Prevention of Over-indebtedness

1. Prevention of Over-indebtedness

2. What is over-indebtedness? Sacrifice approach “A microfinance customer is over-indebted if he/she is continuously struggling to meet repayment deadlines and structurally has to make unduly high sacrifices related to his/her loan obligations” (Schicks, 2010) Net indebtedness index (NII) approach “A microfinance borrower to be over-indebted when his/her total debt service is higher than his/her net income during a defined timeframe, whether it is from one or multiple loans” (Cambodia Over-indebtedness study 2013) Default/delinquency approach A microfinance client is over-indebted if he/she can not repay the loan.

3. Identifying the Causes of Over-indebtedness • Multiple loans are issued to client, by one or more institutions, due to: • Lack of information on the client’s liabilities • Incentives for loan staff to oversell credit products Multiple loans Poorly designed repayment schedules • Repayment schedule does not match the client’s business cycles (e.g., agriculture) Inadequate capacity analysis • The institution relies on guarantees as a substitute for adequate capacity analysis Unpredictable events • Accidents, disease, or natural disasters

4. Example from Campaign research Regardless of education levels, understanding of loan terms is low.

5. How over-indebted clients affect the MFI Increase in client delinquency Portfolio provisioning prevents institution from making other loans Slow and costly legal proceedings for collections Damage to the institution’s image and portfolio

6. How over-indebtedness affects the client Source: DAI

7. Example from Campaign research Some clients take extreme measures to keep up payments

8. Prevent Over-indebtedness MFI Borrowers • Are able to handle debt service requirements without sacrificing their basic quality of life. • Carefully establishes the borrower’s ability to afford the loan and repay it. Consider this: Research and practical experiences shows that borrowers consistently overestimate their own capacity to repay debt.

9. Principle in Practice Over indebtedness is avoided in product design through carefully defined and rigorously assessed eligibility criteria and defining debt threshold limits. There should be rationale for target setting, incentive schemes and senior management should monitor and respond to issues around portfolio quality.

10. CPP#2: Adequate Standards of Care • Define max debt and use cash flow analysis • Approvalis NOT based on guarantees & insurancecoverage • Repaymentcapacityanalysisisdoneevery time and for every group member • Creditdecisionprocessincludes at least 1 non- field staff • Policy for cooling off b/w 2 loans and definingpre-payment conditions • Robustinternalcontrols for underwriting • EVERYONE trained on creditprocess Policy and well-documented process for loan approvals using appropriate information criteria Credit reporting information is used • Report to & check Credit Bureau • If no Credit Bureau: data exchnaged w/ competitors

11. CPP#2: Adequate standards of care Senior management and board monitor and respond to heightened OI risk. • Portfolio qualitymonitoredregularly • Trackrestructured and rescheduledloans • Boardreviews OI levels & portfolio quality • In heatedmarkets ; riskmitigatingpolicies • Define PAR levelsthat trigger extra measures Sound Portfolio Quality maintained • Total CreditRisk a quarter is < 10% • If >10% then corrective measurestaken Staff incentivized to approve quality loans • Policy & procuess to determine sales targets • Reasonableproductivitytargets • Incentives – balanced & reviewedannually • 50% of total salaryisfixedandat least a living wage

12. Example of Good Practices from Bosnia-Herzegovina Good Practice: Interview delinquent clients. Practice Outcome Internal audit department conducts regular interviews of a sample of clients who have fallen behind on their payments. The MFI uses the information to improve its credit procedures and to monitor risk. • Two main areas of investigation: • Did loan officers follow proper procedures to avoid over-indebtedness when issuing credit? • What are the causes of the client’s repayment challenges?

13. Tools available from the Smart Campaign Examples from MFIs

14. Key Messages FI's senior management review results related to over-indebtedness in the market at least quarterly. FI verifies that third parties train staffs on loan analysis and the credit approval process. FI defines PAR levels that trigger additional internal monitoring and response. FI has rigorous internal control process for credit underwriting process. In last 3 years, if the Credit Risk > 10% then FI demonstrates corrective actions. For overheated markets, FI adopts risk mitigating policies, ie slower growth, conservative loan approval.