Perplexed about overindebtedness, Part 2: What exactly are we talking about, anyway?

by Richard Rosenberg : Wednesday, April 28, 2010

The previous post in this series ticked off some reasons why we ought to be looking more closely at overindebtedness in microfinance.  But what do we mean when we use that term?  This question, like most others about overindebtedness, gets annoyingly complicated.

There is no uniform definition of overindebtedness.  The term is sometimes associated with loans that don’t get repaid, or with loans whose repayment ties up more than X percent of household income, or with loans whose repayment becomes stressful for the borrower, or with clients taking loans from too many sources at once. Can we find a unifying concept at some deeper level?

“Indebtedness” refers to loan obligations—that’s easy enough.  And the “over” part means too much.  But too much from whose perspective? If we’re analyzing from the lender’s point of view, then things are still pretty straightforward.  Too much debt = debt that doesn’t (or isn’t likely to) get repaid. Looking backwards at least, determining whether there’s been an overindebtedness problem is a simple matter of tracking default indicators.

But for many of us in microfinance, the ultimate objective is the welfare not of the bank but of the borrower. From this perspective, it seems natural to say that overindebtedness occurs when borrowers owe so much that their loans (or at least their last loan) have made them worse off than they would have been without the loan(s).

[Hmmm…is the overindebtedness question any different from the impact question?  Aren’t they both about figuring out what would have happened to the borrower’s welfare in the counterfactual event of not receiving—or having access to—a microloan?  More on this later.  In the meantime….]

In a borrower-welfare frame of analysis, we can no longer equate overindebtedness with nonrepayment.  A borrower may repay a loan but still have been hurt by taking it.  Conversely, default leaves more, not less, money in the borrower’s pocket, at least for the short term.

Once more: when we say that we don’t want overindebtedness, we mean that by and large we don’t want clients to borrow so much that they’re making themselves worse off.  Why do we need to stick “by and large” in that formulation? To illustrate, let’s assume that a woman wants to buy a sewing machine to expand her little tailoring business. There’s no absolute guarantee that she’ll be able to grow sales enough to pay for the machine, but the woman and her loan officer think the risk is a prudent one, based on her talks with potential customers.  Let’s also assume that she doesn’t have enough cash or another source of credit, so she is able to buy the machine only because the local MFI gives her a loan for it.  No microloan, no machine (and no risk).  Now let’s assume that the woman buys the machine but the expected demand doesn’t materialize.  And while we’re at it, let’s further assume that someone steals her machine, leaving her with an extra debt to repay but no extra income or asset to help repay it.  Without the loan, none of this would have happened, so the loan obviously made her worse off.

I’m hesitant to regard this loan as a case of “overindebtedness,” because I associate that term with a kind of lending that MFIs shouldn’t be doing.  But there was nothing wrong with this loan: we certainly want MFIs and their borrowers to continue taking prudent risks.  In this hypothetical case there has been no irresponsible lending, just some bad luck.  And there will always be some borrowers hit by bad luck.  The only way an MFI can make sure that it is never leaving borrowers worse off is to do no lending at all.

Maybe it’s more useful to think in terms of larger groups of borrowers.  Provisionally, let’s end for now with this formulation:  “MFIs are contributing to over-indebtedness when an unacceptably high percentage of their borrowers are made worse off because of the loans the MFI gives them.”

What’s an unacceptably high percentage?  I think most readers would find 2% acceptable and 25% unacceptable.  Narrowing the band more than that would be complicated, and there are enough complications to deal with for the moment.

Next time:  various proxy indicators for overindebtedness and what’s problematic about each of them.

PS:  I’m far from sure that I’ve got the definitional issues sorted out properly (or usefully) here. Further suggestions from readers much appreciated.

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  1. April 29th, 2010 at 4:00 am, Subrata Bhattacharyya ()

    I think the over-indebtedness can be better understood by the repayment-ability of an individual. Repayment-ability is easy to understand and easy to measure. The following indicators might help to understand the ability:

    * Total income of the household.
    * Total expenditure for necessary consumption.
    * Disposable income after necessary consumption.
    * Irregularities in income flow.
    * Productivity of the loans taken (how much additional income do they generate).
    * Total amount of loans taken.

    Obviously, this list is just indicative and not exhaustive. But repayment capacity would add value to understand over-indebtedness better.

  • April 30th, 2010 at 1:33 am, V.Rengarajan ()

    Thanks Rich! An interesting second part on the subject. I share some of my knowledge on the subject gained while working in the formal banking sector for 3 decades
    The dynamics of ‘over indebtedness’ in public and private financial system
    . In the formal system , the over indebtedness( ‘over due’ in banking parlance from supply side perspective) is very much associated with the repayment schedule fixed for the loan product concerned. .Here the size of the loan/debt and the repayment schedule are planned associating with the factor ‘income generation (IG)of the activity for which the loan/debt is provided. Besides, for ensuring the purchase of intended income generating asset without fungible one ( a borrower welfare oriented concern ) at client level, some time the loan is disbursed directly to the supplier of the asset and post supervised credit is also carried out to overlook the IG process.
    Particularly in the case of the rural clients including the poor, the economics of the proposed activity to be financed in the given area are assessed based on the potential of economic activity suited to them and market demand for their output, (potential linked service area credit plan under lead bank scheme in India) Based on the above assessment, the micro credit product is designed for the poor. More ethically the quantum of loan (scale of finance/unit cost), the size of loan installment and periodicity for repayment are planned depending on the level of ‘income generation’ of the each activity in the given area.. In some cases the repayment schedule with provision of some initial holidays for repayment till the income is generated as in the case of crop loan where the repayment starts only in harvesting period- depending on the crop production pattern.. In the case of dairy animal loan repayment holiday is allowed during non lactation period as there is no income generation.. That is to say repayment schedule and the quantum of installment may vary for each loan product . No second loan is sanctioned if first loan becomes over due.
    Here the repayment schedule assumes importance, because when the installment (principal and interest)which is due to paid on the scheduled date, is not paid, then it will become over due and if over due continues, it leads to over indebtedness attracting penalty fees at client house hold level. .The accounting for due collection starts only from the date indicated in the repayment schedule and not necessarily during holiday period. If the income generation process is choked either due to internal factors or external factors, then shoe starts pinching .leading to over indebtedness.

    Where as in MFIs, there is ‘one size fits for all’ approach for the quantum of loan product and repayment schedule as well with rigorous collection procedure, starting from the immediate month of loan sanction without taking cognizance of income generation from the particular activity or the capability of the poor client to honor the loan contractual terms. During post sanction of credit, no body knows the functioning of the loan at client household level. All these environ coupled with peer pressure ( SHG system) push the poor clients to seek asylum of loan sharks. Otherwise some MFIs give another loan for closing the previous loan fallen over due. Hence while the poor remains indebted and over indebted, MFIs is safe with glittering collection rate.

  • April 30th, 2010 at 6:27 am, V.Rengarajan ()

    Two more points Rich pl. here instead of over loading in my previous posting.
    1. In the case of your sewing machine illustration, the indebtedness problem emerges due to some other reasons too besides lack of demand for marketing her product for the tailor.
    • Assumingly in case MFI sanctions loan uniformly fixed amount without product differentiation disproportionately to the value of sewing machine ( no other choice also for the client in this case), debt burden and the level of indebtedness eventually is bound to increase.
    • Lack of demand for her product due to competition from her counter parts who are also likely financed by the same MFI or other institution in the given area.
    It is therefore that correct size of the loan for the sewing machine and flexible repayment schedule suited to ‘little business’ in the given area , are needed.
    • In the case of theft of the machine, as cited, it leads certainly to ‘an extra debt burden’. But here, why isn’t that risk covered under micro insurance? Borrower welfare oriented institution (MFI) /loan officer , I trust, could very much help avoid ‘too much’ or ‘over’ indebtedness. by prudently covering the risk with insurance and thereby facilitating for a insurance claim and revival/continuance of the tailoring business and income generation followed by good repayment /recovery .as well.
    2. I agree with you Rich on absence of uniform definition of over indebtedness. An attempt has been made to initiate towards a unifying concept at some deeper level subject to changes
    The ‘indebtedness’ of the household could be conceptualized as one where the household’s inability to repay the total due debt amount (both principal + interest) as per contract/s by means of borrower household’s income, expected from the utilization of debt/s availed (here indebtedness is related to Income generation (economic)activity created from the debt/s)
    The ‘over indebtedness’ household could be defined as one where the household in debt with total amount of loan/s utilized for non income generating purpose /activity/s like health care, social ceremony, remaining over dues as per contract/s with no adequate main and supplementary household income for repaying the debt/s requiring debt relief ( by government) or debt swap or otherwise submerged in debt trap.( here indebtedness related to non IG(social) activity and the higher debt amount relatively with the one for IG activity )

  • May 2nd, 2010 at 3:16 pm, Beth Rhyne ()

    Rich — I think you are trying to go deeper than is practical in defining overindebtness by whether a borrower is better or worse off. The definition of overindebtedness I like is still rough, but I think it gets at the heart of the problem: “Overindebtedness refers to a state in which a borrower has to make sacrifices to his or her basic standard of living (or, for businesses, productive capacity) in order to repay debts.” Using that definition, which is from the client not provider side, overindebtedness could be temporary or chronic, and it could be the result of “overlending” or of bad luck.
    In order to determine whether they are overlending, then, lenders would not worry too much about individual cases of overindebtedness, but about getting a lot of people in trouble. I still think this should show up in the default rate, but given reports coming out about microlenders placing undue pressure on borrowers, maybe this indicator needs to be supplemented by routine client surveys that ask questions like, “In the past month, have you borrowed in order to repay a loan?” and “In the past month, have you gone without meals in order to repay a loan?” We wouldn’t know how to interpret the answers to this, and would expect the answers to be consistently different for different populations, but repeated use of questions like this should reveal trends. What do you think?

  • May 4th, 2010 at 1:45 pm, Richard Rosenberg ()

    Beth — Defining overindebtedness in terms of clients being worse off may or may not make conceptual sense, but I agree with you that it would never be a practical measuring rod for general use. (I’ll discuss this in future postings on this topic.)

    I like your suggestion about focusing not so much on individual cases but rather on whether we’re getting a lot of people in trouble. Like you, I think that in most cases this would probably show up sooner or later in the default rate; but also like you, I entertain some worries about how reliable this assumption is. In fact, my most pressing question (as yet unanswered) is how one could test the usefulness of delinquency/default as a trailing-indicator proxy for the effects on borrowers that we want to avoid.

    Portfolios of the Poor suggests to me that paying off one loan with proceeds of another may be standard operating procedure for many households, and not a strong indicator that basic consumption is being hurt. As to going without a meal, suppose that we learned that a lot of food-insecure clients were successfully using microcredit to avoid going hungry for extended periods, and that they occasionally had to skip a meal or two to make payments. I’d hesitate to tag this as “overindebtedness,” because that term suggests something bad that we don’t happening to very many borrowers.

    Notwithstanding my quibbles about the two questions you suggested, your definition (basic consumption being hurt) may well have merit as something that can be tested practically. Even if such testing turned out to be complicated and expensive, we might be able to establish how well damage to basic consumption correlates with more easily measurable proxies.

  • May 4th, 2010 at 2:49 pm, Perplexed About Overindebtedness? « ()

    [...] Last week CGAP’s Richard Rosenberg posted a question on the Microfinance Blog–what do we mean when we say overindebtedness? Click here to see the original post. [...]

  • May 5th, 2010 at 10:52 am, Richard Rosenberg ()

    Further reply to Beth Rhyne:

    In or phone conversation yesterday you suggested that it may be useful to de-link the notion of overindebtedness from the notion that the lender has done something wrong. By this token, if we find that a lot of borrowers are making substantial sacrifices in their basic standard of living, we’d know that there was a serious problem we needed to investigate, but we couldn’t automatically conclude that the cause was imprudent lending, as opposed (for instance) to an unpredictable external economic shock that hit a lot of the borrowers at once.

    In terms of a viable research strategy, I suspect there is more light at the end of the tunnel with your approach than with mine.

    Thanks!

  • May 17th, 2010 at 12:32 pm, Elisabeth Rhyne: How much debt is too much? Microlenders want to know. - Daily World News ()

    [...] developed in dialogue with Richard Rosenberg of the Consultative Group to Assist the Poor, who has explored the question in depth on the CGAP blog, revolves around the idea of sacrifice. If a family has to [...]

  • May 17th, 2010 at 12:51 pm, Elisabeth Rhyne: How much debt is too much? Microlenders want to know. | CelebUtopia ()

    [...] developed in dialogue with Richard Rosenberg of the Consultative Group to Assist the Poor, who has explored the question in depth on the CGAP blog, revolves around the idea of sacrifice. If a family has to [...]

  • August 17th, 2010 at 8:55 am, Multiple Borrowing in Microfinance: Causes and Effects – Part I « Microfinance Hub ()

    [...] incidence of multiple borrowing (read definition at the CGAP) is particularly high in competitive microfinance markets and is often a precursor of a repayment [...]

  • August 24th, 2010 at 4:09 pm, Word of the Week: Avoidance of Over-indebtedness « ()

    [...] in general terms but it is difficult to articulate with measurable precision. As Rich Rosenberg asks, is a client over-indebted when a loan equals a certain percentage of her disposable income? Or is [...]

  • January 16th, 2011 at 10:08 am, Ajit Grewal ()

    All
    I have not had the opportunity to read prior articles.
    The over indebtedness feature in India should be a function of the below in terms of the lenders and the government :
    1. Interest rates – it is a pity that the government lends money to banks for lending to the poor. The MFI is forced to raise monies from banks and elsewhere at commercial rates and on lend. So interest rates become an issue.
    2. Tenure of loan repayment – the longer the tenure the lesser the monthly repayment. However the tenure of the loan impacts MFI profitability too.
    The following underlying reasons for over indebtedness relate to the joint responsibility of the MFI and the borrowers. The lender being a socally responsible corporate, which has embarked on this type of business, and does not take adequate precautions to cause hardship to the relatively uneducated borrowers has a greater responsibility in respect of the below.
    1. Inadequate existing borrowing disclosures / recording on the part of the borrower and MFI
    2. Disregard of clear evidence of borrowing constraints
    3. Disregard of the growth dynamics of business and number of business persons vis a vis the environment of the poor
    4. Inadequate market linkages
    5. Inadequate financial education of the poor
    Ajit Grewal

  • January 25th, 2011 at 8:18 pm, Iwan Nazirwan ()

    A week ago I posted a similar of over-indebtedness that is now presence in Indonesia’s microfinance and microbanking sectors. The evidence shows that several commercial banks, mostly belong to foreign ownership, tap into the microfinance and microbanking segment by pouring commercial international funds into the communities akin to Bolivia and India cases. In general the new comer banks employ aggresive strategies to penetrate the market and reach economic of scale in short period. These strategies including: First, focus on bankable clients that already in the market preferably in urban areas and highly populated, i.e. across the Java Island. In effect, the new comer banks led these clients into more than one loan commitments.

    Secondly, the banks embrace the consumer (credit card) banking technology of develoved countries rather than based on the genuine microfinance approach. Practically these banks heavily rely upon the credit scoring technique and client risk profile in structuring the loan contract. In many instances this mechanism is out of context in developing countries as well as in Indonesia. One of good examples is how the credit scoring work when a client has multiple indentities (id card), no financial record, etc. Clearly these banks have no sense on the importance of character and personal realtionship when dealing with their clients.

    Another interesting phenomenon I learnt during conducting a microbanking workshop in Jakarta is nearly all new microbanking players develop their microbanking business through “copas” (copy-paste) by hijacking bankers and the whole system including the customers. One participant complains “he loss half of his managers and credit officers as well as the business portfolios; it likes a tsunamy and I should start it over again”.

    I am is very sad to see what some people mostly citybankers and investors proudly said “we bring innovation and new wave to microfinance”, however now we are witnessing an opposite direction

    Iwan Nazirwan
    Managing Director MicroBnaker Connection Australia

  • February 17th, 2011 at 9:09 pm, AMY DELOS SANTOS ()

    Over indebtedness may mean borrowing more than what they are able to pay back on the scheduled time particularly , borrowing from various lenders without regard as to how the borrowed money will be used. This borrowers’ behavior is developed when competing MFI’s do not also give due regard to how the borrowers plan to use the borrowed funds.

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