When Is Microcredit Unsuitable? – Guidelines for Lending

Authors: Vaishnavi Prathap & Rachit Khaitan, IFMR Finance Foundation – December 2016

Abstract:

Rapid expansion in the microfinance sector has been credited with advancing financial inclusion in India, even as much of this growth has focused exclusively on simple group loans and credit-linked insurance. Both central bank regulations and self-regulations seek to address the risk of over-indebtedness often associated with rapid credit expansion through the implementation of lending caps and mandatory credit reporting, while recent regulatory developments additionally emphasize the need for lending institutions to detect and prevent mis-sale. This paper seeks to understand what might constitute a loan mis-sale and to inform the use of suitability guidelines for lending to low-income households by MFIs, SHGs and banks.

We reviewed a diverse body of evidence on microfinance and addressed specific evidence gaps with a year-long financial diaries survey of 400 active borrowers in rural south India. We find that certain features of borrowers’ cashflows in interaction with lending practices and the nature of market sector development greatly influenced how credit was used and consequences for borrower distress. We observed high levels of over-indebtedness (21% sample households), financial distress and debt-dependence in the sample.

Critical faultlines in credit bureau reports may cause even fully compliant lenders to mis-sell credit to at least 33% MFI clients in the sample. To ensure responsible sale, there is an urgent need to integrate credit information about all institutional lending into a single report but once this is done, our data suggest that it would no longer be appropriate to apply overindebtedness regulations in their current form. Doing so could prove too restrictive for 20% or more borrowers, and greatly limit the ability of formal finance to serve clients’ needs. The focus must shift away from limiting consumer choice and instead towards building institutions’ ability to conduct independent assessments of borrowers’ repayment capacity and to use integrated credit information alongside their own risk assessments of clients. Specifically, suitable lending to low-income households will require lenders to review all outstanding debt,
assess income and adequately respond to critical vulnerabilities including unusual income flows and uninsured cashflow risk originating from the nature of loan use.

In addition, the success of suitability in lending is also critically dependent on expanding commensurate access to savings, insurance and investment markets. Given the lack of marketbased incentives to implement suitability and regulatory barriers to multi-product origination, we conclude with recommendations aimed at regulators and financial institutions, as well as directions for future research.

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