees. The National Credit Regulator now regulates all consumer credit by both bank and nonbank lenders. Colombia (1998–2000)b • Crisis: Unprecedented growth in the housing mortgage market (reaching 8% of GDP) was based in part on a financing system (UPAC system) that became delinked from inflation and made mortgages more accessible through the 1990s. When a recession hit, the portfolio became unsustainable. Housing prices collapsed; the number of past- due mortgages soared from 3.3% in 1995 to 13.6% in 1998 and 18% in 1999. One specialized mortgage bank was nationalized, and others were merged or liquidated. Ultimately, this bank category was eliminated. • Response: In the face of the crisis, the government required financial institutions to repossess houses no matter their value in relation to the outstanding loan. Then in 1999, the Constitutional Court declared the UPAC system unconstitutional and ordered Congress to pass a new housing law. In the longer term, new risk assessment models were imposed and judicial foreclosure was reformed. Bosnia–Herzegovina (late 2008)c • Crisis: Microfinance services expanded rapidly from 2006 to 2008. The repayment crisis coincided with the global financial crisis, which affected repayment capacity. MFIs responded by aggressively writing off loans. By the end of the crisis, the number of clients had returned to 2006 levels. • Response: The response included creating a new credit bureau at the Central Bank with mandatory reporting from MFIs and other lenders. A nonprofit debt counseling center was set up in one of the cities with the highest concentrations of microlending. Nicaragua (2009–2010) • Crisis: In 2009, widespread reports of multiple borrowing and high levels of indebtedness began to appear. The No Pago movement was started, and people blocked highways, attacked MFIs, and harassed loan officers, demanding debt forgiveness and lower interest rates. With vocal support from the president, the movement became increasingly politicized and eroded the repayment culture. • Response: A bill proposed strict interest rate limits, a six-month interest-free grace period, and repayment extensions of up to 4–5 years. In 2011 the legislature passed an MFI law and created the microfinance regulator (CONAMI). India (2010) • Crisis: A decade of microcredit expansion by diverse lenders including state-sponsored Self-Help Groups, banks, and MFIs, particularly in the state of Andhra Pradesh (AP), resulted in almost 32 million borrowing accounts (estimate end March 2011), just over 100 percent of the number of eligible “financially excluded� households (Micro-Credit Ratings International Limited 2011b). Analysis of the data in AP showed that some of these families had seven to eight loans from all sources and were spending a substantial portion of their gross income on debt service. Amid growing concern about over-indebtedness and reported coercive collection practices and borrower suicides, the state government responded with “draconian� regulations that made microcredit operations virtually impossible and threatened US$2 billion in loans in AP. In the face of ongoing political attacks, MFI loan repayments dropped to 10%, and banks stopped lending to microfinance companies. • Responses: Following the AP legislature’s action, the Reserve Bank of India (RBI) commissioned the Malegam Committee Report, which resulted in RBI regulations, including compulsory affordability assessments and limits on debt collection practices. A microfinance law that is pending before Parliament would further formalize the legal status of MFIs, including opening the possibility of offering deposit services if certain conditions are met. While collections in AP have remained very low for an extended period, the microfinance sector is recovering and beginning to grow again in other parts of India. (continued) 27 Annex 2. Debt-Related Crises and Political and Policy Reactions in Diverse Developing Credit Markets (continued) Chile (2011)d • Crisis: From 2000 to 2009, rates of household indebtedness grew from 35.4% to 59.9% debt-to-income, with particular expansion in credit cards and retailer financing. A mid-2011 scandal involving the fourth largest retail credit provider, La Polar, led to its collapse and politicized over-indebtedness. • Response: The Central Bank has taken steps to extend supervision by the Superintendent (SBIF) to nonbank credit card issuers and retail credit providers.  Multiple borrowing� refers to “clients borrowing from different types of lenders, simultaneously, to meet their diverse needs.� a. “ http://www.cgap.org/events/day-1-session-4-multiple-borrowing-%E2%80%93-definition-concepts-and-reasons b. See Cardenas and Badel (2003); Forero (2004); and Arango (2006). c. See Bateman, Sinkovic, and Skare (2012). d. See Jimeno and Viancos (2012) and Banco Central de Chile (2010). 28 Annex 3. Debt Stress in the Microcredit Industry Lending methodologies in microcredit institutions pose therefore, should have a lower risk of becoming challenges to applying usual regulatory prescriptions, over-indebted. The payment discipline of low- e.g., a compulsory affordability assessment. Loans income borrowers has been an important part of to start-up microenterprises and to very poor the microcredit experience over the past three families would almost inevitably appear to exceed decades, and there is a fear that a soft approach the repayment capacity of the microentrepreneur to payment obligations could undermine that or family, particularly if the income expected from payment discipline through contagion, especially the business is disregarded. In solidarity group loans where loans are not secured by traditional it could be both complex and costly to assess the collateral. However, the number of cases of debt repayment obligations against the income sources stress in countries with relatively high penetration of the individual group members, particularly if an of microcredit in recent years indicates that there individual’s liability for the repayments of other group is increasing risk. The potential of harm that members is factored in. For those providing microcredit can result from excessive debt for vulnerable and reaching financially excluded populations, cost- households also calls for caution to avoid debt efficiency is extremely important, and lenders would stress. In assessing the procedures of microcredit justifiably want to avoid any unnecessary expenses. institutions, regulators should consider and address the factors that typically characterize Microcredit is targeted at people who are microcredit markets, methods, and client base, excluded from conventional finance and who, laid out below. Microcredit factors Possible policy/regulatory approach Market-level considerations • Bear in mind that, where there are low levels of financial inclusion, it may be reasonable for institutions to experience high growth rates. • Increase surveillance for signs of debt stress if several different institutions are targeting the same client segment in the same area. • Monitor average loan size, average repayment period, and the level of rescheduling. If there is an increase in these variables this may be a cause for concern. Monitor arrears rates, disaggregated by region. Assess whether repeat loans, with incrementally higher loan sizes or longer terms, are associated with greater levels of arrears. • Monitor the potential threat as a result of lending by different categories of lenders to the same client base (MFIs, banks, credit co-operatives, money lenders). High growth and saturated, • Where there is aggressive competition among different lenders in the same highly competitive markets area, require some form of client information sharing. Initially this may be limited to sharing of lists of clients who are experiencing arrears, although participation in a credit bureau is preferable. • Require that lenders establish a complaints system for clients with repayment problems. • Review large institutions’ growth targets. • Review loan officer incentive structures to ensure there is a balance between growth and quality incentives. • Assess whether management considered the risk that repayments could be funded through diversion of other income sources (e.g., remittances, social welfare transfers). • Require lenders to introduce affordability assessments. Be flexible in different approaches by different lenders and in lenders using proxiesa rather than direct measures of income. • Require lenders to submit an annual report, in which each lender does a self-assessment of the risk of over-indebtedness and of its own procedures. 29 Microcredit factors Possible policy/regulatory approach Solidarity group lending • Include some form of business plan assessment that could substitute for an affordability assessment into programs. • Ensure lending procedures include an enquiry on existing debtb and discussion of debt problems. • Ensure loan staff should do an added assessment if the group experiences regular arrears. Irregular income; reliance on • Loan officers should assess whether income sources are realistic and household or informal income reasonablec and perform further enquiry if there is a cause for concern. • Set the level of repayments at a reasonable level in relation to estimated family income. Automatically increased • Recognize that eligibility for repeat loans is a powerful incentive for on-time repeat loans repayment, which also reduces cost and increases efficiency. However, increasing repeat loans will over time increase the risk of loan size exceeding repayment capacity. • Place a limit on loan increases when repayments become irregular. Proxies are often more effective than direct measures of income as a result of clients’ unwillingness or inability to provide reliable income a.  statistics. Lending programs that have a savings component could use the amount saved as an indication of a borrower’s ability to service a higher loan size. The key is that each lender should use sound judgment to arrive at an appropriate affordability indicator within its own context. b. Clients who want more credit may not reveal their obligations. However, there may be indirect sources of information on clients who are over-committed. Although such assessment may be expensive and unreliable, it may be possible to create proxies that will set parameters for c.  “reasonableness.� Such proxies could be set in relation to family size, source of income, etc. No. 83 March 2013 Please share this Focus Note with your colleagues or request extra copies of this paper or others in this series. CGAP welcomes your comments on this paper. All CGAP publications are available on the CGAP Web site at www.cgap.org. CGAP 1818 H Street, NW MSN P3-300 Washington, DC 20433 USA Tel: 202-473-9594 Fax: 202-522-3744 Email: cgap@worldbank.org © CGAP, 2013 The author of this Focus Note is Gabriel Davel, independent research support from Megan S. Chapman and valuable input consultant and former CEO of the South Africa Microfinance by Katharine McKee and Richard Rosenberg, without which this Regulatory Council and the South Africa National Credit Focus Note could not have been completed. Regulator. The author wishes to acknowledge the editorial and The suggested citation for this Focus Note is as follows: Davel, Gabriel. 2013. “Regulatory Options to Curb Debt Stress.� Focus Note 83. Washington, D.C.: CGAP, March. Print: ISBN 978-1-62696-000-8 epub: ISBN 978-1-62696-002-2 pdf: ISBN 978-1-62696-001-5 mobi: ISBN 978-1-62696-003-9 UKa from the British people