Taking It from the Top – How Market Infrastructure Sets the Rhythm of Default Management

> Posted by Alexandra Rizzi, Deputy Director of the Smart Campaign, and Jami Solli, Independent Consultant and Founder of the Global Alliance for Legal Aid

When clients are facing loan default, they’re often in the most precarious financial position of their lives. As we detailed on this blog last week, navigating the default process can be exceedingly complex for clients. It can be complex for providers, too. No doubt, on both ends the stakes are high. In a new Smart Campaign research report released last week, What Happens to Microfinance Clients who Default?, we examined how providers behave at this juncture and the factors informing these practices.

The research team selected three very different markets to compare – Peru, India, and Uganda.¹ An analysis of three markets does not represent the entire sector. However these three countries represented great diversity in legal and regulatory systems, market infrastructure, in particular credit reporting, and use of group versus individual loans, among other factors. These three countries are also locations where the Smart Campaign has cultivated supporters and partners, which persuaded providers to share information on sensitive debt collection practices.

In total, we conducted interviews with 44 providers. In addition to MFIs, the most helpful interviews were with credit bureaus. Fonts of information, they helped us understand the topography of market debt as well as the information MFIs have when making decisions. And, as we came to understand, information was a critical determinant to what actions MFIs took when a client defaulted.

What did we learn? Among the dozens of data points on how MFIs treated clients in default (some good, some bad, some ugly), the influence of market conduct regulation and supervision, as well as credit reporting on practices stood out as defining features. In Peru, the market is regulated by two entities with overlapping consumer protection mandates: the SBS (the banking regulator) and INDECOPI (the general consumer protection agency). Interviewed MFIs were very aware of these regulators and the rules and sanctions against bad practices. For example, the team was told that the incidence of humiliating collection practices such as hombrecitos amarillos (“little yellow men” formerly painted by debt collectors on the side of debtors’ homes) had dropped precipitously because of regulatory sanctions.

In India, while the Reserve Bank of India’s (RBI) Fair Practice Code and the Industry Code of Conduct specify acceptable and unacceptable collection practices, MFIs did not appear to be influenced by the threat of monitoring or sanctions as they had been in Peru. The situation will hopefully change as the Microfinance Network (MFIN) begins to supervise and monitor the sector in its new role as a self-regulatory organization (SRO) with delegated regulatory powers.

In Uganda, the Bank of Uganda published guidelines in 2011 on financial services consumer protection.  Unfortunately, the guidelines are only applicable to regulated providers. The team found that supervision of these guidelines and of providers’ practices is weak and enforcement low to non-existent.  The lack of legal protection and sanctions allows bad market conduct and aggressive collections measures to proliferate and increases mistrust between clients and providers.

In addition to regulation and supervision, the influence of credit information systems on MFI practices was also powerful. Quality credit information not only helps providers make informed underwriting decisions, it also appears to influence collections behavior. Specifically lenders felt that the perceived value of a good credit report gives clients a strong motivation to repay, thus lessening the burden of a potential collection on the provider. Comparing the three markets, the study observed differences in the speed and intensity of MFIs’ reactions to delinquency, partially driven by the existence of credit information systems which contribute to the security of the lender.

In Peru, the credit bureaus cover all regulated microfinance institutions and a large number of the unregulated. The quality of data is generally high, though there were some instances where unregulated NGOs indicated that the regulated institutions ignored their reports of default. In Peru, the response times to early-stage delinquency were not immediate, with some providers stating that their normal procedure is for the loan officer to telephone or text the borrower about a week after a missed payment.

On the opposite end of the spectrum in Uganda, a single, expensive credit bureau covers a small percentage of the market and a national identification system does not exist. As a result, it is difficult for lenders to verify even basic information about clients. Ugandan MFIs respond very quickly to delinquency, with an almost immediate in-person visit to the debtor. Two former MFI executives mentioned that due to multiple lending, coupled by a dearth of information on the borrower, loan officers adopt a “race to the bottom of the pyramid” to collect before the other MFIs’ loan officers arrive.  MFIs cited the risk of debtor flight, where borrowers who can’t pay run away to another town, as justification for their swift reaction. One would imagine that the fear of aggressive reaction by MFIs might also fuel borrower flight – deepening the spiral of mistrust, and the potential for harm.

India falls between Peru and Uganda, as credit bureaus are a new and important part of the sector. In just four years, MFIN has corralled its membership to report more frequently – from monthly to weekly – and the use of credit reports is now standard practice. In India, the research team found that response times to delinquency are not immediate, but this is driven by the use of group liability, which was cited by 21 out of 22 MFIs interviewed. While group liability can act as a buffer before the intervention by a loan officer, there were indications that the laissez-faire approach overlooked abusive behavior within groups.

What should the industry do with these findings? The Smart Campaign has articulated standards for acceptable collections practices, but the challenge lies in applying them in individual markets. These issues need to be discussed and addressed at the market-level with, among other interventions, stronger credit information infrastructure as well as better regulation and supervision. Unfortunately in many markets, even explicit and appropriate regulation can become meaningless without supervision. Programs such as the Smart Campaign’s Certification Program as well as India’s Code of Conduct Assessment can be powerful signals of good practice as a form of regulatory supervision. Whatever the path, these market-level gaps must be bridged as they leave too many openings for mistrust and misinformation to lead to undue harm to borrowers in distress.

Have You Read?

“D” Is for Default

CFI Publishes ‘Over-Indebtedness of Microborrowers in Ghana’ by Jessica Schicks

Investigating What Happens to Clients Who Default

[1] Thanks to the in-country interviewees who shared sensitive information with us and to Smart Campaign Client Voice Task Force members who provided suggestions on the research design and commented on findings – Jessica Schicks, Rafe Mazer, Alex Fiorello, Andrea Stiles, Christopher Linder, Elisabeth Rhyne, JD Bergeron, and Jesila Ledesma.