The following post was originally published on the CGAP Blog.
Gabriel Davel knows what he’s talking about, and so should you. Davel is the veteran bank regulator who helped create and lead South Africa’s National Credit Regulator, one of the most capable financial consumer protection agencies in the world. In CGAP’s new Focus Note, Regulatory Options to Curb Debt Stress, Davel draws on the experience of a number of debt crises in microfinance and consumer credit and distills his own hard-won experience into practical guidance aimed mainly at regulators, but also highly relevant for financial institutions.
A perennially intriguing – and urgent – question is how regulators can tell when a crisis of reckless lending and over-indebtedness is on its way. Before a crisis hits, everyone has interests in credit expansion: individuals want loans, lenders want to grow their client base and loan portfolios, and governments want credit expansion, especially for previously excluded clients. But at some point, the bubble over-inflates, highly-leveraged clients are living precariously, and even a modest economic shock can trigger the inevitable collapse. Davel recounts 11 such incidents in microfinance and consumer finance. In their book, This Time is Different, on banking panics, Reinhart and Rogoff document not dozens but hundreds of similar crises throughout history. Their point? It is never different. Credit markets fool themselves time after time.
Is there any way for financial sector participants, happily tipsy from an expansion of credit, to recognize when they need to slow down? Does it take a restrictive set of credit rules? What are the secrets to responsible credit?
These secrets are what Davel reveals in the Focus Note. Davel divides crises into five stages: 1) preconditions; 2) commercialization and expansion; 3) debt build-up with low default; 4) default and contraction; and 5) institutional failure and potential contagion. The first three phases are the run-up to the crisis, while in the last two, the crisis has hit. The crux of the matter is for regulators and responsible lenders to recognize the signs while the market is still in one of the first three phases.
The preconditions arise when a new form of credit is introduced into a relatively virgin market, especially if that credit comes from a new player and targets a very specific clientele. Regulators may not be inclined to do anything at this early stage, but Davel suggests that they must be continually alert to new market activity. This requires an active market monitoring role quite different from the dominant orientation of regulators toward supervising the traditional activities of traditional players. The next phase, commercialization and expansion, begins when the new activity is sufficiently attractive for new players to come in and compete. Some observers think that this has been happening in Mexican microfinance since the success of Compartamos convinced many new social and commercial entrepreneurs – and major players like Banco Azteca – to enter the market.
In the third stage, credit is booming, but defaults are low – both because growth makes default rates appear low and because borrowers are flush with liquidity. Nevertheless, during this time, debt stress is building up among clients, especially if the target is a specific client segment that can become saturated relatively quickly. This is the time for a course correction, but in order to trigger a response, regulators must recognize and document the danger of increasing indebtedness and summon the will to act. This is complicated by the fact that the typical indicators regulators monitor, such as non-performing loans (NPLs), are lagging indicators and thus don’t generally work well for detecting problems. Is there any way to correct course before the crash?
Davel suggests that routine supervisory processes will not suffice at this stage. Regulators need to conduct special information gathering exercises from multiple sources – “pop quizzes” for lenders, clients, loan officers, and credit bureaus.
A number of observers of microfinance in Mexico think the market is in this third stage today, with many clients borrowing simultaneously from multiple sources. Some participants in the market are conducting their own special analyses to document the state of the market (watch for the forthcoming report from the Microfinance CEOs Working Group). Mexico may be at the all-important tipping point where a crisis can still be prevented, but where the will to act has not yet emerged.
When regulators do recognize increasing debt stress, what can they do next? The Focus Note offers a comprehensive outline of possible actions. When I read through these prescribed remedies, my main reaction is that if applied early on, many of them would have prevented a crisis in the first place. For example, one of my favorite points is for regulators to prohibit any lending model that relies on late fees or penalty interest as a means of attaining profitability. This is a lesson that has been learned time and again.
Davel is conscious that a heavy regulatory hand can stifle growth and innovation, but his best advice for preventing a credit market from running rampant is for regulators and providers to join in agreeing on practicing responsible habits.
Image credits: Thanh Hai Nguyen
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