64980 OccasiOnal paper Too Much Microcredit? A Survey of the Evidence on Over-Indebtedness Important Notes about the Scope of This Paper This paper is written primarily for microlenders, along with the institutions that fund and support them. CGAP is exploring development of a separate paper addressing regulatory aspects of over-indebtedness. We use the terms “microcredit,� “microloan,� and “microborrower� in a narrow sense, to refer to loans to low-income people—mainly unsalaried people—using new techniques developed over the past 30 years (see Christen, Lauer, Lyman, and Rosenberg [2011] for a list) and made by lenders who usually describe themselves as providing “microcredit� or “microfinance�. We don’t imply that such lenders provide all, or even most, of the formal-sector loans to poor or low-income households. In many countries, microfinance institutions offering microcredit compete with other forms of low-income retail credit, such as consumer lending and merchandise finance, all of which can have a bearing on the indebtedness levels of microcredit clients. This is an exploratory paper. We examine conceptual issues and the limited empirical evidence about over- indebtedness in microcredit markets. That evidence does yet not permit a general conclusion about the extent of microcredit over-indebtedness worldwide. We also offer a rudimentary checklist—certainly not a how-to manual—of possible approaches to dealing with over-indebtedness risk. Most of these are presented only as options, not recommendations, because their feasibility and usefulness can depend heavily on local circumstances. Executive Summary but as a rough, provisional definition to begin the discussion, let us say that borrowers are over- Microcredit has long had an enviable repayment indebted if they have serious problems repaying record—levels of delinquency and default have their loans.2 This definition implies a view that been very low. But more recently, collection borrowers can be over-indebted even if they are problems have appeared in some major markets. repaying their loans. In a review of four countries, Chen, Rasmussen, and Reille (2010) reported that delinquent loans, Over-indebtedness often implies heightened which averaged 2 percent of portfolio in 2004, vulnerability and further impoverishment of skyrocketed to 2009 levels of 7 percent in Bosnia– borrowers. Material effects include reduced Herzogovina, 10 percent in Morocco, 12 percent consumption levels, late fees, asset seizures, in Nicaragua, and 13 percent in Pakistan. In some downward spirals of ever-increasing debt, and of these countries, subsequent levels have risen eventually, a loss of creditworthiness. There are quite a bit higher. More recently, collection has sociological effects related to peer pressure and collapsed in the Indian state of Andhra Pradesh.1 a loss of social position, as well as psychological effects on mental and physical health. In extreme No. 19 Delinquency and default threaten the viability of cases, borrowers’ desperation can even lead to September 2011 microlending institutions. But this paper looks at suicide. Jessica Schicks and repayment problems mainly from the perspective Richard Rosenberg of the clients, not the lenders. We examine The objective should be to reduce the prevalence of definitions of “over-indebtedness� in some detail, over-indebtedness to reasonable levels. Complete 1 in nicaragua, pakistan, and andhra pradesh, at least some of the repayment problem was due to “strategic� default: borrowers who were able to repay choosing not to do so. 2 We’ll address what “serious� means later in the discussion. 2 elimination of over-indebtedness is not a practical even approaching saturation, at least for the goal: the only way to accomplish this would be typical current credit products.3 (Demand to drastically restrict access to microloans. Many estimates about the number of people who measures to reduce over-indebtedness can have want a typical microloan and don’t yet have some degree of negative impact on borrower access tend to be inflated.) In retail credit access and cost. For instance, tightening credit markets, competition and saturation tend to standards will lower over-indebtedness, but it will increase over-indebtedness. In their quest also prevent some loans to borrowers who would for expansion and market share, lenders have had no difficulty repaying. Careful balancing turn to higher risk borrowers, and may get is needed. sloppy with their internal risk management systems. In the absence of a credit reporting Warning Light or Crisis service, lenders find it harder to assess client repayment capacity, because they have no For most of its history, the main concern of the way of knowing about clients’ repayment microfinance movement has been to rapidly obligations to competing lenders. increase delivery of financial services—especially • Borrowers don’t always make smart choices. credit—to low-income clients. However, the recent The emerging field of behavioral economics crises in a few markets have fueled growing concern is challenging the classical assumption that that microcredit may be getting borrowers into borrowers can be counted on to behave trouble. Rather than assuming that the problems in rationally and make decisions that serve their these markets are isolated occurrences, there may own best interests. be reason to be more alert to this risk worldwide. • Strong repayment statistics don’t assure us that all is well. Present evidence doesn’t permit a conclusion about • Of the few—we have located six—empirical the actual prevalence of over-indebtedness in most studies of microcredit over-indebtedness so markets. But several factors suggest that managers, far in particular countries, most have found regulators, and funders ought to devote much more significant levels of over-indebtedness. attention and resources than they currently do to (At the same time, these results cannot investigating and perhaps reducing the number of be generalized. Not only is the number clients who are getting into trouble with microloans. of studies very small, but the sample is not To reiterate for the sake of clarity, we are making an representative. Most of the studies were done assertion about the appropriate level of vigilance, because there were pre-existing concerns not about the proportion of borrowers who are in about over-indebtedness in the particular fact over-indebted. country or local markets.) There are two main reasons for increased vigilance Consequences and Implications about microcredit over-indebtedness: it might be more prevalent than suspected in the past, and its • The most important consequences of over- consequences may be more serious than we used indebtedness are the impact on borrowers, as to think. discussed above. • Over-indebtedness can lead to political Prevalence backlash and damaging over-reaction by policy makers. Such over-reaction can • A rapidly increasing number of microcredit destabilize the industry and deny access to markets, especially regional markets within many potential borrowers. There is also a risk a country, are becoming competitive and of backlash from donors and public and social 3 The final qualifying clause is important: this statement and much of this paper have reference to the simple and relatively rigid microcredit products that have made up most of the supply until now. Many microlenders are now looking to supplement their offerings with more flexible and client-responsive products, including not just loans but also voluntary and commitment savings, insurance, and money transfer services. 3 investors, who may turn away from funding too far out of step with borrowers’ cash flows can not only microcredit, but microfinance more create serious repayment distress even when the broadly. debt amount is reasonable, especially if there is • Today there is less confidence in assertions rigid enforcement of a “zero tolerance� policy that microcredit can raise millions of people toward delinquency. Once borrowers get into out of poverty. The actual benefits may be trouble, over-aggressive collection practices can considerably more modest. If the quantum of worsen their problem. Finally, there is a complex benefit we expect is lower, then the potential debate about whether it is unduly risky to lend downsides for clients that we are willing to to borrowers who wind up using their loans for tolerate should be lower. consumption rather than for investment in an income-generating activity. Causes of Over-Indebtedness Some of the impetus behind over-indebtedness Multiple factors contribute to over-indebtedness: comes from borrowers. The emerging field of lender behavior can put borrowers at undue risk, behavioral economics has mounted a strong clients themselves make bad borrowing decisions, challenge to the proposition that borrowers actually and external factors beyond either party’s control behave like the fully rational homo economicus of (e.g., illness or natural disaster) can push borrowers classical economic theory. Behavioral experiments into situations where it’s very difficult or impossible confirm and extend commonsense perceptions to repay. about borrower biases. Many borrowers put too much weight on present gratification, because it It seems plausible that very rapid growth of an is “salient,� and pay too little attention to future individual lender could strain its systems and lead consequences because they seem less real. People’s to loan portfolio problems. But it is hard to find predictions of the future tend to be over-optimistic, support for this proposition in the statistical data. and “habit persistence� causes them to reduce Rather, it appears more likely that repayment consumption too slowly when net income declines. deterioration is associated with characteristics of the aggregate market (which is not necessarily a External shocks can turn a perfectly manageable nationwide market), including the growth rate in repayment situation into an impossible one. Poor aggregate number or amount of active loans, as people often experience sudden reductions in well as the penetration rate—i.e., the percentage income (e.g., a job loss or illness in the household) of the population in the market who have loans. or large unexpected expenses (e.g., accidents, medical expenses, or funeral obligations). Other As noted, microcredit providers may relax their shocks—e.g., natural disasters or manmade lending standards or stray from proven loan conflicts that destroy livelihoods—can affect many management methods under conditions of borrowers at the same time. competition in markets approaching saturation. Over-aggressive marketing—e.g., pressuring Defining and Measuring borrowers to take out a new loan after they Over-Indebtedness have paid off an old one—adds to risk. Lenders sometimes fail to give borrowers clear and Coming up with a precise definition of over- accurate information about loan costs and terms, indebtedness—e.g., for research or regulatory communicated in a format that supports good purposes—is a surprisingly complex challenge. We decision making. The common system of gradually look at six different approaches that are used to increasing loan sizes sometimes becomes define, or proxy for, over-indebtedness. All have practically automatic, which eventually puts clients limitations. at risk if there has not been sufficient investigation of their ability to repay. Loan products that are Negative impact. Calling people over-indebted too inflexible and repayment schedules that are would seem to assert that they have too much 4 debt, which would ordinarily mean more debt such systems exist, they don’t contain income than is good for them. In this view, the question information for microborrowers. would come down to whether loans are making borrowers worse off. This might be a good Multiple borrowing. Most (but not all) of the definition from a theoretical perspective, but as available empirical studies find that multiple a practical matter, reliably determining whether concurrent borrowing is associated with some loans are helping or hurting individual borrowers degree with higher risk of default. But multiple is too difficult, expensive, and time-consuming debt is a very common cashflow management to be used for monitoring purposes. Also, most technique for poor households, many of whom people wouldn’t describe a borrower as over- manage such borrowing with minimal difficulty. indebted if the loan had a minor negative impact Multiple borrowing by itself is not a reliable but was easy to repay. indicator of over-indebtedness. Borrower struggle and sacrifice. The advantage Default and arrears (late payments). These are of this kind of definition is that it captures the most commonly used indicators of over- situations where loans are repaid, but only at indebtedness because they are the easiest to the cost of severe distress—a situation that most measure. The main problem with these indicators people would regard as “too much debt.� One is that they fail to embrace a situation that most such definition posits that the threshold of over- people would think represented “too much debt.� indebtedness is reached when a microborrower For instance, to avoid being socially humiliated by is continuously struggling to meet repayment default, some borrowers might repay their loans deadlines and structurally has to make unduly high by making drastic sacrifices, such as going without sacrifices related to his or her loan obligations. food, taking children out of school, or selling off The authors think that this is a strong and useful productive assets. In addition, repayment failure definition for purposes of survey research. But isn’t a leading indicator; rather, it’s a trailing when are sacrifices “unduly high�? There is a good indicator that flags a problem that may have argument for letting borrowers themselves make reached a point of no return months or even years that judgment. The more subjective approach earlier. entails risks in terms of borrower idiosyncracy, honesty, and bias, and would not be sharp-edged Debt ratios. Over-indebtedness is often enough for regulatory use. But these risks can be measured by ratios that compare borrowers’ managed in a research setting. total debt, or periodic debt service payments, to their income or assets. Such ratios are clearly A crucial clarification is in order: the fact that a meaningful and useful—they are at the core of borrower can’t repay without severe sacrifice does many lenders’ systems for appraising borrowers’ not automatically mean that the loan has hurt the creditworthiness. One limitation, though, is borrower. For instance, if a woman can repay only that it can be hard to determine an appropriate by going without food for two days, it’s tempting threshold ratio beyond which the borrower is to conclude that she would have been better off regarded as over-indebted. Because there are without the loan. But perhaps she borrowed the wide differences in borrower circumstances, money in the first place to avoid going without there are also wide differences in the level of food for two weeks, in which case the loan has debt they can comfortably manage. Furthermore, been a great help, and we would not want to most microcredit markets don’t yet have credit prevent it from being made.4 reporting systems that allow determination of borrowers’ total debt from formal lenders (not to Loan repayment is only one of the cash demands mention informal loan sources), and even where that poor households face, and many of those 4 in this clear cut hypothetical example, the borrower would probably not declare her skipped meals as an unduly high sacrifice related to the loan repayment. But real situations are often less clear cut. 5 demands can be met only with struggle and The Empirics of Microcredit sacrifice, with or without microloans. This Over-Indebtedness: What Do We consideration might temper our judgment as Know to Date? to what level of struggle-and-sacrifice over- indebtedness is reasonable in microlending. As noted, we’ve been able to locate only six studies that quantified microcredit over-indebtedness in Composite indicators. Given that all definitions specific markets, using various definitions and or proxies for over-indebtedness have their methods. Most of these studies found levels of limitations, some analysts construct indicators that debt problems, usually in a subnational market, quantify and weight several different elements, that seem worrisome. However, the evidence yielding a composite score. so far doesn’t justify any broad generalization about the situation worldwide. The number of Broader measures. More generally, it’s important studies is small. More importantly, they represent to recognize that debt is only one of the financial a very skewed sample. Most of the studies were vulnerabilities facing poor households, who also conducted in a given market precisely because have other obligatory payments. And there is a there were pre-existing danger signs of over- strong argument for combining debt vulnerability indebtedness in that market. Table 1 offers a with other forms of financial vulnerability—e.g., concise (and therefore oversimplified) view of low and undependable incomes, exposure to study results. unexpected expenses that are large in relation to income, etc.—into a composite financial What Can Be Done? vulnerability index. We do not explore this broader approach because this paper focuses only The list of practical steps by lenders and funders on microcredit clients, lenders, and funders. that might prevent or remedy over-indebtedness Table 1. Summary of empirical studies Setting Definition (Author) Methodology of Over-indebtedness Findings Bolivia 1997–2001 Household (HH) survey Costly unanticipated 85% of HH had at least (Gonzalez 2008) actions to repay one occurrence during the four years Ghana 2009 Rapid market assessment, Microbusiness 12% over-indebted, (Grammling 2009) borrower surveys, info decapitalizing (as assessed another 16% at risk exchange between MFIs by researchers) Country X 2009 Debt service and expense Debt service greater than 17% over-indebted and (restricted report) data from credit bureau 100% of HH income net of another 11% at risk (debt and loan files of lenders other expenses service 75–100% of net income) Karnataka, India 2010 Loan records and HH Subjective report of stress; Over-indebtedness (Krishnaswamy 2011) survey sacrifices to repay reportedly high in mass default towns, but low in nondefault towns Tamil Nadu, India Qualitative interviews, Impoverishment through More (possibly much 2005–2009 observation, and HH debt more) than 20% over- (Guérin, Roesch, survey (N=344) indebted Subramanian, and Kumar 2011) Multi-country study Preliminary composition Chronic and involuntary 14 potential early warning (Kappel, Krauss, and of an early warning index, inability to meet all indicators for over- Lontzek 2010) largely based on signaling payment obligations by indebtedness. Highest analysis with an MFI means of the household’s risk countries in sample: survey + MIX market data excess cash. Proxies: Bosnia–Herzogovina, arrears, write-offs, loan Cambodia, Peru losses, debt-service ratio 6 is a long one. This paper can provide only a brief, Marketwide tools broad-brush survey of them—not a how-to manual, • Industry codes but rather a checklist of actions to consider along • Credit reporting systems with a few factors to bear in mind. For most of these topics, we imply no recommendation, not Funders’ actions only because the evidence base is thin, but also Some observers think that an over-supply because their feasibility and usefulness depend on of funding, along with funders’ pressure on local circumstances. microlenders for growth and profitability, has contributed to over-indebtedness crises. Donors or socially oriented investors should factor Lender actions over-indebtedness risk into their evaluation of Product design microlenders as potential grantees or investees. • Flexible product offerings, including savings This includes looking at the saturation level of the • Reduction or tailoring of loan increments in particular market, and whether the microlenders graduated lending ladders are dealing appropriately with the range of options presented above. Sales • Marketing practices and follow-on loans At a minimum, donors as well as public and socially • Fair and intelligible disclosure of loan terms motivated investors ought to assure themselves • Measures to improve clients’ financial literacy/ that any microlender they fund is capability • Expansion into new areas rather than already • not using deceptive or high-pressure served ones marketing tactics • not structuring staff incentives in ways that Loan underwriting encourage over-lending • Evaluation of affordability in light of borrower • taking reasonable measures to check cash flows on borrowers’ repayment capacity, past • Specific limits on debt-service ratios repayment history, and outstanding • Verification of borrowers’ repayment history obligations with other lenders and other debts • maintaining and communicating clear written policies to guide employees in addressing over-indebtedness risk Collection • not using collection techniques that are • Restraining of abusive collection practices abusive, given the local setting. • Appropriate rules for renegotiation of loans • Avoidance of inappropriate use of penalty Donors that have grant funding for supporting interest public goods can also finance some of the • Redress mechanisms for customer complaints above measures directly—e.g., development of credit reporting services, early warning systems, Other microlender practices or financial capability campaigns—or support • Staff incentives that don’t encourage over- regulators’ efforts to control over-indebtedness risk. lending • Staff training on avoiding over-indebtedness Introduction • Written policies, enforced through internal audit Microcredit has long had an enviable repayment • Specialized portfolio audits record—levels of delinquency and default in • Early warning systems for over-indebtedness competent institutions have been very low for 7 decades.5 But more recently, collection problems level, over-indebtedness can have sociological have appeared in some major national or implications, including peer pressure in groups, loss subnational markets. In a review of four countries, of one’s dignity and social position, and violence Chen, Rasmussen, and Reille (2010) reported that in the household. Finally, over-indebtedness can delinquent loans, which averaged 2 percent of have other long-lasting mental and physical health portfolio in 2004, skyrocketed to 2009 levels of effects, including suicide in extreme cases.7 7 percent in Bosnia–Herzogovina, 10 percent in Morocco, 12 percent in Nicaragua, and 13 Over-indebtedness clearly hurts people. But percent in Pakistan. In some of these countries, elimination of over-indebtedness is not a practical subsequent levels have risen even higher. More goal. Everyone knows that borrowing does not recently, collection has collapsed in the Indian always work out well for the borrower. Sometimes state of Andhra Pradesh.6 These and other people get in over their heads because they make developments have focused a lot of attention on an imprudent borrowing choice, or the microcredit over-indebtedness among microborrowers. provider makes an imprudent lending choice. But even when the borrowing and lending decisions have The topic of microcredit over-indebtedness raises a been perfectly sensible, unpredictable circumstances, lot of questions, the first of which is what we mean such as emergencies or failed investments, can make when we use the term. This definitional issue is a repayment difficult or impossible. The only way to complex and difficult one that we explore at length eliminate over-indebtedness altogether would be to later in this paper. For present purposes, we can eliminate lending. make do with the imprecise notion that borrowers are “over-indebted� if they have serious problems This basic point is worth emphasizing. If there is paying off their loans. This provisional definition microlending, some borrowers will inevitably wind reflects an important underlying choice. We do up with repayment problems. Thus, there is some not restrict the concept of over-indebtedness degree of trade-off: we cannot maximize borrowers’ to situations where the borrower is completely access and minimize debt stress at the same time. unable to repay. If our main concern were the For instance, the most obvious way to lower over- sustainability of the lenders, we might view over- indebtedness is to tighten lending standards. This indebtedness simply as debt that can’t be repaid, will prevent loans to some people who would wind because that is what hurts a microlender most. up having serious repayment problems. But it will Rather, our primary focus is on the well-being also prevent loans to some other people who could of clients, so our definition incorporates client have repaid without difficulty, even though they fell distress, even in cases where the loan gets paid. short of the new loan requirements. As anyone who makes credit decisions can tell us, it’s not always Over-indebtedness can seriously damage clients. easy to predict who’s going to fall in which group. They struggle to make repayments, cutting back on basic consumption as well as other important The useful question is not whether microcredit is household expenditures, such as education or over-indebting borrowers, but whether it is over- healthcare. Then, of course, over-indebtedness indebting too many borrowers. How many is too has material costs, such as late fees and, in many? This belongs on the long list of questions default cases, asset seizures. The resulting loss we can’t settle in this paper. We don’t try to of creditworthiness can deprive the household develop an a priori norm for acceptable levels of crucial cash management tools. On another of over-indebtedness. The approach that seems 5 For historical collection data, see MiX Market (www.mixmarket.org). 6 e.g., cGap (2010). it is unclear how much of the andhra pradesh problem stems from borrower inability to repay, as opposed to “strategic� default. 7 see schicks (2011) for a detailed discussion of the consequences over-indebtedness can have on borrowers and on other stakeholders. 8 more useful is to develop a working definition, or Section 1 asks whether lenders and funders definitions, of over-indebtedness; conduct more really need to be all that concerned with over- research to determine actual levels in various indebtedness at this stage of microfinance markets; and then attempt judgments (necessarily development. (Our answer is yes—we do not fuzzy ones) about whether the level found in a know the extent of over-indebtedness worldwide, given market is reasonable or not. but there are strong reasons to be alert for the occurrence of such problems.) Most people would have an instinctive sense that over-indebting, say, a third of the borrowers of a Section 2 looks at causes of over-indebtedness. microfinance institution (MFI) would be unacceptable We discuss some of the probable causes, though in any circumstance.8 Likewise most would agree we don’t have the evidence to say much about that if only one out of every hundred borrowers how widespread each of those causes is. has serious difficulty in repaying, that would be unfortunate but acceptable because the only way to Section 3 addresses the harder-than-it-looks question eliminate this problem would probably be to deny of how to define and measure over-indebtedness. credit to the 99 who can repay without difficulty. Between 1 percent and 33 percent, where does the In Section 4, we look at the results of six tipping point of acceptability lie? One’s answer may empirical studies that have tried to quantify over- depend more on instinct than analysis. In any event, indebtedness and over-indebtedness risk. we think there is a better chance of getting some consensus about whether a given level is too high Section 5 is a brief survey of potential responses or not when the discussion is focused on the actual to over-indebtedness by lenders and funders. circumstances of a specific market. When we find a problem, or anticipate one, what if anything can be done about it? This paper offers a broad-brush survey of a wide range of issues associated with over-indebtedness. Finally, a brief conclusion distils the core messages It is neither exhaustive nor conclusive, but we hope of the paper. it advances the discussion of this crucial issue. In particular we caution the reader not to expect clear, concrete answers to the question, “What 1. Why Worry about should I do about over-indebtedness right Over-Indebtedness? now?� We wish we could offer such answers, but the state of the evidence does not permit it, For a long time, the main concern of microfinance especially because so much depends on widely was expanding access—delivering formal financial differing local circumstances. The best we can do services, mainly credit, to as many people as is offer a menu of options to consider. possible. Few people were thinking about over- indebtedness. As late as April 2008, Deutsche One further caveat: we discuss over-indebtedness Bank, the Boulder Institute, and CGAP convened in the context of microcredit, but it is important a group of microfinance practitioners and experts to recognize that many of the same dynamics to reflect together about the state of the industry, and issues apply to other forms of retail lending, its risks, and its future. As an early exercise, including consumer credit. In some countries, participants each listed a few things that worried there may be considerable overlap between the them most about the industry. Over-indebtedness markets for microcredit and other retail lending, so was mentioned by only three of the 35 participants.9 the behavior of one set of lenders can over-indebt In Microfinance Banana Skins 2008, hundreds of people who also borrow from other lenders. practitioners, investors, analysts, and regulators 8 in this paper, the terms “microlender,� “microcredit provider,� and “MFi� are used indiscriminately, referring to any formal institution that makes microloans, whether or not it also provides other financial services or serves other target clients. 9 after discussion, the conferees did go on to list over-indebtedness as a major threat (http://www.db.com/csr/en/docs/pocantico_Declaration.pdf). 9 rated credit risk as a less serious danger than nine It is one thing to assert that there are reasons other threats to the industry (Laschelles 2008). for particular concern about over-indebting microborrowers right now. We do assert this—the Three years later, the picture is very different. check-engine light is on—and offer our reasons Driven in large part by repayment crises in Bosnia– below. It is quite another thing to assert that there Herzogovina, Morocco, Nicaragua, Pakistan, is a worldwide problem with over-indebtedness and India, microcredit over-indebtedness and that affects more than a few markets. We make no its causes are the subject of intense discussion such assertion, because the evidence to confirm and a growing—if still small—body of research. or refute it simply isn’t available yet. Indeed, a In Microfinance Banana Skins 2011, credit risk central contention of this paper is that we urgently had climbed to the top of the list of microfinance need much more research so we can find out how threats (Laschelles and Solomon 2011). much of a problem exists. Readers who forget this clarification may walk away from the paper with a At one level, the answer to the question of whether picture containing more gloom and doom than the to be concerned about over-indebtedness is authors intend or the evidence justifies. obvious. Over-indebtedness hurts poor clients,10 whose welfare is the declared objective of most Let us turn then to the reasons for particular microlenders, funders, and governments. And over- concern. indebtedness sooner or later tends to produce delinquency and default, which threaten the lending Competition and market saturation create institutions’ own viability.11 So over-indebtedness over-indebtedness risk. Since the inception of should always be a concern, in principle. the “microfinance revolution,� its rallying cry has been the need to bring formal financial services The more meaningful question is whether we have (mainly loans, in the early years) to the hundreds reason to be concerned that over-indebtedness of millions of poor people who have had no may be at, or be approaching, problematic access to them. Today, there are more and more levels. Or, to put the question in practical terms, markets where that goal is being reached, at should we be devoting much more attention and least in the limited sense of making standard resources than we currently are to identifying microloan products available to almost all of over-indebtedness problems and correcting or the people who can be served sustainably. In preventing them? other words, more and more microcredit markets are starting to reach saturation. (Typically, local Before we address this question, we need to markets in a country will become saturated make an important clarification, starting with an before the national market as a whole does.) As automotive analogy. When the check-engine this phenomenon spreads, it marks a momentous warning indicator on an auto’s dashboard lights shift in the development of the industry, requiring up, it may mean that there has been a major re-examination of earlier conventional wisdom. In malfunction that will destroy the engine if it is not particular, over-indebtedness risk rises, and MFIs repaired promptly. But it might just as well mean can expand their market only by developing new that there is nothing more than a minor glitch financial products. in the engine’s computer. Either way, a smart driver will want to have the engine checked by a For many people, talk of market saturation seems competent mechanic. odd when most of the low-income population don’t 10 We use “poor� throughout this paper as shorthand for “poor and low-income.� new tools have been developed for testing the poverty status of microfinance clients. (see http://www.povertytools.org; http://progressoutofpoverty.org/.) application of these tools over the past five years has amply confirmed what experienced practitioners have been saying for a long time: most MFis serve not only customers below the official poverty line, but also substantial numbers of low-income customers who are, at least at a given point in time, above the poverty line. 11 Microlenders face a tight margin for error when it comes to collecting their loans. Delinquency (delay in payment) tends to spin out of control if more than 10% of a portfolio becomes late by more than one repayment period. The corresponding critical maximum for annual rates of loan losses (default) tends to be about 5% of portfolio. see rosenberg (1999). 10 have a microloan. This is because there has been can also extend to current customers, who may be a tendency to overestimate demand for standard encouraged, or at least permitted, to increase their microcredit, sometimes drastically. Many poor loan size beyond safe limits, or discouraged from people have income sources—e.g., farming—that resting between loans (Guerin 2006; Hulme 2007; don’t match up well with the microfinance loan terms Collins, Morduch, Rutherford, and Ruthven 2009; presently on offer. And among microentrepreneurs Gonzalez 2008).16 When this kind of “race to the for whom the standard loan terms are a better fit, bottom� occurs, even a careful and responsible large proportions simply do not want to borrow. lender is at risk—especially if there is no sharing Even those who want to borrow may not want to of credit information—because its borrowers’ borrow all the time. And finally, some who might ability to repay may be compromised by reckless want to borrow can’t be given loans because their behavior of other lenders. income is too small, unreliable, or irregular to safely support repayment. There is growing evidence that In most credit systems, there is a considerable the actual number of people who want and qualify delay between the point where borrowers are for a standard microloan at any given time may be getting into trouble and the point where the considerably lower than the demand estimates that problem becomes apparent in the collection MFIs and industry analysts have put forward in the statistics of lenders. David Roodman (2011, ch. 8) past.12 points out that systems—not just economic ones but also biological ones like reindeer herds— Adrian Gonzalez (2010) finds that growth in are inherently prone to unsustainable expansion country-level delinquency and default, which may and recurring crises if they combine high growth reflect market saturation, is statistically associated pressure with a delayed feedback loop. with penetration rates as low as 10 microloans per 100 of population.13 At any rate, microlenders in Borrowers often take advantage of their access to an increasing number of competitive markets are multiple lenders, and accumulate concurrent loans. finding that good new customers are getting harder Especially in settings where there is no credit to recruit, and that most of their existing customers bureau, even a very careful lender will have trouble have access to one or more other microlenders. evaluating clients’ repayment capacity, because it is hard to find out about their other debt service Gabriel Davel, the recently retired chief of South obligations. As all of this happens, more borrowers Africa’s National Credit Regulator, argues that risk getting in over their heads, eventually resulting when competitive retail credit markets approach in serious delinquency and default (McIntosh and saturation, over-indebtedness problems will Wydick 2005). (This does not mean that multiple arise almost inevitably, not just when a few bad- indebtedness is the same as over-indebtedness. apple lenders irresponsibly ruin the market.14 As See Section 3.) competition intensifies, competitors are likely to step up their efforts to capture as large a share All these dynamics are exacerbated by the as they can of the remaining untapped market. common pattern of MFI expansion observed Once lenders have picked most of the “low- in many countries. When MFIs open new hanging fruit�—i.e., low-risk borrowers—they branches, they prefer, where possible, to do it may relax their standards and start lending to a in “safe� places where a competitor has already higher risk clientele.15 Over-aggressive marketing developed customer awareness of microcredit 12 For a fuller discussion of demand estimates, see anand and rosenberg (2008). 13 Gonzalez focuses on national population and penetration because the MiX data he relies on do not give regional breakouts. in fact, at the present time microcredit markets in most countries are more likely to be regional rather than national. 14 presentations at cGap and at Deutschebank over-indebtedness roundtable, January 2011. “retail� credit is aimed at the level of households (including, among other things, their consumption and their informal income-producing activities) rather than at formal firms. 15 e.g., robb (2007), schoell (2010), lupica (2009), White (2007), and Dick and lehnert (2010). 16 “Hellman, Murdock, and stiglitz (2000) link increasing competition to opportunistic behavior by lenders. Their argument is that competition reduces profits, lower profits imply lower franchise or charter values (namely, the capitalized value of expected future profits), and lower franchise values reduce the incentives for making good loans, as bank owners would have a lower stake in the outcome.� (Gonzalez 2008). 11 and demonstrated a strong market, rather than wringing about over-indebtedness. They argue expanding into previously unserved localities.17 that the concern subtly implies that poor people in developing countries aren’t smart enough to know Lenders may get sloppy with their internal systems what’s good for them, and won’t make sensible for tracking and managing delinquency. Borrowers borrowing decisions for their households unless who have amassed more debt than they’re able the state or some other wise and benevolent to pay can paper over the situation, for a while at nanny limits their options. least, by using new loans from one source to pay off old loans from another. This kind of concealed The proposition that people, including poor over-indebtedness is especially likely when large people, generally know what’s best for them and amounts of new lending capital are flowing into act accordingly is a good default assumption. But the market. And even when borrowers in trouble in the case of credit behavior, recent developments have no other formal lender to go to, or have in economics and psychology suggest there may exhausted their other borrowing options, their be substantial evidence to the contrary. MFIs loan officers may try to conceal the situation by rescheduling bad loans so they don’t show up The default assumption is that borrowers act as delinquent. in their own best interest—in other words, that they behave like the rational homo economicus This pattern is not restricted to for-profit of classical economic theory. A new school of commercial MFIs. Not-for-profit MFIs have “behavioral economics� is using the insights and experienced the same problems, for instance in tools of psychology to argue that the classical Morocco and Pakistan.18 As the list of microcredit model of rational motivation fails to account for markets with heavy competition grows, and as important dimensions of real behavior, including they get closer to saturating the demand that can behavior of borrowers whether they’re rich or poor. be met with present methods and products, we Rather, the thesis is that real people are subject to should expect to see widening problems with over- systematic biases pushing them in the direction indebtedness. Lenders will have to improve their of judgments and behaviors that damage, rather marketing, underwriting, and loan management. than promote, their long-term welfare. Borrowers Financial authorities will need to craft better “consistently make choices that, they themselves consumer protection regulations. And many clients agree, diminish their own well-being in significant will have to learn how to deal better with their ways� (Barr, Mullinaithan, and Shafir 2008). new credit access. If these things happen, over- indebtedness won’t disappear, but it will probably We discuss specific biases in Section 2 on the drop back toward more acceptable levels. causes of over-indebtedness. The important point for now is that behavioral economics has raised In the meantime, the natural dynamics of a serious doubts about the proposition that we can maturing retail credit market give us good reason safely rely on microborrowers’ native good sense to “worry� about over-indebtedness—i.e., to to keep their borrowing at healthy levels. There devote much more energy and resources to are plausible theoretical models, and a growing finding ways to identify it as early as possible and body of empirical results, suggesting that over- prevent it as much as possible.19 indebtedness may be a permanent structural concern for any kind of retail credit. Borrowers don’t always make smart choices. Some observers are troubled because they sense Strong repayment statistics don’t assure us that a tinge of neocolonial paternalism in all the hand- all is well. Many people—including one of the 17 e.g., Krishnaswamy (2007) and references cited therein (p. 4) 18 This does not necessarily mean that commercial motives are irrelevant to the problem. even not-for-profit managers may be tempted into intemperate growth by the prospect of eventually converting their MFis into for-profit form. 19 By focusing on the special challenges when competitive retail credit markets approach saturation, we do not mean to imply that over-indebtedness is not a risk at other times as well. 12 authors of this paper—have argued that when political backlash with wide-ranging consequences MFIs in a country show very high repayment rates for the industry and for future borrowers. over the years, they probably haven’t been over- indebting too many borrowers. Even if this view In many countries, microcredit will always be has any merit, it should be subject to substantial politically sensitive, even when MFIs are behaving qualifications. We discuss the interpretation of perfectly responsibly. At first blush, it shocks the repayment statistics in Section 3. For now, we conscience to learn that poor borrowers are being summarize a few core issues: saddled with interest rates that are a lot higher than what wealthy borrowers are being charged • Even a borrower who repays a loan faithfully by banks. The rationale for the higher rates (i.e., may encounter very serious problems in higher costs per unit lent) takes some explaining, making the payments. and there will always be many people who don’t • Default and even delinquency rates are trailing understand or accept it.20 This interest rate issue indicators. Borrowers may be having problems makes microcredit a tempting political target, right now that won’t show up in the lender’s especially when it is combined with occasional repayment statistics until later—sometimes (or frequent) examples of over-aggressive loan much later, especially where borrowers can collection by MFIs. When a political backlash juggle loans from several sources. occurs, it is often driven not only by sincere concern • Some MFIs’ published repayment statistics for clients but also by other political motives. are unreliable. Taking the political crises in Bolivia, Nicaragua, • Finally, as noted, competition and market and Andhra Pradesh as examples, it seems that at saturation change the whole game. Good least some of the storm was fueled by factors that loan collection before that change occurs is had little to do with borrower welfare. no assurance of continuing good collection afterward. When a political backlash occurs, some borrowers who are perfectly able to repay may decide For all these reasons, reports of strong past opportunistically that they can avoid repaying, and and current repayment are not a good reason the MFIs’ viability is threatened. More importantly, to discount the possibility of serious over- there is always a danger of regulatory over-reaction: indebtedness among current borrowers. governments may impose policy measures that not only restrict bad lending but also prevent a much Studies so far have found serious over- larger amount of good lending. indebtedness in some markets. In Section 4, we review six empirical studies that quantify Given the inherent political vulnerability of microcredit over-indebtedness and/or explore microcredit, those who want to promote it should ways to predict it. There are not enough of these be especially vigilant about over-indebtedness, studies to permit much generalization. But most of because—among other reasons—it can fuel a them have found levels of over-indebtedness that public over-reaction that hurts a lot of potential many people would regard as worrisome. borrowers who need the credit and are fully able to repay it. There is also a risk of backlash from Perception of over-indebtedness can lead donors and public and social investors, who may to political backlash. Over-indebtedness is of turn away from funding not only microcredit, but concern not only for its possible prevalence microfinance more broadly. but also for the severity of its consequences. In addition to the above-mentioned consequences We should have an even lower tolerance for for borrowers, over-indebtedness can trigger over-indebtedness if our expectations of what 20 lending costs are not the only component of microcredit interest rates. shareholders’ profits also contribute to the price paid by borrowers, and there is controversy about how much profit is appropriate for institutions serving poor people. 13 microcredit can achieve have become more A few recent and rigorous impact studies modest. In a reasonable weighing of costs and have not found such results, and some older, benefits, the amount of over-indebtedness we’re more optimistic studies are being challenged. willing to accept should depend on the size of the The issue is far from settled. But recent benefit that we think is being delivered to all the developments raise the distinct possibility that other borrowers who are not over-indebted. the benefits of microcredit may be less than previously advertised.22 It may be, for instance, The prevailing narrative about microcredit used that the principal benefit of microcredit lies not to be that borrowers were investing their loan in getting people out of poverty but in helping proceeds in new or expanded microenterprises, them cope better with poverty, giving them and that the extra income produced by these useful cash management tools for a variety of enterprises was raising people out of poverty purposes, including keeping their consumption by the millions. If the benefit is really that great stable, coping with shocks, and accumulating for most of the borrowers, then one ought to be larger sums to pay for business and nonbusiness willing to accept some collateral damage to a small investments. If research confirms this, it is a minority of the borrowers if it is an unavoidable valuable benefit, but considerably smaller than part of the process.21 liberating households from poverty. The point can be illustrated by a stylized example. Returning to our hypothetical example, if the Suppose that, in a given setting, microcredit is benefit to the 75 percent is a much more modest instrumental in allowing 75 percent of its borrowers one, then the acceptable amount of collateral to double their incomes and escape from poverty. damage to other borrowers should be much Further suppose that 10 percent of the borrowers get smaller. Because our confidence about huge over-indebted: some of them struggle hard to repay microcredit benefits is weakening (getting more their loan, and some default, but all are worse off to realistic, some would say) these days, our concern some extent because of the loan. The circumstances about over-indebtedness should be growing of the remaining 15 percent are unchanged. because the amount of it we’re willing to tolerate should be shrinking. Before settling for this situation, we would look for ways to lower the damage for the unfortunate Putting all these considerations together, there 10 percent. But even if improvement is possible, is a strong case for intensifying the attention, we will reach a point where the only way to research, and resources devoted to over- further reduce over-indebtedness would be to indebtedness issues. In particular, there is a strong tighten lending standards so much that plenty of message for most MFIs in competitive markets— otherwise qualified borrowers will be frozen out, or especially markets that may be approaching to relax collection standards past the point where local or national saturation levels. If possible, delinquency can be kept manageable. At this they need to develop early warning systems to point, many people would feel that the remaining identify an over-indebtedness problem before it level of over-indebtedness is acceptable if it is shows up in a collapse of repayment. And they the price of continuing the huge benefits that 75 need to adjust their loan marketing, approval, percent of the borrowers are getting. management, and collection practices with a view to keeping over-indebtedness at acceptable However, there are growing doubts about levels. Section 5 looks at some of the steps that the raising-millions-out-of-poverty narrative. may be needed. 21 This is a utilitarian approach, trying to achieve the best collective outcome for those involved. some people might argue that there are levels of damage (e.g., suicide) that are not acceptable under any circumstances, no matter what the benefit to others may be. 22 e.g., rosenberg (2010); collins, Morduch, rutherford, and ruthven (2009); and Karlan and Zinman (2007). 14 2. The Causes of of preloan analysis as well as post-loan follow-up, Over-Indebtedness and resulting in serious collection problems.24 However, Gonzalez’s analysis of MIX data finds no Over-indebtedness is a complex phenomenon; in correlation between individual MFI growth rates most cases, multiple factors are at work. Lender and portfolio deterioration, except at extreme behavior can put clients at undue risk, clients (and very unusual) levels (Gonzalez 2010).25 themselves make mistakes in their borrowing The picture is different, however, when one looks decisions, and sometimes external factors beyond at aggregate market-level growth rates. Gonzalez either party’s control push debt to unsustainable finds that high aggregate growth of a country’s levels.23 We can describe some of these dynamics, number of microfinance borrowers (greater but there isn’t enough evidence yet to make strong than 63% per year) and an active-loans-to-total- assertions about how prevalent most of them are or population rate above 10 percent are significantly how heavily they contribute to over-indebtedness. related to repayment problems. His findings are consistent with our discussion of the dynamics The Responsibility of Microlenders of competition in saturating markets in Section 1. MFIs push harder and harder to capture the When trying to understand what can go wrong, we remaining market share, they tie too much of loan tend to learn best from examples where problems officer compensation to making more and bigger are most visible. There have been complaints about loans, they start lending to borrowers who are microlender behavior in a number of countries with likely to have more trouble repaying, their ability to recent repayment crises. MFIs are said to have assess repayment capacity declines because their marketed too aggressively, expanded too fast, borrowers are also carrying debt from competing used staff incentives that encouraged over-lending, lenders, and borrowers use their multiple access offered the wrong products, obscured their loan to refinance loans that are ultimately unpayable.26 terms, and used abusive collection practices. We look first at the challenges entailed by fast growth, Some observers think that an over-supply of and then at the products and procedures of MFIs funding, along with funders’ pressure on MFIs for more specifically. growth and profitability, has contributed to over- indebtedness crises. Investor behavior affects the Since its inception, the microfinance industry has incentives of MFIs. In addition, the fast growing pursued growth—indeed, rapid growth. Growth microfinance investment by commercial and quasi- implies outreach to more customers, and—it is commercial players has tended to concentrate on hoped—competition that brings down interest markets that have mature MFIs with strong profits rates and improves customer service. These and high growth—in other words, markets that are arguments may be valid, but they need to be more likely to be saturated.27 handled with care. The industry is learning more about the challenges that come along with growth. Regardless of growth rates and saturation, over- indebtedness can be influenced by specific It is important to distinguish between growth of products and practices of individual MFIs before, an individual MFI and growth of a microcredit during, and after loan approval.28 market. It seems plausible that too rapid expansion of an MFI could overstretch its lending Ex ante, before the loan is made, over- and management systems, lowering the quality indebtedness risks may emerge from a lack of 23 This section is based on the analysis in schicks (2010). 24 e.g., chen, rasmussen, and reille (2010), analyzing debt crises in nicaragua, pakistan, Morocco, and Bosnia–Herzogovina. 25 The study finds that intensive growth (adding new borrowers to existing branches) is more dangerous than expansive growth (adding branches in new locations), but neither form of growth appears to correlate with collection problems except at growth rates that are very rare in large MFis. 26 e.g., abed (2011). 27 e.g., chen, rasmussen, and reille (2010) and roodman (2011). 28 some of these products and practices are discussed further in section 5. 15 transparency. MFIs may reduce borrowers’ ability loans that are a lot smaller than those borrowers to make smart choices if their advertising and want and can handle. Where possible, borrowers face-to-face marketing do not communicate loan go to other lenders to make up the total loan conditions—including pricing—in accurate, fair, amount they want. This adds to the borrowers’ and easy-to-understand terms. transaction costs, and may even contribute to over-indebtedness by making it harder for each Next, in giving loans, MFIs that are too growth- individual lender to assess borrowers’ ability to focused may relax lending standards and invest less handle their total indebtedness. in a sound evaluation of repayment capacity. This is especially likely when loan officers’ incentives During the course of the loan contract, the are strongly linked to adding new clients or making installment schedule can affect the borrower’s larger loans.29 ability to repay. Products that are too inflexible and repayment schedules that are too far out There is a complex debate about offering loans of step with borrowers’ cash flows can drive that will be used for consumption purposes. borrowers into over-indebtedness even when Some MFIs offer loan products that are explicitly the debt amount is reasonable. When individual focused on consumption uses. But even where borrowers are struggling with liquidity problems loans are declared to be for business uses, rather than structural debt problems, the zero- many—sometimes most—borrowers use them for tolerance policy that has been the mantra of nonincome-generating purposes. Following up many MFIs may need to be relaxed.31 The policy with borrowers to enforce business use of loan is valuable in teaching borrowers the importance proceeds raises costs (and thus interest rates), of regular repayments, especially compared to and may not be effective. When loans finance typical government lending. It promotes the early consumption, the loan use does not produce recognition of repayment difficulties and keeps returns that compensate for the interest expense. borrowers from piling up obligations (Gonzalez On the other hand, nonbusiness uses may be very 2008). It reduces the risk of spillover effects of helpful for managing emergencies, smoothing the delinquency on nondelinquent borrowers and volatility of poor people‘s incomes, and funding avoids the operational cost of handling large nonbusiness investment, such as education.30 The numbers of rescheduling requests. Nevertheless, relationship to over-indebtedness is ambiguous. if the zero-tolerance policy is so strict that there is no room to accommodate legitimate individual Paradoxically, a standard microcredit feature that circumstances, the result can be an unnecessary was directed at testing repayment capacity of increase in the struggles of honest borrowers.32 borrowers and reducing over-indebtedness risks can, in some cases, create the opposite result. A related issue concerns collection methods. Once Automatic loan size increases may lead some borrowers have gotten into trouble, inappropriate clients to take larger loans than are appropriate collection practices can worsen their situation. for them. Especially in group lending, where a While a certain level of firmness is necessary to loan officer is not assessing repayment capacity, provide sufficient repayment incentives, collection ever-increasing loan sizes can eventually outstrip needs to respect the basic rights of borrowers. borrowers’ ability to repay. At the other end of Also, if the MFI charges substantial penalties for the graduated-loan-size ladder, many MFIs control late payments (over and above continued accrual credit risk by testing out new borrowers with of regular interest), it may place itself in the 29 e.g., chen, rasmussen, and reille (2010). 30 e.g., collins, Morduch, rutherford, and ruthven (2009). The authors caution against the assumption that borrowing for nonbusiness purposes is usually a recipe for over-indebtedness. 31 some MFis point with pride to their “perfect� 100% collection rate. in fact, that level of collection is anything but ideal. it usually means that the MFi is being too conservative in extending loans, which reduces both borrower access and MFi profits. long experience has shown that most MFis can tolerate low levels of nonrepayment (e.g., annual loan losses below 3–4%) without the problem spinning out of control. 32 several studies have found that microborrowers resort to expensive informal moneylenders to make loan payments during low-income periods. e.g., Jain and Mansuri (2003) and the studies cited therein; care/Bangladesh (2005 and 2005a). 16 dubious position of making higher profits when can lead borrowers to take on more debt than clients can’t or don’t pay on time, which is hardly is good for them. Some of the biases described an incentive to minimize over-indebtedness. by behavioral economists and confirmed by their experiments don’t surprise us very much, Finally, after a loan cycle has been completed, it because they are consistent with our everyday is difficult for some MFIs to accept that borrowers commonsense experience. sometimes need a break from credit rather than an immediate follow-up loan. This is especially the To begin with, many people put too much weight case if MFIs are not offering deposits or other on present gratification, because it is “salient,� services that would bind clients to the institution and pay too little attention to future consequences while they are not borrowing. because they seem less real. 34 “Hyperbolic discounters� have a strong bias toward receiving This list of the ways MFIs can contribute to rewards (e.g., loan disbursements) now and over-indebtedness is not an indictment but deferring costs (e.g., repayment) into the future. rather an illustration of the difficult challenges They regularly make present decisions that their involved in lending to poor people, especially in future selves wind up regretting. In one study, an ever-changing and increasingly competitive they were found to borrow three times as much as market. Some of the core methodologies that “rational� consumers.35 There are other theoretical make microlending successful and safer for approaches as well to the universally recognized both institutions and borrowers (e.g., fixed phenomenon of temptation interfering with self- weekly repayment schedules or graduated loan control.36 See Box 1. sizes) can have unexpected effects in specific situations. The microfinance industry is currently There are other relevant biases. For instance, in the process of learning about, and dealing people’s predictions of the future tend to be over- with, risks that are becoming more apparent as optimistic. They underestimate the likelihood of the industry matures. shocks, underestimate the amounts they will wind up borrowing, and overestimate their ability to Why Borrowers Get Themselves into pay on time (Barr, Mullinaithan, and Shafir 2008; Trouble Kilborn 2005; Vandone 2009). “Habit persistence� causes people to reduce consumption too slowly Some people don’t repay their loans simply when income declines, with obvious consequences because they would prefer to keep the money— for the likelihood of over-borrowing (Brown 1952). they are able but unwilling to repay. Our focus in In general, human beings have difficulties with this paper is not on these opportunistic defaulters, processing all the complex information related to but on borrowers who have genuine difficulties loan contracts. They tend not to fully understand in repaying—those who are willing but unable all the implications of loans and sometimes rely to repay.33 Borrowers need protection from on rather weak proxies in their decision making. irresponsible lender behavior, but this should not For example, people are inclined to think that the obscure the role borrowers themselves play. Every credit limit they are given by financial institutions over-indebting loan contract represents a decision is an indicator of their ability to repay (Soman and not only by the lender but also by the borrower. Cheema 2002). As noted in Section 1, the emerging field of Some behavioral biases affect poor people more behavioral economics has identified biases that than others. It seems plausible to assume that 33 We would probably include borrowers who make dishonest statements in their loan applications, embellishing their financial situation or not admitting the real purpose of a loan, as long as they borrow in good faith that they will repay the debt to the MFi and, if problems arise, will make serious efforts to fulfill their repayment obligations. 34 e.g., Mullinaithan and Krishnan (2008) 35 e.g., laibson (1997); laibson, repetto, and Tobacman (2003). 36 e.g., akerlof (1991), Gul and pesendorfer (2004), Fudenberg and levine (2006) 17 At the same time, it is important not to overstate Box 1. Poor People Recognize Their the case about cognitive and behavioral biases. Problems with Self-Discipline To begin with, while everyone acknowledges the Paradoxically, many poor people take out loans existence of such biases, there is some scholarly precisely for the sake of external discipline. They use the loan proceeds for some important disagreement about how much they skew real purpose, knowing that the repayment schedule borrowing behavior.37 Also, many of the empirical will force them to regularly set money aside, results cited here are from rich countries. One protecting it from the insistent temptation of cannot automatically assume they apply equally current consumption.a Accumulating a usefully large lump sum of cash through borrowing is more well in poor country settings. expensive than doing the same thing through saving, but many poor people are happy to pay the In addition to the biases discussed above, price to shore up their self-control. When savings products are designed with a commitment feature microborrowers have to deal with a learning curve. that deliberately prevents everyday access to the Many of them have gone quite quickly from having money, there tends to be strong demand from no formal loan access to having simultaneous poor people, and their asset accumulation and access to multiple sources. Some speculate that investment are likely to improve.b borrower inexperience is a major source of debt a E.g., Collins, Morduch, Rutherford, and Ruthven (2009); problems. Rutherford and Arora (2009); Rutherford (2000) b E.g., Ashraf, Karlan, and Yin (2005); Duflo, Kremer, and Robinson (2009). In sum, when we look for the causes of over- indebtedness, we need to examine borrower decision making, not just the behavior of lenders. Indeed, lenders’ policies should be based on a resisting the “temptation� to over-borrow is realistic recognition of the biases of their borrowers. particularly challenging for poor people, who The existence of borrower bias does not absolve are more likely to find themselves in desperate lenders from their responsibility for prudent, fair situations. Inequality and social comparison can lending that does not leave undue numbers of lead lower income groups to borrow irresponsibly borrowers in trouble. in a desire to keep up with the consumption levels of peers (Duesenberrry 1949, Luttmer 2005, The Power of External Factors Christen and Morgan 2005, Brown 2004). Social obligations to support relatives and neighbors In addition to behavior by lenders and borrowers, at any cost may drive people into indebtedness circumstances beyond the control of either of them (Cressy 2006, Guerin 2000). Obviously, the pain contribute to over-indebtedness. of deferring a given quantum of consumption is worse for the poor than for the rich (Bannerjee Individual borrowers are hit by household-specific and Mullainathan 2009). And mistakes in external shocks, most commonly a sudden predicting the future tend to have more drastic reduction in income (e.g., a job loss or illness in the consequences for people living closer to the household) or a large unexpected expense (e.g., an edge of survival. We emphasize that none of this accident, medical costs, or funeral obligations).38 necessarily means that the poor are less rational Other shocks affect many borrowers at the same than the rich. For the most part, poor people time—e.g., natural disasters or conflicts that destroy probably have the same biases as rich people, but livelihoods. Changes in government policies because of their more vulnerable circumstances, can affect input and market prices, or displace those biases tend to produce more damaging street vendors (Stearns 1991). Macroeconomic results (Bannerjee and Duflos 2007, Bertrand and contractions and currency fluctuations can impair Mullainathan 2010). many borrowers’ repayment capacity. 37 e.g., ellihausen (2010). 38 e.g., Bouquet, Wampfler, ralison, and roesch (2007), Krishnaswamy (2007). 18 One key characteristic of poverty is the difficulty We begin by distinguishing definitions from of building safety buffers for such situations. proxy indicators. A definition tries to clarify the These shocks are very common in the lives of core meaning of a term. For instance, our rough vulnerable populations, but it is difficult to account provisional definition at the start of this paper was for them at the time of borrowing and lending, that borrowers are “over-indebted� if they have so they subject all credit decisions to a higher serious problems in paying off their loans. It is hard level of uncertainty. Before the shock occurs, to do direct measurement of over-indebtedness the debt level can seem quite manageable. But defined this way. So we might look for a more pre-existing debt tends to limit the household’s easily measurable proxy—e.g., we could measure maneuvering room in handling a shock when it borrowers’ debt payments as a percentage of their occurs. What originally seemed like a reasonable income. One could reasonably assume that this debt burden can quickly turn into unsustainable correlates pretty well with over-indebtedness—i.e., over-indebtedness. And the more rigid the loan people whose debt service ratio is high are more repayment schedule is, the harder it is for the likely to encounter serious difficulty in repaying. borrower to manage the shock. It’s useful to keep this distinction between definitions and proxies in mind while reading this One by one, each of these shocks is unpredictable. section, which discusses both. But it’s not always But the overall prevalence of such shocks among clear which is which: one person’s proxy can be the target population is eminently predictable. another’s definition. Lenders need to factor in these risks when they design their loan products, and when they decide The choice of an indicator (whether as definition how much to lend to whom. or proxy) depends on its purpose. Regulators, for instance, look for legal definitions that can be Finally external sources of over-indebtedness applied more or less mechanically, with as little risks can also include the regulatory environment, ambiguity as possible, so that the application infrastructure for information exchange among of the regulation will be as predictable as lenders, etc. They impact the behavior of lenders possible for all parties. Academics or market and borrowers. researchers need indicators that can be measured by the data or investigative tools To conclude, lenders, borrowers, and external available to them. influences all contribute to over-indebtedness, and each of the factors discussed in this section This section looks at the following definitions and represents a potential lever to reduce the problem. proxies: Section 5 presents a brief survey of commonly proposed approaches. • Negative impact • Default and arrears 3. Defining and Measuring • Debt and debt service ratios Over-Indebtedness • Multiple borrowing • Borrower struggles and sacrifices When people in the microfinance industry • Composite indicators discuss over-indebtedness, they usually don’t have to interrupt the conversation to figure out Negative impact. Saying people are over- whether they’re talking about the same thing. In indebted would seem to be an assertion that this sense only, the term is not problematic. But they have too much debt—which would ordinarily when the time comes to design research or draft mean more debt than is good for them. In this regulations, being precise about the meaning of view, the question would come down to whether “over-indebtedness� raises tricky questions, not or not the loan is making the borrowers worse all of which have clear answers. off than they would have been without the loan. 19 We might think that this should be the core the moment when over-indebtedness puts the definition from a policy perspective. After all, we sustainability of MFIs at risk, and when borrowers would like as much as possible to prevent loans may be exposed to public humiliation, asset that make borrowers worse off. As for loans that seizures, loss of creditworthiness, or erosion of make borrowers better off, we should prefer not to the social networks on which they rely. prevent such loans, even if (for instance) repaying them ties up a big portion of the borrowers’ However, borrowers who default don’t usually do income, or the borrowers have to struggle to so because they are suddenly struck with too much repay. The test, then, would be whether the loan debt on the day payment falls due. The problems has a negative impact on the borrower. have most likely been around for quite some time. The over-indebtedness has usually started much But this definition doesn’t fit well with common earlier and has probably been accompanied by usage. Let’s imagine someone who is temporarily signs of the problem getting worse. Also, some short on cash and takes out a very small loan borrowers default not because they have an to buy a shirt he doesn’t really need; the loan unmanageable debt situation, but because they is repaid very easily when payment falls due. find it more convenient not to pay. Default is not Perhaps the loan made the borrower worse off— a definition of over-indebtedness, but rather it a it might have been better not to spend money on trailing indicator of it. the shirt, and the loan interest was a further cost— but this is not the sort of image most of us have Arrears (delinquency), as an indicator, have the in mind when we talk about over-indebtedness. same advantages and disadvantages as default. They start flagging the problem a little earlier, when A further problem is that credibly determining a payment is late, but before it’s clear the loan won’t the impact of loans is difficult and expensive.39 be repaid. But the borrowers’ debt situation may For example, at present one of the most widely have been unmanageable well before a payment recognized tools for testing the impact caused is actually missed. Arrears and default rates often by loans is the randomized controlled trial (RCT), measure a consequence of over-indebtedness,42 an approach that (1) imposes severe demands but not over-indebtedness itself. They are the most on the lenders who participate, (2) can cost widely used indicators only because they are the hundreds of thousands of dollars per study, and easiest to measure. (See Box 2.) (3) can take years to produce results. RCTs are not a practical tool for ongoing monitoring of Debt ratios. Another common set of indicators over-indebtedness.40 Thus, the negative impact takes the term “over-indebted� more literally. definition may not be of much practical use, It defines as over-indebted borrowers who have whatever its theoretical merits. borrowed “over� a certain limit. The limit is often framed as the ratio of individual or household debt Default and arrears.41 The most common proxy service to income (or take-home pay, or disposable indicator for over-indebtedness is default. Clearly, income after deducting minimum consumption when microborrowers have loans they can no expense). One is over-indebted if loan payments longer repay, they are over-indebted. This is eat up more than X percent of one’s income. This 39 see, e.g., rosenberg (2010). 40 in theory, it might be desirable for impact rcTs to collect data about over-indebtedness indicators, so as to determine how well they correlate with negative impact. e.g., if someone fails to repay a loan, how strong an inference (if any) can we draw that the loan made them worse off? However, there are challenges to the practical implementation of such a strategy. 41 “Default� as used here refers to a situation where the borrower never repays all of the loan, and the lender is left with a loss of principal. “arrears� or “delinquency� refers to a situation where the borrower fails to make one or more payments on time, but might later repay the loan in full. 42 Of course, arrears and defaults occur not only when borrowers are unable to repay, but also when borrowers are able but unwilling to repay. in particular, when most MFis are collecting well, high arrears at an individual MFi more often reflects a management problem than over- indebtedness. 20 Box 2. What Do Repayment Rates Tell Us? High delinquency or default in a market is usually— rates. Taking into account the possibility of such though not always—a good sign that there has been rollovers of unpayable debt, and assuming the serious over-indebtedness.a But what about the correctness of the MFI’s repayment statistics, we might converse proposition: do high repayment rates that repose more confidence in the situation as reported characterize microcredit in most markets tell us that two years ago than in the situation reported last year there’s little over-indebtedness there? As noted in or during the current year. (Remember that we are Section 1, this is a more dubious proposition. talking here about confidence that most borrowers were willing and able to pay, not confidence that few To begin with, the fact that borrowers repay loans borrowers were being over-indebted.) doesn’t tell us whether they’ve had to struggle with Looking at repayment statistics from a different serious difficulties to do so. Over-indebted people perspective, the sad truth is that, even at this late sometimes repay, albeit at the cost of major sacrifices. stage in the evolution of management information (See “Borrower struggles and sacrifices� on p. 23.) systems for microfinance, some big MFIs’ repayment The stronger the external incentives to repay (e.g., statistics can’t be trusted. There may be a gap peer pressure or aggressive collection practices), between reporting and reality because managers the more likely it is that borrowers will make serious are deliberately concealing problems. Probably more sacrifices to repay. often, the problem is inadequate information systems, Also, a borrower may be in trouble for some time so the managers are as much in the dark as anyone before a failure to pay shows up in the loan collection else. statistics. This risk of hidden delinquency is aggravated A striking example can be found in the rating firm by the fact that, especially in competitive markets, M-CRIL’s on-the-ground testing of likely loan loss borrowers who are unable to repay their loan can levels in branches of several big Indian MFIs. The postpone the day of reckoning by taking out a new MFIs’ financial reports showed annual loan loss loan from some other source—e.g., a competing MFI levels of about 0.5 percent of portfolio. M-CRIL or an informal lender—to pay off the original loan. investigators estimated that real losses were likely On the one hand, juggling different credit sources is to be 5–7 percent (Sinha 2010). (The prevailing rule a standard survival skill of the poor in certain markets of thumb for uncollateralized microcredit has been and does not automatically imply over-indebtedness.b that something like 5 percent tends to be an upper On the other hand, such juggling can conceal over- limit of sustainability. An annual loss rate above that indebtedness for a long time until it eventually hits level must be reduced quickly or it will tend to spin some lender’s books as a failure to pay. out of control, rising rapidly to levels that cannot be How long can borrowers’ inability to pay be compensated for through higher interest rates.) In camouflaged this way? Clearly, the more lenders a the Indian MFIs, the gap between report and reality borrower has access to, the longer an unpayable debt happened mainly because loan officers were simply can be shifted around among them, at least if there is rescheduling or otherwise renegotiating the loans no credit bureau. (Note that borrowers also roll over of borrowers who couldn’t pay, even when eventual their unpayable debt with informal moneylenders, who repayment was very unlikely. This left the loans don’t show up in any credit bureau.) Some practitioners looking like they were being paid on schedule, and will hazard a guess that it’s hard to keep such a house protected loan officers’ bonuses that were linked to of cards in place for more than a couple of years. But low delinquency.c The MFIs should have had internal we don’t know of any empirical evidence on the topic. audit systems that would flag such practices. Imagine an MFI in a competitive market that has All in all, then, high repayment rates are not a clean reported a continuous history of very high collection bill of health. a High default in a market usually involves serious over-indebtedness. But high default for a particular lender, when other lenders in the market are collecting successfully, is more likely to be a symptom of poor loan management and insufficient attention to collection systems and performance. Also note that in some repayment crises, political agitation may be a major contributor, leading to opportunistic default by many borrowers—e.g., Krishnaswamy and Ponce (2009a). Of course, the political agitation may have resulted from a real over-indebtedness problem in the first place. b E.g., Collins, Morduch, Rutherford, and Ruthven (2009) and Morvant-Roux (2009). c Rescheduling or renegotiating loans is appropriate when borrowers have temporary cash flow problems but are likely to be able to pay off their obligations somewhat later. Rescheduling is inappropriate, indeed dangerous, when it is done to postpone the day of reckoning on loan amounts that are unlikely ever to be recovered. 21 measurement is based on an admittedly crude ratio that is perfectly manageable for one borrower estimate that such a situation is unsustainable, or may be too much of a burden for another. at least that it is bad, for the average borrower.43 Even if debt ratios were perfect proxies for over- The debt service ratio compares scheduled loan indebtedness, the necessary data are usually not payments with the income available to make those readily available, especially in less developed payments. This comparison is a fundamental tool markets. Most microcredit markets do not yet of risk management for many microlenders. In have credit bureaus that cover microcredit. And most individual lending programs, a key part of the even where such credit bureaus exist, they have loan officer’s job is supposed to be sizing up a loan no income information for microborrowers and applicant’s likely repayment capacity by looking can’t give a complete picture of their debt either, at income and household expense, and seeing because so many borrowers also use informal whether there is enough surplus income to cover lenders that don’t report to credit bureaus. This the periodic payments on the proposed loan.44 problem is especially acute if there is no way to determine the borrower’s consumption expenses, Sometimes a microlender’s loan policy states an so that the ratio has to be based on income rather explicit numerical threshold—e.g., “loans should than income net of basic expenses. normally not be approved if the payments would exceed X percent of the borrower’s disposable Finally, the use of the loan proceeds can make a household income.� The percentage threshold huge difference. For example, suppose we are told may be a seat-of-the-pants guesstimate, or it may that a given borrower’s total monthly debt service be determined by analyzing historical repayment is 75 percent of monthly income. At first blush experience with thousands of borrowers: if that sounds terribly high, because it seems as if borrowers have a debt service ratio of X percent, only 25 percent is left for essential consumption what percent of the time do they default? expenses. This analysis would be near the mark if, for instance, the loan proceeds are used to pay Other microlenders require the same cash flow for a wedding. But suppose the loan proceeds are analysis, but do not define a numerical threshold. used to finance basic food, clothing, and shelter. In Either way, when the debt service ratio is judged that case, the inflow (loan disbursement) and later to be too high, the loan is refused. outflow (loan payment) of principal doesn’t change the total amount available for consumption. It is So debt service ratios can help estimate the odds only the interest expense on the loan that reduces of loan repayment. Indeed, debt or debt service consumption possibilities. The same debt service ratios are often used in efforts to quantify over- ratio might be completely unsustainable when indebtedness. But such measures have their financing a funeral, but very manageable when limitations. financing basic consumption.45 One challenge is that there is no one-size-fits-all ratio So, it is impossible to set a threshold debt service that is appropriate for everyone. Circumstances of percentage that fits all borrower circumstances well. borrowers and their households vary a lot—e.g., The problems with debt-to-asset ratios are similar. number of children, absolute size of income, etc. A But this certainly does not mean that the ratios 43 Debt-to-asset ratios are also used: over-indebtedness starts when a borrower’s total debt exceeds Y% of the borrower’s assets. This approach is close to the common definition of corporate bankruptcy as a situation where liabilities exceed assets. But debt-to-asset ratios tend to be less relevant in microfinance. Microborrowers tend to have few assets, their loans are usually uncollateralized, and the lenders typically expect to be repaid out of current income, not by liquidation of assets. 44 in group lending programs, decisions about a borrower’s creditworthiness are usually made by fellow group members, not a loan officer. But when group members make such judgments, surely it is not unusual for them think about whether the borrower has enough income to make the loan payments. 45 For an extreme illustration, imagine someone who spends his entire take-home pay every month on consumption, uses a credit card for all purchases, and pays off the card each month without incurring any interest. The debt service ratio is 100% of take-home pay, yet the use of credit rather than cash is completely manageable, and leaves the borrower no worse off. 22 are useless for market research. Not surprisingly, is carrying, and (2) borrowers postpone—and some studies have established a robust correlation deepen—their problem by taking out new loans to between a given debt ratio and high delinquency.46 pay off old ones, even though they may never be High delinquency is not the same as having serious able to retire all their debt. problems in repaying (our provisional definition of over-indebtedness), but it seems reasonable to Conceptually, there are two problems with multiple assume that there equally is a correlation between borrowing as an indicator of over-indebtedness. the debt-to-income ratio and over-indebtedness. First, someone can be over-indebted with even a single loan. Second, and more importantly, there Guérin, Roesch, Subramanian, and Kumar (2011) are many settings where multiple indebtedness is point out another limitation of debt ratios, a common, and perfectly manageable, cash flow especially for poor borrowers in developing management technique for low-income households. countries. Working with rural villages in Tamil Nadu in India, they find that debts differ in their In some cultures, the phenomenon has existed social meaning, depending on their conditions and for a long time in the informal sector. It is part of the relationships involved—especially given the the sophisticated system of money management diversity of informal loans that microborrowers may poor people have developed, where one person also be carrying. Certain debt contracts, or failure is often a borrower and a lender at the same time to pay those contracts, are more dishonoring than (Collins, Morduch, Rutherford, and Ruthven 2009; others, more difficult to handle, or more costly in Morvant-Roux 2009). Poor borrowers may consider terms of reciprocal obligations (e.g., expressing it totally normal to juggle their different sources gratitude or making a return loan at a time that of cash, including a number of lenders. They may be inconvenient). Some have tight repayment may make smart choices within their systems of schedules with high penalties on late payments, multiple indebtedness, aiming not to pay off the while others pose less of a problem even if their total amount they owe, but rather to keep their amounts may be higher. The concept of a “total creditworthiness with as many lenders as possible amount of debt� is therefore not intuitive for many as a safety net for future cash needs. They may not poor borrowers and can feel like comparing apples consider themselves at all over-indebted (Guérin, to oranges. The more we aggregate information Roesch, Subramanian, and Kumar 2011). There are into ratios and unified thresholds across a market, other good reasons for multiple borrowing that or even an industry, the further we get from the real have nothing to do with having too much debt. world of microborrowers and their experiences of Good borrowers may want, and be able to handle, over-indebtedness. larger loans than individual MFIs are ready to offer,48 or an additional opportunity may come up Multiple borrowing. Once borrowers have in the course of a loan cycle. An emergency can be access to competing lenders, some take loans a good reason to borrow anew without implying from more than one of those lenders at the same over-indebtedness. Finally, additional loans may time. Multiple borrowing—or to be more precise, help manage an unfavorable timing of disbursement cross-borrowing—is often seen as a proxy or or a strict repayment schedule that doesn’t fit a early warning signal for over-indebtedness.47 The borrower’s cash flow. In short, multiple borrowing standard picture includes two problems: (1) if there options are beneficial for many borrowers. is no credit bureau, borrowers accumulate more debt than they can handle because lenders have no Empirical findings are mixed. Most studies have way of knowing how much other debt the borrower found at least some degree of correlation between 46 e.g., Maurer and pytkowska (2010), Vogelgesang (2001), rinaldi and sanchez-arellano (2006). 47 strictly speaking, “multiple borrowing�—carrying more than one loan at a time—would include having two or more loans from a single lender. “cross-borrowing� refers to simultaneous loans from different lenders. This section focuses on the latter situation. But we retain the term “multiple borrowing� because it is the one most commonly used. 48 e.g., Grammling (2009). 23 multiple loans and repayment problems.49 But Some researchers have looked at the sacrifices studies in other settings have found no such borrowers make to repay.50 Others have framed correlation. For instance, Gonzalez (2008) found a formal over-indebtedness definition along these that the Bolivian over-indebtedness crisis in the late lines.51 1990s was not associated with multiple borrowing. The indicator would not have revealed that an over- Gonzalez’s (2008) definition is that “over- indebtedness crisis was going on. Another study indebtedness occurs when the repayment actually found a negative relationship between outcome of a loan contract does not correspond multiple loans and repayment failures—i.e., multiple to the original expectations of either the borrower borrowers repaid better than those with single loans or the lender or both.� Even if they eventually (Krishnaswamy 2007). This somewhat surprising repay, microborrowers are over-indebted already finding might be explained by hypothesizing that when payment requires more costly actions than the more skilled money managers were more likely expected. This is quite a broad concept of over- to take on multiple debts. Alternatively, it might indebtedness. It includes costly actions even if the be that those with multiple loans were temporarily borrower might not view them as sacrifices.52 postponing an inevitable delinquency or default; longitudinal research would be required to test this According to Schicks (2010), the threshold of over- explanation. indebtedness is reached when a microborrower “is continuously struggling to meet repayment To sum up, there is reason to believe that, for some deadlines and structurally has to make unduly borrowers, multiple borrowing can be a step on the high sacrifices related to his/her loan obligations.� path to over-indebtedness, but, by itself, it is not a Especially in the context of an industry that says reliable measurement to identify over-indebtedness its purpose is to help the poor, microborrowers problems in a population. At best, it might be a who manage to repay only by sacrificing minimum useful piece of a multi-factor over-indebtedness nutrition levels or their children’s education should index. be counted as over-indebted. In the context of short-term microlending, this definition treats Borrower struggles and sacrifices. The above over-indebtedness as a structural phenomenon. measures leave out some people we normally Only repeated sacrificing or severe sacrifices that would think of as over-indebted, and include indicate persistence of debt problems meet the people we would not think of as over-indebted. Our threshold. earlier provisional definition—borrowers are “over- indebted� if they have serious problems in paying But when are sacrifices “unduly high�? In the off their loans—was chosen because we think it absence of any objective standard that would corresponds to what most people have in mind apply in all settings, Schicks’s approach is to let when they use the term. If borrowers simply can’t the borrowers themselves indicate the outer limits repay, almost everyone would regard them as over- of the level of sacrifice they feel is acceptable. If indebted. If certain borrowers do manage to repay the focus is on the level of distress experienced by their loans, but have to make extreme sacrifices to borrowers, then their subjective judgment is the only do so, most of us would think they probably have source that can take all individual circumstances and too much debt. (More later on what’s “extreme.�) complexities of the debt phenomenon into account. 49 e.g., Maurer and pytkowska (2010), chaudhury and Matin (2002), care/Bangladesh (2005), Martinez and Gaul (2011), Grammling (2009), Krishnaswamy and ponce (2009a). 50 e.g., care/Bangladesh (2005, 2005a). 51 cf. rhyne (2010). 52 Gonzalez’s definition includes opportunistic default (in this case, it is the lender’s expectations that are not met), even though most people would not describe such defaulters as over-indebted. 24 Like any other approach with subjective elements, hurt by their loans, it is still very useful as an using borrower judgments about the acceptability indicator. First, if a large proportion of borrowers of sacrifices has its downsides. It has to deal with the are struggling to repay their loans, we would want idiosyncrasies, biases, and honesty of respondents. to know that regardless of whether the loans are This can be an acceptable challenge in a research ultimately pluses or minuses in their lives. Better context but would be problematic for regulatory loan analysis, more flexible loan policies, or other purposes. Box 3 illustrates one approach to measures (even alternatives to credit) might reduce implementing this struggle-and-sacrifice definition the problem. in on-the-ground research, showing that it can deliver useful results. Second, repayment struggles may not prove negative impact, but it seems reasonable to think There is also an ethical complexity. If over- that, all other things being equal, higher levels of indebtedness is defined in terms of subjective borrower struggle increase the probability that the acceptability of sacrifices, then one might loans are actually making people worse off. And the conceivably make the perverse argument that borrower’s judgment that sacrifices were related the way to reduce over-indebtedness is to to the loan and “unacceptable� given the loan’s condition borrowers to accept greater sacrifices. purpose implies a certain relationship to impact. Nevertheless, the idea that borrowers are not The link between struggle and negative impact over-indebted if they are happy with their loans in gets stronger when the definition includes only spite of some struggle is powerful from a consumer those sacrifices that borrowers themselves judge protection perspective. For example, reducing as “unacceptable.� Presumably, borrowers would the stigmatization of borrowers in difficulty and be less likely to feel that repayment sacrifices are enhancing their safety network may be a valid unacceptable in situations where they think the measure to ease over-indebtedness. loan has made them better off, notwithstanding the sacrifices. Finally, the notion that borrowers are suffering from serious sacrifices to repay their loans might lead to an inference that the loans have hurt the borrowers Finally, tracking this kind of indicator (like some of and that we’d therefore prefer to prevent such the other indicators) over time can reveal important loans. This inference is not necessarily true. For trends and perhaps reveal growing problems before instance, a borrower who has to go without food for they hit the lenders’ delinquency reports. We would two days to repay a loan may have taken the loan argue that, for survey work oriented to consumer in the first place to avoid going without food for a protection, it is the most powerful of the definitions. full week. In this scenario, the loan has helped the borrower notwithstanding the serious and repeated Composite indicators. Finally, when no definition repayment sacrifices. Struggle and sacrifice are is free of challenges, it makes sense to adapt the not the same as negative impact.53 Given the low, definition and measurements we are working with variable, and vulnerable incomes of poor people, to the questions we ask. It is not one solution we coming up with the money for any cash need, are looking for but a set of responses to the various not just loan repayments, often requires serious purposes of measuring over-indebtedness. A client sacrifice.54 This consideration might temper our protection question is likely to work best with one judgment as to what level of struggle-and-sacrifice of the latter definitions; a regulatory definition over-indebtedness is reasonable in microlending. is more likely to use fixed criteria that might be imperfect but at least provide clear guidelines. And Even if measuring struggle and sacrifice doesn’t a risk management definition for lenders may look automatically tell us that borrowers are being slightly different again. 53 in this simple example, the borrower would probably not rate the sacrifice of going without food as “unduly high.� But real situations are usually more complex. 54 cf. footnote 56. 25 One approach to deal with the limitations of the 4. The Empirics of Microcredit various criteria is to combine several measures Over-Indebtedness: What We into a composite indicator. One such example, in Know to Date a developed nation context, has been suggested by the European Commission (2008). For the We have been able to locate six field studies that political purpose of approximating the number of try to quantify microcredit over-indebtedness. consumers with over-indebtedness problems in Given the small number of studies, our ability to a society, it combines subjective elements, such generalize is limited. But most of them have found as the household’s perception that repayment is levels of over-indebtedness (variously defined) “very difficult� and the debt a “heavy burden,� that seemed higher than what the conventional with objective criteria, such as persistent arrears wisdom about microcredit might have suggested. and debt or other required payments that push a As noted earlier, a normal, “healthy� level of household below the poverty line. Applying several over-indebtedness—i.e., a level that couldn’t be indicators simultaneously reduces the number lowered without undue restriction of loan access— of subjects who fall into the over-indebtedness is probably higher than what we would expect or category, while applying them selectively increases want to see at first intuition. But even with that the number. See Box 3 for a brief discussion of caution in mind, the levels of over-indebtedness financial vulnerability indices. found in most of the studies seem worrisome. On the other hand, most of the markets studied were The microfinance industry needs empirical research selected precisely because local observers were to identify proxies, or proxy combinations, that not concerned about over-indebtedness problems,55 only correlate well with over-indebtedness but are so the small sample of countries is highly skewed. practical for ongoing collection. Kappel, Krauss, A brief discussion of each of the studies follows, and Lontzek (2010), described in the next section, with key points summarized in Table 1. report on work toward an early warning index that incorporates multiple indicators. Bolivia. Gonzalez (2008) relied on a 1997–2001 household survey. He identified 1,256 households that had at least one microloan during the period and were willing to repay it. Three quarters of these households had to resort at least once Box 3. Financial Vulnerability Indices to costly, unanticipated measures to repay the loan. The list of costly measures included having The University of South Africa’s Bureau of Market Research has developed a Consumer Financial to work more than one’s regular schedule Vulnerability Index (CFVI), which combines income (66%), liquidating financial savings (47%), having vulnerability (household income and savings) with remittances specially sent for the purpose (29%), expenditure vulnerability (consumption and debt service) (van Aardt and Moshoeu 2009).a CFVI selling productive assets (23%), getting a new loan incorporates a broad range of financial obligations, to repay another (10%), and others. not just debt service. Conceptually, this is a superior approach. Being short of money to pay a debt is Gonzalez’s definition of over-indebtedness was not that different from being short of money to make any other required payment. Likewise, the an unusually expansive one. It included some inclusion of income in the equation makes sense. repayment measures (e.g., working extra hours Difficulties spring not from payment obligations, or drawing on savings) that most people would but from a mismatch between payment obligations not regard as drastic, even if the household didn’t and income. Collecting this fuller set of information is, of course, more challenging, especially in less anticipate them at the time of the loan. And a developed countries. single occurrence of such actions over a four- a See also European Commission (2008). year span was enough to count the household as over-indebted. So it is not surprising that the 55 Bolivia, Ghana, country X, Karnataka, Tamil nadu, south africa 26 proportion of people who were over-indebted by levels much higher than what the MFI’s ongoing this definition was quite high—85 percent.56 collection statistics would have suggested at the time of the study. More than half the Gonzalez found that, for his sample as a whole, borrower respondents had more than one loan there was no significant association between at a time, and cross-borrowing did correlate with multiple borrowing and over-indebtedness. over-indebtedness, even though many cross- Surprisingly, in spite of the comprehensive borrowers were not over-indebted. Grammling information (including past repayment problems) concluded that multiple and over-indebtedness the Bolivian credit bureau collects, he couldn’t were growing fast, and that a credit bureau was detect a significant relation between use of a urgently needed. See Box 4 for a discussion of a credit bureau and lower loan delinquency. later Ghana study. Ghana. Grammling (2009) studied cross- Country X. A restricted-distribution study used indebtedness and over-indebtedness among a sample of roughly a thousand microborrowers borrowers at an MFI affiliate in Ghana, using a at a half-dozen institutions. Levels of over- combination of techniques, including “rapid indebtedness were assessed using data on client market appraisals� of microfinance clientele in debt service and income from a credit bureau and markets, villages, and the MFI’s premises; in-depth the lenders’ loan files. In a second phase, problem interviews with the MFI’s clients; and an exchange clients and lender staff were interviewed to shed of information on a sample of clients of the MFI light on the causes of over-indebtedness. and two competitor MFIs.57 Over-indebtedness was based on a debt-service Over-indebtedness was broken into three ratio: households’ monthly loan payments divided categories: by gross income net of expenses:58 • Not over-indebted. • Not over-indebted—debt service below 75 • At risk of becoming over-indebted—the percent of net income. borrower is decapitalizing, but business assets • At risk of becoming over-indebted—debt exceed liabilities. service between 75 and 100 percent of net • O v e r- i n d e b t e d — t h e b o r ro w e r is income. decapitalizing, and business assets do not • Over-indebted—debt service more than 100 exceed liabilities. However, private assets percent of net income. are not included in the analysis, so it can be assumed that some borrowers in this category Among the borrowers studied, 17 percent were will manage to pay their loan by selling classified as over-indebted and 10 percent as nonbusiness assets. at risk of becoming over-indebted. Multiple borrowing correlated strongly with over- The researchers assessed the over-indebtedness indebtedness. Poorer clients were more likely to level of each borrower, based on interviews, loan be over-indebted. The average monthly income of files, and information exchanged among MFIs. over-indebted households was less than half that of the not-over-indebted households. Twelve percent of the MFI’s borrowers were found to be over-indebted, and 16 percent were Karnataka, India. In 2009, there were mass judged to be at risk of over-indebtedness— defaults, largely by Muslims, in several towns 56 Gonzalez’s focus was not to identify problem lending, but rather to explore clients’ willingness to make extra efforts to repay loans. 57 in Ghana (and no doubt in some other countries as well), borrowers are culturally reluctant to discuss loans, and especially their difficulties in repaying loans. Grammling provides a useful description of techniques he used to overcome this problem. 58 This analysis treats household expenses as a fixed amount per month (probably drawn from loan officers’ appraisal of borrowers’ cash flow as recorded in the MFis’ loan files). in fact, household expenditures are somewhat flexible and can rise or fall to accommodate loan payments. 27 that had mass defaults and two similar towns Box 4. Recent Over-Indebtedness where such defaults did not occur. Study in Ghana Two years following the Grammling study, after the In the mass-default towns, 21 percent of Ghanaian microfinance market stopped growing respondents said repayment was a burden (versus and MFIs became more careful with disbursements, one of the authors of this paper returned to Ghana only 3% in the nondefault towns); 34 percent said to analyze over-indebtedness in more detail. In they had skipped important expenses, including cooperation with the Independent Evaluation meals, or sold/mortgaged assets to repay loans Department of the German development bank KfW (versus 2% in the nondefault towns); and the amount and the Smart Campaign, the study is the first to apply an over-indebtedness definition that is based of weekly loan service actually paid at the time on excessive sacrifices in quantitative empirical of the crisis averaged 27 percent higher than the research. borrowers said was affordable (versus 4% less in the The researchers asked more than 500 microborrowers nondefault towns). In the mass-default towns, some from five of Ghana’s top MFIs about their of the default was probably opportunistic. One can experiences with their loans. They collected detailed only speculate as to how much the opportunistic information on the borrowers’ personal situation, default and the environment of political agitation financial literacy, risk attitude, and borrowing behavior. Most importantly, they mapped current may have skewed borrowers’ accounts of their outstanding loans for every borrower and collected sacrifices in the mass-default towns. a detailed list of whatever sacrifices borrowers had to make to repay. Borrowers rated the acceptability An index of subjectively reported debt stress was of each sacrifice on a subjective scale from “easily acceptable� to “not acceptable at all.� For example, found to be correlated with debt service ratio, they would rate “cut down on eating� as acceptable income shocks during the preceding year, income if it was about buying less meat in a week and as variability, and numerical literacy, among others. rather unacceptable if it was about going hungry and eating only a single meal per day. Their Tamil Nadu, India. Combining quantitative and subjective judgment showed a fairly high tolerance for sacrifice, some borrowers finding it acceptable to qualitative research methodologies, Guérin, eat less or sell their belongings. Borrowers indicated Roesch, Subramanian, and Kumar (2011) find that how frequently they experienced each sacrifice. the average household in the sample villages in South India has about one year’s household The study sheds new light on over-indebtedness, tackling it from a thoroughgoing customer income outstanding in debt and is making monthly protection perspective. By quantifying sacrifices, repayments that amount to half of its income.59 the study gives struggling borrowers a voice and provides insights into the efforts microborrowers The paper argues that over-indebtedness is make to meet their payment obligations. Additionally, the data will enable us to reassess a complex social concept that has multiple whether over-indebtedness is a significant problem meanings. For the purpose of the study, it defines in Ghana and to test some of the potential drivers over-indebtedness as a process of impoverishment that we have discussed in Section 2 of this paper for through debt, distinguishing three different levels: their relevance in the Ghanaian microfinance setting. Watch upcoming Smart Campaign publications from the Centre for Financial Inclusion for results. • Transitional over-indebtedness—debt servicing leads to a poverty trap, preventing any accumulation of assets, but households in Karnataka, prompted in large part by orders have effective strategies in place that promise from local Muslim organizations banning Muslims a reduction of debt in the future. Average from continuing contact with MFIs. Krishnaswamy debt levels of 1.4 annual household incomes. (2011) reports on a CGAP study, conducted by the Debt service around one-third of monthly consulting firm EDA, of borrowers in two towns household income. 59 some alert readers may wonder how the math in this sentence works. it makes sense if some of the debt is amortized over a period greater than a year. The most common sources for loans in Guérin’s study were “well-known people� and “pawnbrokers.� self-help groups, which are often included within the boundaries of “microfinance,� ranked third, being used by 41% of the households. 28 • Pauperization—in spite of assets sales, debt only 3–4 crisis countries. The authors acknowledge levels continue increasing, just to service that this imposes severe restrictions on the existing debts and ensure household survival. reliability of the index, but the paper takes an Households survive on multiple borrowing important first step in developing a methodology and have no realistic prospect of meeting for predicting country-level repayment crises. their repayment obligations in the long run. Average debt levels of 3.2 annual household The study focuses on over-indebtedness in the incomes. Debt service ratio around 100 sense of repayment problems, defining it as percent. a chronic and involuntary inability to meet all • Extreme dependence—households depend payment obligations by means of the household’s on kin support and charity for daily survival excess cash. It approximates over-indebtedness and have no possibility of ever repaying their on the country level, using 30- and 90-day arrears debt. Many cases lead to complete social as a measurement of crisis outbreak and the loan isolation and loss of self-dignity. The average loss rate and write-off ratio as measurements of debt level of this group is 13 times its average continued crisis.62 On an individual level, it uses a annual household income. debt service ratio as proxy for over-indebtedness. Of the original sample of 344 households, Guérin, Drawing on the available data for a modified Roesch, Subramanian, and Kumar studied only approach of signaling analysis and sometimes on the most indebted 20 percent in detail. Out of hypotheses from the literature or the judgment these 68 households, 13 (19%) have fallen into of microfinance practitioners, Kappel, Krauss, and “transitory over-indebtedness,� 26 (38%) represent Lontzek (2010) identify 14 potential early warning cases of “pauperization,� and 29 (43%) suffer from indicators for over-indebtedness: “extreme dependence.�60 The findings suggest that over-indebtedness is also prevalent among 1. Remittances households that didn’t fall into this subsample. 2. Market penetration Twenty percent is, therefore, the absolute 3. Growth rates of total volume of loan portfolios minimum estimate for overall over-indebtedness 4. Quality and use of credit information sharing in the original sample. systems 5. Perceived commercial bank involvement Analyzing the causes that lie behind the over- 6. Perceived level and trends in competition indebtedness phenomenon, Guérin, Roesch, 7. Perceived investment flows Subramanian, and Kumar make out two major 8. MFI liquidity forces: over-indebtedness seems to result from 9. Average loan balance per borrower the combination of material poverty and growing 10. Loan requirements and lending methodologies social aspirations. 11. Productivity 12. Growth and market targets Multi-country study. Kappel, Krauss, and Lontzek 13. Multiple lending (2010) develop a preliminary early warning index 14. Consumer lending for over-indebtedness on a country level, using primary data from an MFI survey combined The study concludes that countries such as Bosnia– with secondary data from MIX Market61 and Herzegovina, Cambodia, and Peru currently have macroeconomic databases. The sample is limited the highest over-indebtedness risks among the 13 to 13 countries and is based on the experience with sample countries. Bolivia, Ecuador, El Salvador, 60 We are providing percentages to give the reader an idea of the magnitude of problems identified by this study. However, we cannot draw reliable statistical conclusions about the distribution of households within this smaller subsample of only 68 respondents. 61 Microfinance information exchange, an online information portal based on self-reports but offering the broadest global database on MFis to date. www.mixmarket.org 62 The loan loss rate and write-off ratio measure unrecoverable loan amounts as a percentage of total loan portfolio. 29 and Georgia display the lowest risks of over- support access to finance) that might prevent or indebtedness according to the selected indicators. remedy over-indebtedness. The list of such steps is fairly long. We can provide only a brief, broad- [There have been several studies of over- brush survey here—full discussion of any one of indebtedness among low-income and other the topics would require a separate paper. borrowers in South Africa. We have not included them here because little of the lending involved Note that this paper does not address actions by was the kind of microcredit that is the focus of this regulators. paper. Nevertheless, it’s worth noting that these South Africa studies have generally found worrisome Despite the desire for concrete, down-to-earth levels of over-indebtedness.63] As noted, the list of advice on what to do and what not to do, on quantitative studies available so far seems much too most topics we avoid recommendations, not short. We hope that many more researchers will work only because the evidence base is thin, but also on such studies, including not only academic research because the usefulness of the action depends but also less rigorous market research conducted by heavily on local circumstances. We cannot offer a MFIs and regulators. See Table 2 for a summary of how-to manual, but rather we can offer a checklist the empirical studies discussed in this section. of options to consider along with a few factors to bear in mind when considering them. We begin 5. What Can Be Done? with measures that MFI managers can take, and then turn to possible actions by funders. (See Finally, we will look at practical steps by lenders Box 5 for a discussion of the Smart Campaign’s (and, secondarily, by donors and investors that consumer protection resources.) Table 2. Summary of empirical studies Setting Definition (Author) Methodology of Over-indebtedness Findings Bolivia 1997–2001 HH survey Costly unanticipated 85% of HH had at least (Gonzalez 2008) actions to repay one occurrence during the four years Ghana 2009 Rapid market assessment, Business decapitalizing (as 12% over-indebted, (Grammling 2009) borrower surveys, info assessed by researchers) another 16% at risk exchange between MFIs Country X 2009 Debt service and expense Debt service greater than 17% over-indebted and (restricted report) data from credit bureau 100% of HH income net of another 11% at risk (debt and loan files of lenders other expenses service 75–100% of net income) Karnataka, India, 2010 Loan records and HH Subjective report of stress; Over-indebtedness high (Krishnaswamy 2011) survey sacrifices to repay in mass-default towns, but low in nondefault towns Tamil Nadu, India 2005– Qualitative interviews, Impoverishment through More (possibly much 2009 observation, and HH debt more) than 20% over- (Guérin, Roesch, survey (N=344) indebted Subramanian, and Kumar 2011) Multi-country study Preliminary composition Chronical and involuntary 14 potential early warning (Kappel, Krauss, and of an early warning index, inability to meet all indicators for over- Lontzek 2010) largely based on signaling payment obligations by indebtedness. Highest analysis with an MFI means of the household’s risk countries in sample: survey and MIX Market excess cash. Proxies: Bosnia–Herzegovina, data arrears, write-offs, loan Cambodia, Peru losses, debt service ratio 63 e.g., collins (2008) 30 payments.64 Note that if an MFI allows penalty-free Box 5. The Smart Campaign prepayments, borrowers are more likely to pay off The Smart Campaign is a global coalition of their loans during good times, which obviously hundreds of MFIs, investors, donors, and other eliminates the risk that they will run into trouble industry players who are committed to keeping clients’ welfare as the driving force in microfinance. meeting later payments. Its Client Protection Principles include a heavy focus on avoidance of over-indebtedness. For a list Whatever the relation to over-indebtedness, of normative recommendations in this regard for MFIs, see Smart Campaign (2011). More generally, improving product flexibility and, more generally, the Campaign’s Web site (www.smartcampaign. matching products better to client needs are org) offers a wealth of client-protection resources. important overall goals for the microcredit industry. And it seems strongly plausible that over-indebtedness would be lower if amortization We begin with measures that MFI managers can schedules could fit better with the timing of take, and then turn to possible actions by funders. borrowers’ incomes, and if more flexibility could be allowed in repayment. However, we don’t MFI actions want to imply that all microlenders should be moving to flexible loan products right now. All MFIs can consider revisions to product design: other things being equal, flexible products tend to be more complex and expensive to administer, Flexible loan product offerings that better and there are situations where insisting on too meet client needs. The incomes and expenses of much flexibility can actually limit access. General microborrowers tend to be irregular and unreliable. discussions like this one can’t go very far toward The harder it is for them to match their actual cash defining the proper balance among flexibility, flow with their loan repayment schedule, the more cost, risk, and access. That question should be debt stress is likely to occur. addressed in specific settings, based on the particular characteristics of individual lenders and In the early years of microcredit, most MFIs settled their borrowers. on one-size-fits-all loan products with lockstep installments due every week or every month. More conservative loan amounts and increments The MFIs understood that this rigid approach on graduated lending ladders. Lenders might didn’t fit their borrowers’ cash flows very well. lower the size of new clients’ first loans, or slow They chose the model because a single cookie- the growth in loan sizes when previous loans are cutter product helped keep costs low (cost was repaid, or not grant the same size increase to the central challenge of early microcredit), and everyone automatically. Steps like these should frequent regular installments reduced repayment be approached cautiously, because they directly risk for uncollateralized borrowers. reduce loan access. As noted, clients are often driven to multiple borrowing (including informal But much of the industry has moved a long way up borrowing) because they want, and can handle, the learning curve since then. Lending institutions loan amounts that are larger than an MFI is willing are more experienced and solid. Numerous MFIs to give them. have demonstrated the skill needed to offer multiple loan products, including more flexible Savings. Voluntary savings products might also products, without delinquency or costs spinning play a role in reducing borrower stress. If the MFI out of control. Grameen Bank, for instance, has offers convenient, safe, liquid savings vehicles, its had great success with its Grameen II product customers will use them. A customer with a liquid line up, which includes options for borrowers savings cushion would seem less likely to have to who have temporary problems making their make extreme sacrifices, such as selling a business 64 e.g., rutherford, Maniruzzaman, sinha, and acnabin & co (2004). 31 asset or taking a child out of school, to make a loan requirements of their loan clearly would be less payment. likely to over-indebt themselves. And indeed, there is a straightforward case for informing borrowers Nonliquid “commitment� savings products, with about the obligations they are undertaking, restrictions on withdrawal, and/or incentives to whether or not it reduces over-indebtedness. make regular deposits, can play a role as well. As Even in the absence of regulatory requirements, discussed in Section 2, many poor people take MFIs should ensure that borrowers get a brief, out loans to help themselves with the discipline understandable statement of how much net cash to save—i.e., to set aside a regular amount each will be disbursed to them, the expected repayment period and protect it from the temptations of schedule, any fees and penalties, and perhaps immediate consumption. They find this service so other key terms and risks (e.g., the consequences valuable that they are willing to pay high interest of default).66 The format for such disclosure needs rates to save this way. A good commitment savings to be tested for intelligibility—information that product would be much better than debt for this is complete and accurate may still be useless if purpose. The borrower’s cost and risk are both it is stated in language that borrowers cannot much lower that way.65 digest, or is buried in a lengthy and complicated disclosure document. MFI managers have reported that when loans are funded largely by local community deposits, both When it comes to disclosure of interest costs, the loan officers and borrowers are more responsible picture is more complex. Theoretically, the ideal about putting those funds at risk. And finally, a interest rate disclosure format would capture all loan officer may be less likely to twist a borrower’s information about amount and timing of cash flows arm to take out an inappropriate follow-on loan if in a single number that can be used to compare the MFI will have a continuing deposit relationship the cost of various forms of credit that may be with the customer. structured quite differently. Discounted cash flow calculations, such as the annual percentage rate MFIs can consider adjustments to their sales (APR), do this, and APR is the standard disclosure process: tool in most of the world. Marketing practices and follow-on loans. Some marketing practices—e.g., targeting active clients But an emerging body of evidence suggests that of another microlender with offers to add to APR disclosure doesn’t work very well, at least by their debt level—can intensify the risk of over- itself. However accurate it might be, it seems to fall indebtedness. short of the desired effect on borrower behavior, especially for lower income and less sophisticated Loan officers should avoid pressuring existing borrowers, in both rich and poor countries.67 It clients who have repaid a loan to take out another seems likely that in most microcredit settings, one immediately, especially if the clients don’t clients will be better served by complementing need a new loan just then. Particularly, they should or replacing APR with some other price disclosure not say, or imply, that these clients will lose access method—e.g., a simple statement of the total to future loans if they don’t borrow constantly. amount of interest and fees that the borrower will pay over the life of the loan. The Philippine central Clear disclosure of loan terms. It seems plausible bank is involved in field research testing various that people who understand the costs and other forms of interest disclosure with microborrowers. 65 see abed (2011). 66 although it is less common among microlenders, late-payment penalties can be a major source of income for some lenders. But such penalties are usually not included in apr calculations, because there is no way to predict their amount at the beginning of a loan. 67 e.g., collins, Morduch, rutherford, and ruthven (2009); Bertrand and Morse (2010); robb (2007); Barr, Mullinaithan, and shafir (2008); elliehausen (2010); Brix and McKee (2010). 32 Financial literacy. Growing concern about over- consumption and other expenses, including, indebtedness is matched by growing interest where possible, debt service on other borrowings. in programs that help cultivate the knowledge, The risk of adverse shocks to income and expenses skills, attitudes, and behavior people need to make should be considered. sound financial decisions. Some MFIs deliver such material to customers at the preloan stage. Often However, information about the borrower’s other such programs are also promoted by governments, debts may be difficult to get if there is no credit educators, and civil society actors. Evidence so far reporting system, and even a good credit reporting about the effectiveness of these programs seems system will not capture debts to informal lenders.69 mixed.68 More research and experimentation is We discuss credit reporting later in this section. needed. This kind of cash flow analysis is a common feature Expand into new areas rather than already of individual and solidarity group lending,70 even served ones. As noted in Section 1, MFIs often though it is not always vigorously implemented. prefer to expand into areas where some competitor It is far less common in group lending. In some has already developed customer awareness of circumstances, the threat of over-indebtedness microcredit and demonstrated a strong market, might require substantial adjustments to group rather than expanding into previously unserved lending techniques. After an over-indebtedness localities. As MFIs become more aware of the crisis, Kashf Foundation in Pakistan eliminated risks to themselves and their customers posed by group lending and moved to an individual model oversaturated local markets, we hope that they where loan officers analyzed each borrower’s cash will channel their expansion more often into un- flow, though this roughly doubled the cost of or underserved areas. This could reduce over- lending.71 As a less drastic alternative, the Negros indebtedness and improve outreach at the same Women’s Trust for Finance in the Philippines is time. experimenting with training group borrowers to analyze each other’s cash flow.72 Many MFIs face key issues in their loan underwriting (i.e., analysis of borrower credit- MFIs sometimes fail to refresh the cash flow worthiness). analysis when borrowers take out follow-on loans that are much larger than the original loan for Cash flow evaluation. The most obvious way to which the analysis was performed. reduce overindebtedness risk is to strengthen the assessment of a borrower’s repayment Specific limits on debt service ratios. Once the capacity before approving loans. This starts with cash flow analysis is done, an MFI may constrain determining the amount, regularity, and reliability loan officers’ discretion by imposing a cap on the of the borrower’s (or, more typically, the borrowing debt service for the proposed loan as a percentage household’s) income. Income has to be matched of net income—e.g., a loan will be denied if the against outgoing cash flows, including not only repayments would constitute more than X percent the debt service on the proposed loan, but also of household income minus consumption and other 68 e.g., Bilal (2010). 69 clients are usually not forthcoming about their other debt. They perceive (quite correctly) that disclosing other debt may hurt their chances of getting their loan approved. in the absence of a credit reporting system, one possible approach to improving clients’ incentives to disclose might be for microlenders to make it clear to borrowers that (1) carrying multiple loans is fine as long as total debt service doesn’t exceed repayment capacity, and (2) failure to disclose other active loans (perhaps only loans from formal lenders) will, if detected, result in the cancellation of the current loan and the borrower’s permanent exclusion from the MFi’s services. e.g., the lenders could try to locate occasional examples of false disclosure by informal consultations with other lenders, and make sure that its broad clientele is aware that the sanctions are in fact enforced vigorously in these cases. This approach sounds harsh, but it could reduce over-indebtedness. 70 in solidarity group lending, borrowers are organized into small groups, but the MFi lends to individuals rather than the group, and assesses each individual loan separately. 71 roshaneh Zafar at the 2011 Boulder MicroFinance Training. Kashf’s Web site is www.kashf.org. 72 roque caseres at the 2011 Boulder MicroFinance Training. The MFi’s Web site is www.nwtf.ph. For suggestions on loan underwriting in group lending, see smart campaign (n.d.). see also smart campaign (2010) for a recommendation against approving loans based solely on guarantees by others, when there has been no appraisal of the borrower’s repayment capacity. 33 expenses (including debt service on other loans). borrower. In addition, inappropriate rescheduling The MFI may or may not allow exceptions to the may allow borrowers to dig themselves deeper policy based on a specific approval process.73 into debt problems instead of facing them at an early stage where less drastic solutions might still Verifying borrowers’ repayment history and be available. other debts. Where there is a credit reporting system, MFIs need to be sure their loan officers Getting the rules right involves some tricky use it to identify borrowers who have experienced balancing. Opening the door to loan rescheduling problems with repayment in the past, as well as to introduces ambiguity and may increase costs, but find out what debts the borrower has with other keeping this door totally shut hurts borrowers who formal lenders. Even in the absence of a formal have run into honest repayment difficulties but are or informal credit reporting system, MFIs may be likely to be able to pay eventually. MFIs need clear, able to tap community knowledge, or use other carefully thought out renegotiation policies. techniques, to identify borrowers who are in debt to another lender. And in any circumstances an Restraining abusive collection. Over-aggressive MFI can, of course, check its own collection history loan collection practices are doubly dangerous. with the borrower; surprisingly, a few MFIs fail to They increase the likelihood that borrowers will do this systematically. make draconian sacrifices to repay, which may be good for the lender but can be bad for the An MFI’s collection process is another arena for borrowers. And conscience-shocking collection possible action. practices have often fueled major political backlash. Appropriate policies for renegotiation of loans. When borrowers cannot meet a payment, Which practices are abusive? Some—e.g., physical loan officers or managers may renegotiate the threats—should be unacceptable in any setting. delinquent loan, either by amending its terms to But as long as they do not reach the extent of stretch out the repayments (rescheduling) or by harassment, the acceptability of others—e.g., giving the borrowers new loans they can use to repeated visits to a borrower’s house, publicizing pay off the old ones (refinancing). The motivation the names of nonpaying borrowers, or pressure for the renegotiation may be to accommodate from other members of a borrower’s group—may individual borrowers who are likely to be able to depend on local attitudes and culture. repay eventually. This is appropriate. As discussed earlier, literal enforcement of a zero-tolerance Collection practices need to be effective, without policy is seldom desirable. But often, staff—with trespassing on the courtesy and respect clients or without the collusion of branch managers— deserve. This can be a delicate balancing act. MFIs will extend or roll over loans for a borrower who need to define acceptable practices with care and has no realistic prospect of eventual repayment, specificity.74 to protect salary bonuses that are tied to loan repayment. This kind of renegotiation is extremely Penalty interest. Some lenders charge higher dangerous, because it can conceal from central interest on late payments. This has obvious value management a serious outbreak of repayment as a repayment incentive, but it can be dangerous. problems until it spins out of control. Perversely, a Not only does it add to the payment obligation of policy that prohibits loan rescheduling altogether already overburdened borrowers, but in addition, if can make it more likely that loan officers roll over a lender is making a substantial portion of its profit uncollectible loans by issuing new ones to the same from late fees, it may have created, intentionally 73 The smart campaign (2011) cautions that if the lender is calculating debt service ratios, “[i]t is also useful to have a qualitative definition of over- indebtedness to help staff keep the main objective in mind and to avoid the rote use of numeric tools.� an example of such a definition is a state in which a borrower has to make significant sacrifices to his or her standard of living or business affairs in order to repay debts. 74 The smart campaign’s checklist on collection practices is at http://www.smartcampaign.org/storage/documents/Tools_and_resources/ collections_Guidelines_Final.pdf. For a good example of a collections policy, see swadhaar (2011). 34 or unintentionally, an incentive to get borrowers Written policies, and enforcement through in trouble. internal audit. Whatever policies the lender adopts on each of the topics discussed so far Internal redress mechanisms. Problems and in this section, they should be stated in writing, misunderstandings inevitably arise in the course communicated clearly to loan officers, and of collections as well as other aspects of credit reinforced periodically. delivery. They can be addressed better if the lender has a clear and fair dispute process Even when an MFI puts its policies in writing that is known to customers, readily accessible, and communicates them clearly, the parts that and efficient. Some complaints turn out to are inconvenient for loan officers will not be be inquiries or misunderstandings. If they are implemented consistently unless incentives handled well, the borrower ends up more loyal are properly aligned. One strong incentive is a to the lender; if not, the borrower may be less vigorous system of internal audit that regularly inclined to meet his or her loan obligations. In checks on compliance with these policies. other cases, legitimate complaints may point to inconsistent or inappropriate behavior by staff Most MFIs use people with accounting backgrounds (e.g., pressure to borrow more than desired, to staff their internal audit department. But for overly aggressive collections) or their failure testing loan officer behaviors like the ones we’ve to follow established policy. If customers know been discussing, managers should strongly where to go in such cases and have confidence consider adding former loan officers into their that they will get an even-handed hearing and internal audits. Former loan officers “know all that the matter will be dealt with promptly, the tricks,� and they will be much more effective the lender has a chance to identify credit risk at interviewing loan officers and borrowers— trouble spots, ensure compliance with policy, an essential component in testing compliance and take appropriate action against infractions. with the policies discussed above. Staff whose The lender also receives valuable feedback that background is accounting are more likely to focus can inform improvement in loan products and on paper documentation. processes. Specialized portfolio audits. Normal external Some lenders place internal dispute resolution audits of MFIs, and sometimes even bank with a person or unit that is separate from lending examinations by prudential supervisors, do not operations, and reports to senior management or look at loan portfolio quality intensively enough the board. Special care should be taken to ensure to provide solid assurance that the reported that customers know their options for recourse. collection performance reflects reality. This is a Some lenders’ procedures for handling borrowers serious gap. Loan collection is far and away the with serious repayment problems include one-on- biggest business risk facing most MFIs. And while one debt counseling and a well-articulated process good collection is not a guarantee that there is for deciding when rescheduling or refinancing little over-indebtedness, deteriorating collection might be justified. is a sign that there may be serious borrower distress.75 Redress mechanisms could also be lodged externally, for instance with a federation of An MFI that wants solid independent portfolio microlenders. testing usually needs to supplement its standard annual audit with additional “agreed procedures� Other MFI measures that can affect over- that instruct auditors to conduct specified tests indebtedness are not associated with a particular and report the results. There are at least two stage of the loan process. portfolio testing tools available that focus on the 75 in some cases, poor collection results not so much from borrower distress as from management’s failure to keep their staff strongly focused on loan repayment. 35 specific risks presented by microcredit portfolios One of the Smart Campaign’s assessment criteria is (Christen and Flaming 2009, MicroSave 1999). “Portfolio quality valued: Productivity targets and Both of these tools can also be used by internal incentive systems value portfolio quality at least auditors. They examine not just loan balances but as highly as other factors, such as disbursement or also MFI policies, procedures, and information client growth. Growth is rewarded only if portfolio systems. Note that we are speaking here of quality is high� (Smart Campaign 2010). auditing issues connected with loan repayment. We are not suggesting audits as a tool to directly But collection targets can be a double-edged determine client over-indebtedness. sword. If the targets are so high that they amount to zero tolerance for delinquency and default, then Staff training. Training can raise loan officers’ three problems occur. First, the MFI is probably awareness of the problem of over-indebtedness, restricting access by lending too conservatively. educate them about the lender’s formal policies, Maintenance of perfect collection is often a sign and illustrate practical ways to deal with commonly that the MFI is denying loans to many people encountered situations. One good way to find out whose odds of repayment are very high. A modest whether management is serious about preventing level of delinquency—say, maybe a PAR of 1–2 over-indebtedness is to see whether this topic percent—is safe and sustainable, and consistent features prominently in employee training—both with serving a less restricted range of borrowers. initial training at the time of hiring and follow-on Second, expectations of zero delinquency can training thereafter.76 encourage loan officers to engage in abusive collection practices. Third, such an expectation Staff incentives. Employees respond to incentives. can lead loan officers to reschedule or refinance Many MFIs offer cash bonuses for certain kinds loans that are ultimately unpayable, depriving of results, for instance recruiting new borrowers, management of critical information about portfolio increasing the loan portfolio, or maintaining strong problems. collection. Even when there are no cash bonuses, employees have expectations about what kind of Staff quality. It has been suggested that higher results lead to promotion and salary raises. pay may attract more qualified loan officers, who would exercise better judgment in assessing At the risk of some over-simplification, we can repayment ability. The suggestion seems plausible, divide staff incentives into two groups: those but we have no empirical evidence to offer on that push toward expansion of the MFI’s or the the subject. Of course, higher loan officer pay will individual loan officer’s number of borrowers usually mean higher interest rates for borrowers. or amount loaned, and those that focus on collection of loans. It has long been argued that Early warning systems for over-indebtedness. expansion incentives are dangerous unless they Many MFI managers are caught unawares by an are balanced with strong collection incentives. over-indebtedness crisis that would have been The concern was mainly for the well-being of much easier to fix if it had been spotted earlier. the MFI. Without enough staff attention to This strongly suggests the need for formal or maintaining repayment, delinquency could spin informal early warning systems. The approaches out of control. But even if the concern is client discussed here could be implemented by MFIs, welfare rather than MFI welfare, a strong focus on MFI associations, or government bodies. loan repayment makes sense. When loan officers know their compensation or promotion depends First consider nonsurvey approaches that are on high repayment, they are less likely to structure possible if microlenders and their borrowers are loans that hurt borrowers by over-straining their covered by a functioning credit reporting system. repayment capacity. Such a credit database can be used to track multiple 76 sample training resources can be found at www.smartcampaign.org. 36 indebtedness, the amount of indebtedness per In the end, responses don’t have to be totally customer, the number of loan commitments, or the honest for the results to be useful. The usual bias number of credit inquiries—at least for debt with will be to understate one’s debt or difficulty in formal creditors. This information can be useful for repaying. So the reported result can be treated watching trend lines even if we aren’t prepared as a lower bound, with actual over-indebtedness to identify particular thresholds as unacceptable. likely to be higher rather than lower. Also, for all kinds of trend analyses, as long as the same biases As credit bureaus are unlikely to have income are present from quarter to quarter or year to year, information for microborrowers, an MFI could trend data can be meaningful even if we can’t draw on its own loan files to produce a debt- quantify the amount of the biases. (See Box 6 for service-to-income ratio. At a minimum level, advice on conducting client surveys.) national household surveys may have average income estimates for various occupational groups Finally, some initiatives are implemented at the that could be combined with debt information level of the market rather than of individual MFIs. from the credit bureau. Credit reporting systems.77 Credit reporting Loan officers often know their customers well systems allow lenders to share information on and could provide useful indications of over- borrowers’ debt, debt service, and/or repayment indebtedness trends if this information can be performance. By informing lenders about a loan collected in ways that don’t threaten their bonuses, applicant’s other obligations, these systems reduce raises, and promotions. Another approach that the risk of over-indebting the borrower, and the doesn’t require formal survey work is to find a way consequent risk to the lenders’ own viability. to collect loan officer views about how many clients Just as important, a credit reporting system lets are over-indebted, and whether things are getting borrowers convert their good repayment behavior better or worse. For MFIs that offer voluntary with one lender into a reputational asset that gives savings services, it may be useful to monitor them access to other credit sources as well. Many for deposit withdrawals that are used to pay a people consider credit reporting to be the single loan installment. And, obviously, management most powerful weapon to fight over-indebtedness and information systems that flag delinquency in competitive markets. At the same time, credit immediately and control inappropriate loan bureaus can have their downsides for clients and renegotiation will bring problems to light more aren’t a silver bullet that fixes over-indebtedness quickly. alone without attention to the other kinds of measures discussed here.78 Now turn to approaches that involve surveying— going out and asking an appropriately sized The ideal reporting system for low-income sample of clients. In most cultures, money and borrowers would allow (or require) participation especially debt are sensitive subjects. In addition, not only by licensed banks, but also unlicensed respondents may worry that disclosing their nondepository lenders, such as MFIs and consumer debt problems will make it harder for them to credit companies, as well as other providers that get new loans. Interviewers need to be taught clients owe regular payments to (e.g., telephone how to win respondents’ confidence, guarantee providers or appliance and furniture merchants), confidentiality, and frame tactful questions to get and include both positive and negative repayment the desired information. information. 77 Our discussion of this topic draws on christen, lauer, lyman, and rosenberg (2011). This paper distinguishes three broad approaches to the sharing of borrower information among lenders: government-run “credit registries,� privately owned “credit bureaus,� and MFi-specific databases that are usually set up because credit registries and bureaus won’t incorporate lower income borrowers or lending institutions that are not licensed and prudentially regulated. 78 Data accuracy and client privacy are common issues. and in one sense, credit bureaus can increase repayment stress for borrowers. Without a credit bureau, the borrower can default with one MFi but then get loans from its competitors. Once the credit bureau is in place, the pressure on the borrower to pay is higher, because default could reduce access to finance and potentially other types of transactions in the long run. 37 Industry codes. Local MFI networks in a number Box 6. Client Surveys: Advice from Two of countries have worked on voluntary codes of Field Researchers behavior over the years. The earlier attempts were Surveying is complex work that calls for detailed often driven, in large part, by a desire to forestall expertise. In an interview for this paper, Marguerite Robinson and Daryl Collins, two very experienced government regulation. Getting agreement client research specialists, were willing to offer on, and compliance with, the codes has often some general pointers: been difficult. As over-indebtedness and other consumer problems have become more prominent • MFIs or government bodies that want survey work usually can’t expect meaningful answers recently, the motivation behind the codes seems on questions like these if they just turn over the to be increasing, and the codes are paying more whole task to a local research firm. The actual detailed attention to consumer protection issues, surveying can be contracted to a research firm, but the MFI or other commissioning institution including over-indebtedness. The international should have its own in-house expertise to Smart Campaign has made considerable progress develop and pilot the questionnaire, to monitor in developing substantive consumer protection the survey work, and, if possible, to include the principles, offering tools to implement those outside firm’s lead field researcher during the pilot testing to make sure that expectations are principles, and securing endorsements from understood. hundreds of institutions around the world. It is • Field enumerators/interviewers need substantial clearly a promising initiative, though more time training, not just a few general guidelines, if will be needed before the impact on MFI behavior they are expected to get honest and open answers on sensitive questions like household can be assessed. debt. • Organizations that want to launch this kind of market research should begin with intensive Funder actions qualitative interviews with a few respondents, to understand the dynamics of the behavior Some observers have concluded that the behavior they’re investigating, before they launch of funders—i.e., the donors and investors that statistical surveys of large samples. finance MFIs—can contribute to credit crises. In addition, Collins was willing to venture an order- For instance, Chen, Rasmussen, and Reille (2010) of-magnitude guesstimate of survey costs, subject found that in four crisis countries rapid growth, to situational caveats. To survey the clients of a market saturation, and in some cases over-lending single MFI, a sample of around 750–1000 might typically be required. Depending on local survey were fueled by the large supply of funding— firm pricing, the cost might range from $30,000 mainly debt funding—from international investors to $150,000, which should be within the means and domestic “apex� wholesalers. Some of this of a medium or large MFI. For a national survey, one might multiply those estimates by a factor funding was purely commercial, but most of it of something like five. Of course, these figures came from sources that included social welfare in depend on the size of the MFI or country, on the their objectives. Naturally, funders—especially the type of survey, and on the desired results and more commercially oriented ones—want to invest statistical significance levels. Other researchers suggest that costs may be lower. in strong MFIs with solid track records in dynamic markets. This biases them toward markets where the risk of saturation-induced over-indebtedness may be higher. It would be a mistake to assume that every microcredit market needs a credit bureau. Among Many of the institutions that fund MFIs face other circumstances, MFIs in some early stage disbursement pressure of their own. The supply of markets aren’t yet making enough loans for credit money they have to move sometimes exceeds the reporting to be cost-effective. But based on past demand from appropriate investees. If they over- experience, MFIs are much more likely to start fund an MFI or a market, they are solving their own thinking about credit bureaus too late rather than problem in a way that can hurt the very clients the too early. money is supposed to be helping. 38 Here is one point on which we are prepared to regulators’ efforts to control over-indebtedness make a definite recommendation: for all funders, risk. In addition, we encourage institutions and especially for donors or socially oriented who finance microcredit research to emphasize investors, evaluation of microlenders as potential studies that examine the extent and dynamics of grantees or investees should always include an overindebtedness. explicit assessment of over-indebtedness risk. This includes trying to gauge the saturation level of the Conclusion overall markets into which they are investing, and assessing whether the microlender investees are We began this paper by listing reasons for paying dealing appropriately with the range of options close attention to the risk of over-indebting laid out above. In Section 1, we developed an microborrowers, especially as more and more argument for regarding over-indebtedness as markets become competitive and eventually a clear and present danger for microlending. If approach saturation. We pointed out that there is that argument is convincing, then any funder who often a trade-off between over-indebtedness on professes a social objective should avoid financing one hand and access or cost for borrowers on the microlenders that are not taking credible steps to other: the only way to eliminate over-indebtedness address that risk.79 completely is to stop lending. “Credible steps� vary from one setting to another, We looked at some of the causes of over- but at a minimum, a funder ought to assure itself indebtedness, finding that lender practices, that the investee microlender is borrower mistakes, and external factors all contribute to the problem. • not using deceptive or high-pressure marketing tactics We then investigated various definitions or proxy • not structuring staff incentives in ways that indicators for over-indebtedness, finding that all encourage over-lending of them suffer from limitations. For survey work, • taking reasonable measures to check we preferred an indicator based on borrower on borrowers’ repayment capacity, past struggles and sacrifices to repay loans. At the repayment history, and outstanding same time, we noted that poor people often have obligations with other lenders to struggle and sacrifice to come up with many • maintaining and communicating clear written kinds of cash payments, even without microloans, policies to guide employees in addressing and we cautioned that, when one finds borrowers over-indebtedness risk struggling to repay their loans, one cannot • not using collection techniques that are automatically conclude that the loans are making abusive, given the local setting. those borrowers worse off. Roodman (2011, ch. 9) elaborates on the risk of We reviewed a short list of studies that have investor-driven credit bubbles, and argues that tried to quantify microcredit over-indebtedness microfinance funders should set up reporting levels and over-indebtedness risk. Most of them systems that allow transparency and exchange of found levels of over-indebtedness, variously information about levels of investment in MFIs and defined, that seem worrisome, but the study markets. countries were not representative of worldwide microcredit markets. Most of these studies were Public development agencies can finance some of implemented because there was a pre-existing the above measures directly—e.g., implementation concern about an over-indebtedness crisis in the of credit reporting services, early warning systems, particular markets. Overall, the evidence is too or financial literacy initiatives—or by supporting skimpy so far to draw general conclusions about 79 cf. 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Schicks is a doctoral candidate at the Centre for European on redress mechanisms from Kate McKee; and on financial capability Research in Microfinance at Solvay Brussels School of Management, from Margaret Miller. The paper has been improved by review and Centre Emile Bernheim, Université Libre de Bruxelles. She is currently comments from Gabriel Davel, Gregory Chen, Robert Christen, Daryl on educational leave from an international strategy consulting firm. Collins, Tilman Ehrbeck, Marek Hudon, Kate McKee, Alexia Latortue, Rosenberg is a senior adviser at CGAP. Sections 2 and 3 draw on David Porteous, Marguerite Robinson, David Roodman, Stuart Schicks (2010). The authors are grateful for extensive research and Rutherford, Jeanette Thomas, and Jacob Yaron. Of course, this does analysis by Jonna Bickel and Abigayle Seidel, as well as material on not imply that they agree with everything in the paper. The suggested citation for this Occasional Paper is as follows: Schicks, Jessica, and Richard Rosenberg. 2011. “Too Much Microcredit? A Survey of the Evidence on Over-Indebtedness?� Occasional Paper 19. Washington, D.C.: CGAP, September