The Over-Indebtedness of Microfinance Customers – An Analysis from the Customer Protection Perspective

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The Over-Indebtedness of Microfinance Customers – An Analysis from the Customer Protection Perspective

DISSERTATION

Presented in Partial Fulfillment of the Requirements for The PhD in Economics and Management

By

Jessica Schicks, MPhil, Dipl.Oec

At the

Centre for European Research in Microfinance (CERMi) Solvay Brussels School of Economics and Management

Université libre de Bruxelles

Members of the Jury:

Prof. James Copestake, Centre for Development Studies, University of Bath

Prof. Isabelle Guérin, IRD, Université Paris I Sorbonne and French Institute of Pondicherry Prof. Marek Hudon, Supervisor, CERMi, Université libre de Bruxelles

Prof. Marc Labie, CERMi, Université de Mons, Université libre de Bruxelles Prof. Ariane Szafarz, Secretary of the Jury, CERMi, Université libre de Bruxelles

Academic Year 2012/2013

UNIVERSITE LIBRE DE BRUXELLES

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On a Personal Note

In the beginning of a PhD one knows that one will only be able to cover a small part of a topic. That the research will lack data. That no answers will come without new questions. The further the research progresses, the more apparent become its limitations. The things it cannot cover. The shortcomings of the empirical study. The ambivalence of its findings. A PhD is a powerful reminder of the limitations of our knowledge and methodologies. Of the lack of an absolute truth.

Nevertheless, these three years have been an exciting personal experience. I have learned so much. I have been able to follow my passion for this topic with almost unlimited freedom. My work has been received with unanticipated amounts of recognition, both in academia and among the practitioners of the microfinance industry. It has been given a lot of attention in the Ghanaian microfinance sector and in our local results workshops with MFIs, investors, the Ghanaian Ministry of Finance, and the Ghana Central Bank. It sometimes seems like I have been able to give something small back to all those borrowers who talked to us in the course of this research, revealing their personal hardships in the hope of helping microfinance practitioners design better products in the future.

I am immensely grateful for this opportunity. For this experience. For the trust that people put in me at the beginning of this project. My thoughts go to all of you who have helped me to make this project come true and who have been close to me during the last three years, no matter if you were in Belgium, Ghana, Germany, France, the UK, or the US. You know who you are.

Thank you!

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Introduction

Beginning in the 1970s with a scalable microcredit model based on social collateral (Armendáriz and Morduch, 2010), microfinance has developed from a credit focused non- profit activity into a semi-commercial industry offering a range of financial services to low- income populations. However, in spite of the broadened product portfolio offered by microfinance, the focus of the industry remains lending small-scale loans to microentrepreneurs. In spite of its commercialisation, the mission of the microfinance industry remains to benefit a target group whose poverty usually excludes it from formal financial services. A large share of microfinance institutions (MFIs) remain subsidy dependent (Hudon and Traca, 2011). These institutions require a social mission of positively impacting the lives of the poor to justify their existence. Even fully profit-oriented MFIs use the label “microfinance” to position themselves as investments with a positive social impact and are usually managed as “double bottom-line” organisations (Labie, 2004; Copestake, 2007).

Given that credit remains the flagship product of microfinance and that the industry’s existence is based on the social mission of benefitting people in poverty, surprisingly little is known about the impact that microlending has on the lives of the poor. Increasingly rigorous impact studies challenge the original narrative of poverty alleviation through microloans (Duvendack et al., 2011; Karlan and Goldberg, 2011). They show that the benefits of microcredit may be much more limited than originally assumed. Although there is ample indication that microfinance can be highly beneficial for the poor, there is no consistent and robust proof to date that microfinance effectively promotes microenterprise development, that it increases the asset ownership of microborrowers or that it positively affects borrowers’

income. Similarly, recent theoretical developments and empirical research highlight that the contribution of microfinance may lie not in facilitating productive activities that earn high returns on investment but rather in helping the poor smoothen their consumption in the face of volatile incomes and frequent emergencies (Collins et al., 2009; Karlan and Zinman, 2009).

Again, further research has yet to prove the benefits of microloans in terms of consumption smoothing. In the meantime, the concept of microfinance having an impact through consumption smoothing rather than through microenterprise development and poverty alleviation defeats the idea that high returns on productive investments made with microloans allow borrowers to repay their microloans without difficulty.

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Even if the above studies on the social impact of microfinance leave room for future research, their findings on what the positive impact of microfinance may be represent crucial insights for both microfinance scholars and for policy makers. For example, less belief in the benefits of microfinance may reduce tolerance for risks created by means of microfinance. It may reduce the tolerance of the microfinance industry for borrowers struggling severely to repay their loan. However, microfinance research often does not take the potential negative effects of microfinance and the struggles of microborrowers into account. There remains an important need for more research in microfinance on the potential downsides of microloans and on the difficulties that microborrowers face in repaying their debt.

Over the past 40 years of the microfinance industry’s history of growth and commercialisation, the downsides of credit for the poor have been largely ignored by academic research. Scholars have identified a risk of mission drift for microfinance institutions that attempt to combine financial and social objectives. When trade-offs exist between achieving social results and financial results, MFIs may reduce their efforts to pursue their social mission and focus on more easily measured financial results instead (Copestake, 2007; Mersland and Strøm, 2010; Armendáriz and Szafarz, 2011). Some sociologists and anthropologists have noted the damage that social pressure in group lending could do to the poor (Besley and Coate, 1995; Montgomery, 1996; Rahman, 1999). More recently, scholars began highlighting the substantial harm that a debt over-load and repayment problems could imply for the poor (Brett, 2006; Dichter, 2007; Hulme, 2007; Guérin et al., 2009). Hudon (2009) highlighted that the idea of a “human right to credit” follows the tradition of blindness to credit risks and ignores the danger of over-indebtedness that credit implies. Nevertheless, the over-indebtedness risks of microfinance remain one of the most urgent and under- researched topics of microfinance.

Today, over-indebtedness is one of the most important challenges faced by the microfinance industry. It is the most important risk according to “Microfinance Banana Skins 2012”, a global report on risks in the microfinance industry (Lascelles and Mendelson, 2012). Several microfinance markets have reached extreme levels of over-indebtedness that have materialised in the form of market-wide repayment crises and have put the local microfinance industry at risk. For example, in the Indian state of Andhra Pradesh, microfinance has almost come to a halt as the result of an over-indebtedness crisis that has not only threatened the sustainability of lenders because of widespread default but also has had strong political repercussions. This crisis triggered a regulatory reaction that fundamentally challenges the business model of MFIs and has put the future of the local microfinance sector in question.

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Other microfinance markets that in recent years faced substantial crises that included problems with over-indebtedness are, for example, Bosnia, Nicaragua, Morocco and Pakistan.

Furthermore, the industry does not know to what extent over-indebtedness is prevalent in microfinance markets around the world that have not yet reached a stage of crisis and thus whether more markets risk going through similar experiences.

The industry needs to perform research to agree on a definition of over-indebtedness and to understand the extent to which over-indebtedness is prevalent in microfinance markets (Kappel et al., 2010). It seeks to understand and be able to mitigate the harm that over- indebtedness might cause. To develop solutions to the problem of over-indebtedness, the microfinance industry must analyse what factors are related to over-indebtedness and may be potential causes of the phenomenon. It needs to identify the borrowers who are most at risk.

The recent rebalancing in the microfinance industry that has led to a focus on protecting clients and working towards the social mission of microfinance requires a parallel shift to research through the lens of customers (Rozas et al. 2011; Copestake, 2007). Contrary to the wide range of microfinance research at the institutional level, there is now an urgent need for borrower-level research that considers the perspective of microborrowers and gives borrowers, as the main stakeholders of microfinance, a voice in the industry’s future development.

It is this practical and scholarly need for answers to the microfinance industry’s questions of over-indebtedness that has set the research agenda for my PhD. The first paper addresses the conceptual challenges of defining and measuring over-indebtedness. Based on a thorough analysis of the interdisciplinary literature on the over-indebtedness of consumers in developed countries and on the existing research within microfinance, this paper develops an innovative definition of over-indebtedness. It defines over-indebtedness according to the sacrifices microborrowers experience related to their loans. Moreover, in addition to proposing the first definition of over-indebtedness in the microfinance literature that is appropriate for customer protection purposes, the paper suggests a practicable way to use this definition in empirical research.

In a second step, the paper analyses the potential causes of over-indebtedness. It unites the contributions of economics, sociology and psychology into a comprehensive framework of the causes of over-indebtedness that, to the author’s knowledge, does not exist in the literature to date. The framework identifies the role of lenders in pushing borrowers into over- indebtedness due to an exaggerated marketing and growth focus, due to inappropriate lending

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products or due to sub-optimal lending procedures. It equally highlights the role of borrowers, working with insights from behavioural economics and psychology on the impact of cognitive biases on borrowing decisions and taking the sociological influences of, for example, societal pressures into account. The paper identifies economic and socio-demographic borrower characteristics related to consumer over-indebtedness in developed countries, which are likely to at least partially represent causal effects. Moreover, the framework of the causes of over- indebtedness identifies external influences on over-indebtedness, which include both those in the institutional and macroeconomic environment that may prevent or facilitate over- indebtedness ex-ante and those in the form of adverse economic shocks that affect borrowers and turn a healthy debt situation into over-indebtedness ex-post.

The second paper of this PhD develops the customer protection perspective on over- indebtedness further by analysing in detail what consequences over-indebtedness may have on borrowers and on lending institutions. The paper shows that from the viewpoint of customer protection, the consequences of over-indebtedness reach far beyond the risk management concerns that primarily affect MFIs and investors. It details the material effects of over- indebtedness on borrowers, the potential social cost of being over-indebted and the substantial effects that over-indebtedness can have on psychological well-being. With regard to microfinance institutions, this paper indicates that the potential consequences of over- indebtedness on lenders are much more complex than the common focus on portfolio problems in the form of delinquency and default suggest. It points out that there are also significant indirect consequences of over-indebtedness on earnings, operational cost, staff retention, and customer satisfaction. The analysis extends to other stakeholders in identifying briefly the second-order effects that over-indebtedness can have on third parties that are not directly part of the lending contract between an MFI and its borrowers. It recognises the effects that microfinance over-indebtedness can have on borrowers who are not over- indebted, on MFI customers who are not borrowing, on other MFIs and the financial system, as well as on the microfinance industry’s investors, donors and support organisations.

The second paper then moves on to comprehensively review the empirical research on microfinance over-indebtedness to date. It identifies early research on over-indebtedness in microfinance from the first microfinance crisis in Bolivia but notes that microfinance scholars did not grasp the broader structural lessons of this crisis at the time. Instead, the interest in over-indebtedness as a microfinance topic quickly faded away again, followed only by individual pieces of research that were not specific to over-indebtedness but recognised the potential downsides of the group-lending methodology. The paper then reviews a number of

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papers related to microfinance markets with debt problems in the aftermath of the global financial crisis but also points out that the phenomenon of over-indebted microborrowers does not appear to be specific to crisis markets. Looking through a lens of competitive equilibrium and identifying the challenges of a market characterised by a simultaneous demand gap and supply gap, the paper analyses the existing empirical studies with regard to our knowledge on the extent of over-indebtedness in microfinance markets. It shows that there are alternative scenarios for how over-indebtedness in microfinance will develop in the future and notes a need for further research, where the findings from the existing literature are not yet conclusive.

The third paper works with a unique empirical data set from Ghana collected by means of an in-depth survey among 531 microborrowers in Accra, Ghana, at the end of 2010. Respondents represent a random sample from five of Ghana’s most important microfinance institutions:

ProCredit Ghana, Opportunity International Ghana, Sinapi Aba Trust, EB-ACCION and Advans Ghana. They were interviewed anonymously in a research project that was enabled by the cooperation of the microfinance industry’s global customer protection organisation, the Smart Campaign, and the German development bank KfW. The paper measures the over- indebtedness of microborrowers from a customer protection perspective, putting into practice the definition and measurement developed in Chapter 1. It identifies the share of over- indebtedness in the local population of microborrowers and analyses what sacrifices borrowers experience related to their loans, how frequently they repeat these sacrifices and how acceptable the various sacrifices are from the subjective perspective of microborrowers.

The paper proceeds to compare the common risk management indicators of over-indebtedness to the customer-protection definition based on borrower sacrifices. Using econometric regression techniques, it develops a model to predict over-indebtedness from the customer protection point of view by means of more easily available indicators. At the same time, it analyses to what extent the risk management perspective and the customer protection perspective are in line or whether a risk management approach may be inadequate for customer protection purposes.

Finally, the fourth and last paper of this dissertation identifies borrower-level factors related to over-indebtedness. It tests factors identified in the first chapter of this dissertation for their relationship to over-indebtedness among microfinance borrowers in Accra. The paper uses the primary database from Ghana to run a logistic regression model that tests the relationship of poverty, adverse economic shocks, returns on investment, and financial literacy to over-

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indebtedness. It addresses other economic, socio-demographic, and loan- or lender-specific factors by means of control variables. Whereas a cross-sectional dataset cannot establish causal relationships, the paper argues that the factors it identifies as related to over- indebtedness are most likely causes of over-indebtedness. It further breaks down their relationship to the individual sacrifices that borrowers experience and, using ordered logit regressions, to the repetition of sacrifices over time and to the acceptability of sacrifices from the borrower perspective. It deducts policy recommendations for the development of solutions to the over-indebtedness challenge in microfinance.

With these four papers, this dissertation makes an important contribution to over-indebtedness research in microfinance. It suggests a definition of over-indebtedness that meets the requirements of a customer protection perspective. It develops a comprehensive framework of the causes of over-indebtedness. Although this dissertation does not challenge that microfinance may have a substantial positive impact on the lives of the poor and that microcredit is often urgently needed and highly valued by the poor, it shows that the microfinance industry should be cautious about the potential dangers of microcredit. It analyses over-indebtedness risks with regard to their magnitude, identifying the potential consequences of over-indebtedness in detail, and with regard to their likelihood, assessing our knowledge of the extent of over-indebtedness in microfinance markets around the world.

Based on a unique empirical dataset with borrower-level survey data, the PhD puts the customer-protection oriented over-indebtedness definition into practice and measures the over-indebtedness of borrowers in an African microfinance market, revealing what sacrifices borrowers go through and what their subjective experience of these sacrifices are. It contrasts this customer protection perspective to the risk management perspective that is common in over-indebtedness research to date. Finally, it provides empirical insights into what factors are related to over-indebtedness on the borrower level, factors that are likely to be causes of over- indebtedness. It thus contributes to the development of solutions meeting the challenge of over-indebtedness in microfinance.

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References

Armendáriz, B. and J. Morduch (2010) 'The economics of microfinance’ (2nd ed.).

Cambridge, Mass: MIT Press.

Armendáriz, B. and A. Szafarz (2011) 'On Mission Drift In Microfinance Institutions' In B.

Armendáriz & M. Labie (Eds.), The Handbook of Microfinance (pp. 341–366). London, Singapore: World Scientific Publishing.

Besley, T. and S. Coate (1995) 'Group lending, repayment incentives and social collateral'.

Journal of Development Economics, 46(1), 1–18.

Brett, J. A. (2006) '"We Sacrifice and Eat Less": The Structural Complexities of Microfinance Participation'. Human Organization, 65(1), 8.

Collins, D., J. Morduch, S. Rutherford and O. Ruthven (2009) 'Portfolios of the Poor, How the World's Poor Live on $2 a Day'. Princeton, NJ: Princeton Univ. Press.

Copestake, J. (2007) 'Mainstreaming microfinance: social performance management or mission drift?'. World Development, 35(10), 1721–1738.

Dichter, T. (2007) 'Can microcredit make an already slippery slope more slippier?: Some lessons from the social meaning of debt' In T. Dichter & M. Harper (Eds.), What's wrong with Micofinance? (pp. 9–18). Warwickshire: Intermediate Technology Publications.

Duvendack, M., R. Palmer-Jones, J. Copestake, L. Hooper, Y. Loke and N. Rao (2011) 'What is the evidence of the impact of microfinance on the well-being of poor people?'. EPPI- Centre, Social Science Research Unit, Institute of Education, University of London, London.

Guérin, I., M. Roesch, O. Héliès and Venkatasubramanian (2009) 'Microfinance, Endettement et Surendettement: Une Étude de cas en Inde du Sud [Microfinance, Indebtedness and Over-indebtedness: A case study in Southern India]'. Revue Tiers Monde, 197, 131–146.

Hudon, M. (2009) 'Should Access to Credit be a Right?'. Journal of Business Ethics, 84, 17–

28.

Hudon, M. and D. Traca (2011) 'On the Efficiency Effects of Subsidies in Microfinance: An Empirical Inquiry'. World Development, 39(6), 966–973.

Hulme, D. (2007) 'Is microdebt good for poor people? A note on the dark side of microfinance' In T. Dichter & M. Harper (Eds.), What's wrong with Micofinance? (pp. 19–

22). Warwickshire: Intermediate Technology Publications.

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Kappel, V., A. Krauss and L. Lontzek (2010) 'Over-Indebtedness and Microfinance - Constructing an Early Warning Index'. Center for Microfinance, University of Zurich, responsAbility, Council of Microfinance Equity Funds, Triodos Investment Management Zurich.

Karlan, D. and N. Goldberg (2011) 'Microfinance Evaluation Strategies: Notes on Methodology and Findings' In B. Armendáriz & M. Labie (Eds.), The Handbook of Microfinance (pp. 17–58). London, Singapore: World Scientific Publishing.

Karlan, D. and J. Zinman (2009) 'Expanding Microenterprise Credit Access: Using Randomized Supply Decisions to Estimate the Impacts in Manila'. Financial Access Initiative Cambridge, MA.

Labie, M. (2004) 'Introduction'. Mondes en Développement, 126(2), 7–8.

Lascelles, D. and Mendelson, S. (2012) #Microfinance Banana Skins 2012, The CSFI survey of microfinance risk: Staying Relevant.’ Centre for the Study of Financial Innovation (CSFI), Kent, UK.

Mersland, R. and R.Ø. Strøm (2010) 'Microfinance Mission Drift?'. World Development, 38(1), 28–36.

Montgomery, R. (1996) 'Disciplining or protecting the poor? Avoiding the social costs of peer pressure in micro-credit schemes'. Journal of International Development, 8(2), 289–305.

Rahman, A. (1999) 'Micro-credit Initiatives for Equitable and Sustainable Development: Who Pays?'. World Development, 27(1), 67–82.

Rozas, D., I. Barrès, C. Connors and E. Rhyne (2011) 'Implementing Client Protection in Microfinance: The State of the Practice, 2011'. Center for Financial Inclusion Center for Financial Inclusion Publication No. 14. Washington DC.

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Chapter 1 The Definition and Causes of Microfinance Over-Indebtedness:

A Customer Protection Point of View

Jessica Schicks*

Centre for European Research in Microfinance (CERMi) Solvay Brussels School of Economics and Management Centre Emile Bernheim, Université Libre de Bruxelles

With over-indebtedness emerging among microfinance customers, the industry’s sustainability and social impact are both at risk. Filling a void in the literature, this paper develops a definition of over-indebtedness that is appropriate for customer-protection purposes. It provides a framework for the causes of over-indebtedness that highlights the role of external influences and the responsibility of lenders. It recognises the role borrowers play in their own over-indebtedness. This paper challenges several misconceptions and oversimplifications about microfinance over-indebtedness.

These misconceptions include the belief that default-based risk management indicators can present the customer protection perspective, the dangers of consumption loans, and the benefits of competition, regular instalment schedules, the zero-tolerance policy, and Annual Percentage Rates (APRs). By enhancing our understanding of microfinance over-indebtedness and its causes, this paper provides the means for measuring over-indebtedness and tailoring solutions to its root causes.

The analysis shows that combating over-indebtedness does not automatically mean reducing access to microcredit. While a sound evaluation of repayment capacity is essential, adapting products to clients’ needs also reduces over-indebtedness.

*The author is grateful to Marie-Christine-Adam Foundation for its financial support. She thanks Prof. Marek Hudon, Richard Rosenberg and Christoph Kneiding, William Steel, Meritxell Martinez and Katja Kirchstein as well as two anonymous referees for their valuable comments and suggestions. Further thanks go to seminar and conference participants at the University of Oxford’s CSAE conference, the 2nd European Research Conference in Microfinance, and at ULB.

Paper forthcoming in Oxford Development Studies

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1. Introduction

Over the last decade, the microfinance industry¹ has achieved immense growth and public recognition. Its aim to reduce global poverty has been complemented by sizeable profits for some microfinance institutions (MFIs) and their investors. However, the fairy tale is beginning to show cracks. The impact on poverty alleviation may be an illusion, and the social microfinance industry faces increasing criticism for exploiting and over-indebting poor customers in the service of profits.

Although the social mission of microfinance places particular importance on protecting customers, the 2008/2009 global banking crisis has shown that unsustainable financial services based on irresponsible lending imply much broader risks. Over-indebtedness is currently one of the most serious risks in microfinance, endangering both social impact and the industry’s stability (Hudon, 2009). Over-indebtedness can push customers further into poverty, accompanied by the material, psychological, and social consequences of debt (see Schicks (in press) for details). It puts MFIs, their portfolio quality, and institutional stability at risk. The consequences can spill over to investors, donors and the industry as a whole. While the individual experiences differ, several countries such as Bosnia, Morocco, Nicaragua, Pakistan and India have already experienced crises with important elements of over-indebtedness among microfinance clients.²

From a customer protection perspective, this paper contributes to our understanding of microfinance over-indebtedness and its causes. There is widespread ambiguity surrounding the definition and indicators of over-indebtedness. Scholars end up implicitly discussing different things depending on whether they focus on risk management or customer protection. A clear definition is required to assess the extent of the problems in microfinance markets around the world and to provide empirical insights into the phenomenon of over-indebtedness. However, the definitions and indicators that researchers have relied on to date are grounded in a risk management framework. The current need for customer protection creates different requirements. This paper develops an innovative definition of over-indebtedness based on borrower sacrifices. It suggests a practical approach for using this definition in empirical research.

Understanding the risks of over-indebtedness and developing solutions also requires an inclusive understanding of the causes of over-indebtedness. To the author's knowledge, no studies comprehensively analyse the drivers of debt problems. In the consumer finance literature on

1 This paper focuses on institutional microfinance following the solidarity banking, village banking or individual lending models.

Although microfinance has expanded to a broad range of financial services, this paper focuses on its original product: microloans.

2 Earlier crises, although different in many regards, took place in Bolivia and South Africa in the late 1990s and early 2000s.

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developed countries³, our knowledge of the causes of over-indebtedness is spread across different strands of research. We need a comprehensive framework that unites the insights of economists, sociologists and psychologists. In the microfinance literature, academic work on the causes of over- indebtedness hardly exists. The literature on repayment problems focuses on repayment incentives⁴ and ignores many of the findings that consumer finance research offers regarding the origins of debt problems. Therefore, a framework that informs microfinance scholars and practitioners and enables them to better address the current over-indebtedness challenges must gather our knowledge regarding over-indebtedness among microfinance customers and combine it with the interdisciplinary findings from the consumer finance literature.

By providing an account of the most important factors that impact over-indebtedness, this paper pinpoints the roles that external influences, lenders, and borrowers play in causing this problem. It challenges several myths and misconceptions that, for example, treat lender competition as a silver bullet for clients, condemn consumption loan use and insist on a zero-tolerance policy or low- frequency instalment schedules. It raises doubts about Annual Percentage Rates (APRs) and shows why MFI customers’ strong demand for credit does not prove that the loans are beneficial. This paper reveals unexpected answers regarding solutions to over-indebtedness and shows that reducing over-indebtedness does not automatically imply reducing access to finance.

The next section categorizes the various approaches to defining and measuring over-indebtedness in the consumer finance and microfinance literatures. Based on this analysis, it develops a new definition of over-indebtedness that is appropriate for microfinance research. In contrast to the existing approaches, this definition incorporates the industry’s current focus on customer protection.

The article goes on to analyse the causes of over-indebtedness and the responsibilities of lenders and borrowers respectively. The final section concludes and provides directions for further research.

3 In contrast to the paradigm of microenterprise finance, this paper uses the consumer finance literature as a reference. Microfinance primarily relies on character-based lending techniques, and a sizable amount of microcredit is used for consumption purposes.

Microborrowers make personal rather than professional credit decisions. Furthermore, being personally liable for their loans, microborrowers face the same personal consequences of over-indebtedness that are discussed in the consumer credit literature.

4 See Godquin (2004) for a review of the empirical literature.

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2. Defining and measuring microfinance over-indebtedness: When is too much too much?

Despite the importance of the topic, no universal definition of personal over-indebtedness exists.

Definitions in the consumer credit and microfinance literatures vary for example depending on the scientific lens, data availability, and the threshold for over-indebtedness.⁵ There have been several attempts to analyse the different types of definitions and their advantages (e.g., Betti et al., 2007).

However, to the author's knowledge, no structured analysis of all options exists.

Figure 1. Dimensions of over-indebtedness definitions

Figure 1 provides a systematic overview of the dimensions that distinguish the definitions of over- indebtedness used in the microfinance and consumer finance literatures. Definitions differ depending on the purpose of the research, their academic orientation, their precision in distinguishing between actual definitions versus measurements or indicators of over-indebtedness⁶, and their units of reference. There are aggregate measurements that include all customers of an institution or entire country. Other scholars consider over-indebtedness an individual phenomenon. Disney et al. (2008)

5 There is an equivalent macroeconomic debate on sustainable debt on a country level, especially with regards to debt relief for Heavily Indebted Poor countries (HIPC). For details see e.g., Benno (2008).

6 As they are often subject to discussion, Appendix 1 provides an overview of the different dimensions of quantitative over- indebtedness measurements.

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argue that all of a household’s cash flows should be considered. In the microfinance context, the appropriate unit may even be a borrower’s extended kin support network (Guérin et al., 2009b).

In terms of method, over-indebtedness definitions apply either single or multiple criteria. Applying multiple criteria selectively risks extending a definition too far (Disney, Bridges and Gathergood, 2008), applying them simultaneously increases precision. Over-indebtedness can either be defined as a quantitative threshold (e.g. a debt-to-income ratio) or in qualitative terms such as a perceived burden. Although, in legal contexts, qualitative definitions produce uncertainty for lenders seeking to comply, these definitions are more flexible and better able to account for the circumstances of individual borrowers. Definitions are considered more reliable if they are based on objective information. However, many researchers emphasise the merits of a subjective definition of over- indebtedness (Lea et al., 1993; Betti et al., 2007; Guérin et al., 2009b). They consider individuals the best judges of their own debt situation. Guérin et al. (2009a) point out that for borrowers, over- indebtedness may be a question of perceptions and social consequences rather than a material problem of disequilibrium among assets, revenues and debt. Debt conditions are heterogeneous in meaning. Whether debt is a burden depends on the nature of the debt relationship rather than the amount (Guérin et al., 2009b). As a result, for many poor borrowers, the ‘total amount of debt’ is not meaningful. Self-reports are considered less reliable than external data and provide better information about a borrower‘s circumstances and future income prospects, as well as the meanings of debt. For example, in their study on over-indebtedness and financial literacy in the US, Lusardi and Tufano (2009) completely rely on self-reports.

The essential dimension of an over-indebtedness definition is severity. Most researchers only consider borrowers over-indebted if their debt problems are structural and persistent over a certain time horizon (Canner and Luckett, 1991). According to the Life Cycle Hypothesis (Modigliani and Brumberg, 1980) and the Permanent Income Hypothesis (Friedman, 1957), consumers aim for stable consumption over a long time horizon. Permanently high debt levels at a young age may be rational, if income is expected to increase. The correct reference for measuring over-indebtedness would thus be a permanent, life-long estimate of a borrower’s income (Betti et al., 2007). Conversely, given the short-term cash management challenges of microborrowers and their high level of uncertainty about the future, microborrowing focuses on a rather short time horizon.

Researchers use various severity levels of repayment problems as the threshold of over-indebtedness.

Some only count legally bankrupt borrowers, whereas others include cases of default or arrears (e.g.

Disney, Bridges and Gathergood, 2008; Kappel et al., 2010) or even all borrowers who struggle with an unhealthy debt balance (e.g. Collins, 2008). Bankruptcy is easy to measure on an aggregate level,

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but represents a limited understanding of over-indebtedness that is difficult to compare among legal systems. Defaults or permanent arrears are common criteria of over-indebtedness in developed markets, but Guérin et al. (2009b) point out that they may not be suitable in developing countries, where informal lending agreements (that often do not specify explicit payment deadlines) play a large role. Conversely, a system of juggling debts, where borrowers continuously borrow anew to repay old loans, may hide over-indebtedness before it appears in the form of arrears. Manifest repayment irregularities are thus rather a lagging indicator of over-indebtedness.⁷ For unhealthy debt balances, the main challenge is that a no threshold can account for the circumstances of all borrowers. A debt-to-income ratio that is unsustainable for one borrower can be manageable for another. Furthermore, all of these measurements fundamentally focus on repayment and, thus, risk- management. Although using unhealthy balances as measurements leaves room to bring in borrower experiences, their typical application is institution centric.

A common feature in definitions of over-indebtedness is that problems exist despite the will of the borrower, who gets into trouble innocently or at least unintentionally. Gonzalez (2008) provides an exception, and asserts that ‘overindebtedness occurs when the repayment outcome of a loan contract does not correspond to the original expectations of either the borrower or the lender or both.’ Thus, over-indebtedness can result from an unwillingness to repay, an inability to repay, or costly actions that are required to repay. In fact, most indicators of over-indebtedness cannot distinguish the borrowers’ intentions.

Definitions of over-indebtedness also differ in the sacrifices they expect from borrowers. In many countries, bankruptcy proceedings require debtors to give up their incomes and assets above a minimum existence level (see, e.g., European Commission, 2008). Similarly, microfinance practitioners display the attitude that microcredit must not deprive borrowers of their ‘basic survival capacity’ (DeVaney, 2006). In developing his concept of “debt-capacity”, von Pischke (1991) implies that microborrowers should be able to repay on time “without suffering hardship”. He states that debt-capacity is not only about loan recovery but also about determining the loan amount that can be safely provided to borrowers while protecting their interests and avoiding unacceptable risks.

A less severe definition considers borrowers over-indebted if they need to reduce expenditures beyond the level they are accustomed to or make more sacrifices than expected (Murray, 1997). The deprivation of any liquidity buffer for emergencies (European Commission, 2008) is a similar

7 This makes over-indebtedness from the customer protection point of view a potential lead indicator of arrears in MFI portfolios, similar to earlier attempts to use drop-out rates or exit monitoring from lending programms as lead indicators for both social and financial performance of MFIs, including arrears (see Copestake (2002)).

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feature. The most generous definitions count every sacrifice by the borrower as a sign of over- indebtedness (Canner and Luckett, 1991). This expectation is common in microfinance, because the loans aim to make borrowers better off. In many definitions of over-indebtedness (e.g., insolvency regulations) the sacrifice limit is only implicit. Canner’s explicit sacrifice considerations come closest to meeting the needs of the customer protection movement and represent a borrower-centric approach. However, this approach ignores the possibility that borrowers may deliberately sacrifice their consumption levels to reach a certain goal.

This paper requires a definition that promotes a customer protection perspective. It should specify what customers, not lenders, are to be protected from. Default or arrears are inappropriate criteria as they do not sufficiently represent the borrower’s perspective: For example, borrowers who manage to meet their repayment obligations but who must take children out of school or skip meals to do so should count as over-indebted.

Definitions of consumer insolvency for developed countries at least partly account for this customer protection element by guaranteeing borrowers a minimum existence level. Many microfinance markets however lack defined minimum existence levels and most borrowers already live below any objective minimum level of income before assuming a loan. Therefore, they are the only ones who can decide on an acceptable level of sacrifices. The definition requires qualitative elements to account for individual borrower circumstances and will use the borrowers’ subjective perceptions as the best judgments of their debt situations. The current EU definition of over-indebtedness includes a similar element in considering the criterion that borrowers perceive their fixed monthly payments as a ‘heavy burden’ and their payment capacity as ‘difficult’ or ‘very difficult’ (European Commission, 2008). Subjective approaches which account for suffering as a subjective experience are in line with the academic literature on subjective, self-reported measures of well-being and happiness (see Dolan et al., 2008; Oshio and Kobayashi, 2010; Angner, 2010). Viewing the aim of development practice - and for our case of microfinance- though a lens of impact on well-being, allows to distinguish several mental models of well-being and thus of desired and non-desired outcomes (see Copestake, 2008, 2011). A subjective, person-centred view of over-indebtedness recognizes that well-being importantly depends on peoples’ own feelings and that mere material measures ignore important aspects of the broader needs, rights or local solidarity-based mental models of well-being.

This paper considers over-indebtedness a household level or individual phenomenon because broader kin support should not be the reason that borrowers manage to repay their debt. It does not refer to one-off struggles but implies that debt problems are more than transitory. At the same time,

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our definition should account for the limited time horizons of microloans and the implications of severe sacrifices even over short periods of time.

Therefore, this paper proposes a sacrifice-based definition of over-indebtedness that is unique in the academic literature⁸: A microfinance customer is over-indebted if he/she is continuously struggling to meet repayment deadlines and has to make unduly high sacrifices related to his/her loan obligations that have more than transitory effects.⁹

This definition excludes borrowers who strategically default or deliberately accumulate unsustainable amounts of debt. Although the boundaries are blurred, the criterion of ‘unduly high sacrifices’ precludes deliberation. To allow for sacrifices willingly incurred by borrowers, we deem sacrifices to be ‘unduly high’ if they exceed the costs that borrowers consider acceptable for the purpose of the loan. The definition excludes mere short-term difficulties by specifying that, for borrowers to count as over-indebted, their struggles need to be a continued phenomenon over time.

Sacrifices only represent signs of over-indebtedness if they have more than just transitory effects.

The definition is similar to an impact-based approach. If loans make borrowers suffer and worse off because the sacrifices exceed the benefits, then these loans can cause over-indebtedness. However, as in Western insolvency regulations, the definition does not postulate causality between the loan and over-indebtedness. First, establishing causality between loans and struggles is highly impractical due to the general attribution problems related to impact assessments (Hulme, 2000). Second, beneficial loans that an emergency renders unbearable to repay also fall under the definition. The next section will show that borrowers can be over-indebted for a complex set of reasons and that the original cause of the problem is not necessarily a loan that is too large. Third, non-beneficial loans for customers who do not get into serious struggle in spite of the negative loan impact do not fall under the definition. There are thus cases of negative loan impact that are not cases of over- indebtedness. This approach implies that a low level of over-indebtedness exists in any lending market, particularly markets with poor and vulnerable borrowers. Preventing all loans for

8 The notion of sacrifice in microcredit repayments was first suggested by Brett (2006) who finds that microborrowers rely on cash support from their families and social networks, assume additional debt, sell assets, reduce the quantity and quality of their food, and take on additional paid labour to repay their debts on time. Gonzalez (2008) develops a broader definition that accounts for sacrifices but includes strategic defaults. In Bolivia, he identifies similar sacrifices as well as reductions in human capital investments which can reduce income generating capacity and household welfare in the long run. This research is in line with earlier findings on the coping strategies of poor households by Corbett (1988).

9 Other versions of the papers based on this PhD use the term “structural” rather than “more than transitory”. See Appendix 2 for the categories applied to this definition of over-indebtedness.

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investments that fail or to borrowers who get hit by emergencies is impossible and would restrict credit supply below its social optimum. However, such cases should be minimised.

Finally, the definition has parallels with an approach of rational choice under uncertainty that would consider borrowers as over-indebted if, with hindsight, they regret the amount of debt they took on.

Under an ontology of complexity and uncertainty, borrowers who make rational loan decisions may take loans that they would not take if all information was available and understandable to them – loans that they will regret ex-post. Behavioural economics allows for further deviations from the original homo oeconomicus assumptions that explain why individuals may take debt that they will regret (see next section for related literature and detailed arguments). If borrowers could be considered rational in the sense of regretting loans as soon as their impact was negative, this argument would be the same as the impact argument, but regret allows for some more flexibility and circumvents the challenges of impact measurement. Nevertheless, a borrower may regret borrowing without having reached a stage of over-indebtedness. And even an over-indebted borrower may not regret having borrowed if for example a medical emergency drove him to get indebted or if the borrower’s mental representations see the cause of over-indebtedness rather in, let’s say, a failed investment than in the act of borrowing for investment. Regretting one’s situation with one’s debt does not automatically equal attributing one’s regret to the debt.

To put this definition into practice and empirically measure over-indebtedness in microfinance, Figure 2 suggests using a funnel of over-indebtedness criteria that filters out borrowers at each step until only the over-indebted remain. Researchers can collect the information by conducting household surveys, interviewing respondents about their debt struggles and collecting detailed lists of the sacrifices that respondents experience related to their loans. Respondents subjectively weight their sacrifices by acceptability and indicate the frequency of each sacrifice they experience. We consider sacrifices to be unduly high if they are unacceptable to the borrower. They are considered to have more than transitory effects, if they have been performed repeatedly (e.g., more than three times) or if even a one-off occurrence is a sign of non-transitory problems (e.g., asset seizures).

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Figure 2. A survey-based measurement of microfinance over-indebtedness from a customer protection perspective

1 For example suffering an asset seizure, or selling/pawning one’s assets

Struggle to always repay on time

Make

unacceptable sacrifices

▪

Experience sacrifices that indicate structural problems¹or

▪

Make non-structural sacrifices

repeatedly

All Borrowers Over-indebted

Borrowers

1 For example suffering an asset seizure, or selling/pawning one’s assets

Struggle to always repay on time

Make

unacceptable sacrifices

▪

Experience sacrifices that indicate structural problems¹or

▪

Make non-structural sacrifices

repeatedly

All Borrowers Over-indebted

Borrowers

As in any research that leverages the power of subjective measures, subjectivity reduces the claims to universality that can be made. Over-indebtedness is a context-specific phenomenon and the borrower’s subjective perceptions of what constitutes a sacrifice and how acceptable the different sacrifices are depend on cultures, local contexts and individual borrower characteristics. This reduces the comparability of over-indebtedness based on this measurement across settings, as well as the validity of findings based on this measurement for the microfinance industry in general.

Nevertheless, the subjective measure allows for important insights into the real nature of over- indebtedness that remain obscured by looking at more simplified, objectivised measures of over- indebtedness. In an unavoidable trade-off, the more universal and interculturally comparable a measurement is, the less it reflects local realities (Copestake, 2008).

Currently a number of research projects are using similar approaches to gather empirical data about the sacrifices of over-indebted borrowers. These projects will reveal the degree to which microborrowers struggle with debt in various markets. As extensive survey work is costly, future research should analyse to what extent simpler indicators (e.g., debt-service ratios, delinquency, or the number of credit arrangements) represent workable proxies for this definition. Doing so will also show to what extent credit risk management reduces over-indebtedness from a customer protection perspective. Until then, simply relying on the existing risk management indicators for customer protection purposes is inappropriate and risks ignoring many struggling borrowers who manage to avoid delinquency by making heavy sacrifices.

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3. The reasons for over-indebtedness: why do people overborrow?

Microfinance customers have good reasons to take loans but little reason to borrow to the extent of over-indebtedness. Similarly, lenders, especially MFIs with social missions, should have no interest in over-burdening their customers with debt. With a few exceptions¹⁰, over-indebtedness is an undesirable consequence for both parties and should not exist in perfect markets. This section analyses why people borrow more than they can handle by examining the influence of external factors, lenders, and the borrowers themselves. We develop an inclusive framework of the causes of over-indebtedness that will allow future researchers to analyse the full scope of influence factors, be more comprehensive in their empirical approaches, and develop solutions to over-indebtedness based on their full understanding of the issues.

In applying empirical findings from the consumer credit literature to the microfinance context, there are several challenges to keep in mind:

■ Studies differ in their definitions of over-indebtedness. Some are not specific to over- indebtedness but analyse the causes of debt, the accumulation of credit, delinquency, or financial difficulties.

■ Studies vary in the loan products that they consider. Borrower behaviour may differ between for example credit card use and decisions on instalment loans.

■ Borrower behaviour and characteristics differ among Western markets (Betti et al., 2007) and even within countries (Collins, 2008). The applicability of the findings to microfinance markets may be limited.

■ Few studies identify causal relationships (e.g., Webley and Nyhus, 2001, based on a longitudinal approach or Brown et al., 2005, with the Granger causality test). Most empirical studies use cross-sectional data to identify characteristics and behaviour ‘associated’ with debt or over-indebtedness. They are unable to exclude spurious correlations.

Consequently, existing research is a suitable starting point but microfinance specific research will be required to confirm and extend the findings below.

Outside influences: One set of factors that may push borrowers into over-indebtedness lies outside the control of the lending parties. Despite sound lending decisions, external shocks to the incomes or expenses of microborrowers can render their debt loads unsustainable. An empirical study by

10 From a profitability perspective, lenders may accept some arrears and defaults as long as the costs of improving risk management exceed the costs of delinquency. Apart from the indirect impact through customer satisfaction, lenders only consider repayment performance, not the sacrifices of borrowers. In some cases, even repayment problems may be in a lender's interest, as they can increase the interest earned on a given loan or keep the borrower dependent on the lender.

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Bouquet et al. (2007) in Madagascar confirms that credit problems are most frequently due to declining income or rising expenses. In addition to personal shocks (e.g., illness or job loss), macroeconomic developments (e.g., financial crises) can drive borrowers into difficulties. Typical factors for developing countries include natural disasters, changes in government policies (e.g. the displacement of street vendors), and political crises.

Furthermore, the institutional and legal environment influences the behaviour of lenders and borrowers. For example, the existence of credit bureaus, the efficiency of the judicial system, and the level of competition can enhance or reduce the risks of over-indebtedness. A common misconception states that competition among MFIs will always benefit customers by making MFIs more professional and efficient, bringing down costs and improving customer service. In fact, competition increases asymmetric information by making information sharing more difficult (McIntosh and Wydick, 2005), reduces repayment incentives due to the availability of alternative credit sources (Gonzalez, 2008) and creates pressure on MFIs to overlend, particularly if new market entrants are aggressive and pay less attention to repayment capacity. Hellmann et al. (2000) show that by reducing the capitalised value of expected future profits, competition lowers the incentives for making good loans and incites opportunistic lender behaviour. For clients of Grameen Bank, Matin (1997) and Chaudhury and Matin (2002) find that access to multiple lending NGOs reduces repayment performance. Vogelgesang (2003) finds that in Bolivia, competition has positive effects on repayment in good times but negative effects in times of crisis and over-indebtedness. Only Krishnaswamy (2007) finds better repayment rates in more competitive branch locations in India.

This may result from an initial effect of multiple borrowing on hiding repayment difficulties.

Incentive structures also result from the priorities of donors and investors. A strong focus on outreach and sustainability may lead to excessive growth and profit-seeking behaviour from MFIs, as discussed below. Understanding these external influences on over-indebtedness is a prerequisite for developing appropriate solutions. The answers may include regulatory measures, promoting credit bureaus, improving safety nets for borrowers, or simply factoring the likelihood of shocks into the evaluation of repayment capacity.

Lender behaviour: In all institutional environments, over-indebtedness is ultimately created by the parties that make the credit decisions, i.e., the lenders and the borrowers. Three major levers of lending behaviour exacerbate over-indebtedness risks: a) an excessive focus on marketing and growth, b) unsuitable product characteristics, and c) lending procedures conducive to over- indebtedness. All of these factors may be exacerbated by extreme profit-seeking behaviour from MFIs but are not limited to for-profit institutions. Well-managed for-profit MFIs that take a long-

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term view, rather have reasons to avoid such behaviours and take both portfolio quality and customer satisfaction into account.

a) MFIs can push borrowers beyond their limits through an exaggerated focus on portfolio growth and aggressive marketing techniques. The lending focused business model of MFIs can create pressure on customers to continue borrowing instead of focussing on the protective services that they need or taking a break when they do not require credit (Collins et al., 2009).¹¹ Another mechanism driving MFIs to over-indebt clients is the volume-focused incentive system (Rahman, 1999).

Volume-focused incentives reward credit officers for disbursing loans, even if clients struggle to repay them. Many MFIs mitigate this effect by providing complementary incentives for portfolio quality to prevent loans to borrowers who will default. However, in existing lending relationships, portfolio quality incentives can trigger new loans to delinquent borrowers, to enable borrowers to maintain their repayments beyond their capacity. Finally, aggressive sales techniques can incite borrowers to borrow beyond reasonable limits. A randomized control trial by Bertrand et al. (2010) in South Africa shows that advertising content significantly affects demand, particularly by appealing to intuition rather than reason. Small features such as limiting the numbers of examples shown, not suggesting what loans should be used for, and adding pictures of attractive women trigger the same increase in demand as a 25% lower interest rate. This does not yet include particularly aggressive techniques such as door-step sales, limited time offers, or hiding loan costs.

At the root of the MFIs’ sales focus are the industry's growth pressure and the desire for financial returns that may overrule an institution’s social mission. In extreme cases, rapid growth may exceed the institutional capacity of the MFIs’ information systems, lending policies and governance structures. Particularly, growth rates above 250 per cent, local growth in existing branch locations, and growth in countries with a penetration rate above 10 per cent or high aggregate microfinance growth present risks to the portfolio quality of MFIs (Gonzalez, 2010). According to pre-crisis MIX Market data¹², the gross loan portfolios of Morocco's 10 reporting MFIs grew at a compound annual growth rate of 110 per cent in 2006 and 2007, with portfolios more than doubling every twelve months. In 2007, the fastest growing MFI (ARDI) grew at 330 per cent, multiplying its loan portfolio by more than four in the course of one year.

This growth speed creates certain challenges for an institution’s management. Rapid growth leads to a high share of inexperienced loan officers, who may make poorer loan decisions than their experienced colleagues and identify less with the values of their institutions. ARDI’s personnel grew

11 Banerjee and Mullainathan (2009) explain that MFIs have an incentive to keep profitable borrowers trapped in a cycle of debt.

12 www.mixmarket.org, self-reports of limited liability but sufficient for the purposes of this argument

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by approximately 350 per cent in 2007 such that nearly 80 per cent of its employees were new to the institution. Two years after Morocco’s MFIs experienced strong growth, the >30 day portfolio at risk (PAR) rose from below 1 per cent to an average of 7 per cent. This data excludes ARDI which stopped reporting its PAR.

Nevertheless, there are also examples of institutions that maintained high growth rates for years without exceeding their institutional capacities. Fast growth is likely to be most problematic on a market level when markets approach saturation. To date the concepts of market saturation and penetration are still poorly conceptualized in relation to microfinance. The above estimates only provide rough rules of thumb.

b) MFIs further increase over-indebtedness risks if they offer products that are inappropriate to the borrower's situation. In this case, lenders are not inducing borrowers to take on more credit than is reasonable. Rather, the impact chain centres on the debtors’ ability to meet their obligations from existing contracts. For example, the typical repayment schedule starts too early for most investments to generate returns. And if maturities are too short and instalment schedules are too inflexible, it can be difficult for borrowers with volatile incomes to repay their debts on time (Collins et al., 2009; Guérin et al., 2009a). A high-frequency repayment schedule helps borrowers to repay because small, regular amounts of money are easier to assemble than larger ones. It also is an important disciplining mechanism for borrowers and highlights repayment problems early on.

Nevertheless, microfinance practitioners need to abandon the myth that only standardised, short- term, high-frequency loans work, and better adapt to the needs of borrowers and their businesses.

Even if only testing their hypothesis in a low-delinquency environment in urban India, Field and Pande (2008) find that MFIs can switch from weekly to monthly instalments without reducing the borrowers’ repayment discipline. More flexible options should be tested in future research.

The difficulties become exacerbated if MFIs do not reschedule loans for honest borrowers who face liquidity problems. The zero-tolerance policy promotes the early recognition of repayment difficulties and keeps borrowers from accumulating obligations (Gonzalez, 2008), differentiates MFI lending from frequently forgiven government lending, and avoids strategic defaults and spillover effects of delinquency on non-delinquent borrowers (Krishnaswamy, 2007). The policy improves an MFI‘s portfolio quality and has operational benefits in helping MFIs to avoid handling large numbers of rescheduling requests. However, it prevents loan officers from rescheduling loans for borrowers facing short-term liquidity problems. By forcing these borrowers into delinquency and potentially adding late fees or increased interests to their obligations, the zero-tolerance policy may not only put obligors under avoidable repayment pressures but also turn short-term liquidity gaps

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into longer-term problems. For example, in a South African MFI, the zero-tolerance policy was so pervasive that MFIs proudly reported borrowers going hungry and selling their food to repay on time (Smets and Bähre, 2004). According to our sacrifice-based definition, these borrowers are over- indebted.

A regular instalment schedule and the zero-tolerance policy serve a good purpose and might help some borrowers to stay out of over-indebtedness. At the same time, these policies are absolutely inappropriate for other borrowers. Unless the microfinance industry develops a more nuanced approach, the policies may create the same debt problems that they aim to prevent.

Repayment capacity is also a function of loan use. In Bouquet et al.'s empirical work in Madagascar (2007), the most frequent product feature that borrowers cite as a reason for repayment problems is the timing of disbursements. If MFIs disburse too late for the borrowers to exploit their business opportunities, customers may not earn enough returns. Similarly, scholars frequently identify loans used for consumption purposes as a source of over-indebtedness as these loans do not provide debtors with returns for repayment (Vogelgesang, 2003). This argument however should be handled with care: First, as money is fungible and a distinction hardly ever exists between household and microenterprise cash flows, many microloans go to household purposes. Second, distinguishing between consumption and production loan use can be difficult, as in the example of educational expenses (Collins, 2008). Third, although increasingly rigorous impact studies are challenging the empirical results of microfinance, microfinance theory is gradually moving away from the microenterprise approach to a household finance approach. It considers the benefits of microfinance to be in short-term consumption smoothing and managing the risks of low and volatile incomes (Collins et al., 2009; Karlan and Zinman, 2009). Therefore, consumption loan use can be both a cause of and protection from over-indebtedness.

c) Microlenders also contribute to over-indebtedness with their lending procedures. Particularly lax evaluations of repayment capacity and automatic increases in loan sizes over time create over- indebtedness risks. In Bangladesh and Bolivia, larger loan amounts and higher debt-to-asset ratios are positively related to borrowers’ repayment problems (Sharma and Zeller, 1997; Vogelgesang, 2003; Godquin, 2004).

Moreover, lending procedures promote over-indebtedness through a lack of transparency. An Indian study discovered that more than 70 per cent of microcredit clients believed all or most of the rules regarding their loan contracts not to be communicated in written form (Tiwari et al., 2008).

Excessive interest rates and fees contribute to debt problems, especially if borrowers are not fully aware of them. There is a misconception in customer protection debates that MFIs should simply

The Over-Indebtedness of Microfinance Customers – An Analysis from the Customer Protection Perspective