Consequences of Over-Indebtedness

The consequences of over-indebtedness are manifold. Over-indebted clients feel the immediate effects. In addition, institutional and systemic effects might occur as the numbers of over-indebted clients rise. Providing an overview of the consequences of over-indebtedness they are separately discussed on the individual, institutional and systemic level. It has to be noted that sometimes there is no clear-cut differentiation between the three levels. I tried to take into consideration that consequences materializing on the individual level might also translate into consequences on the institutional and systemic level and vice versa.

10.1.3.1

Consequences on the Individual Level

The definition of over-indebtedness as used here emphasizes the unduly high sacrifices a borrower has to make in order to repay outstanding loans. On the individual level there are mainly five consequences: material repercussions, and sociological, psychological and physical consequences. The fifth consequence is that with the rising number of over-indebted borrowers, clients managing their debt well might be incentivized to default as well and suffer the same consequences as the already over-indebted.

10.1.3.1.1

Material Consequences

Probably the most obvious consequences are material repercussions.

Immediate consequences are felt if the loan contract allows for the seizure of collateral, such as tools, utensils or other assets (Van Bastelaer 2000, 12). Therefore, the household might lack vital assets. Regardless of what the loan contract states in case of default, an over-indebted client will primarily start to reduce her expenses and sell assets she has to spare (Gonzalez 2010, 29). Cutting down on expenditures could also mean to

downsize her business, for example to have to let go an employee. To reduce expenses thus means to make unduly high sacrifices to still make ends meet. Depending on the existence of pooled information systems, a client may also face a negative entry in her credit record and her future credit worthiness could be jeopardized. Lastly, there is a severe risk of over-indebted borrowers starting or continuing cross-borrowing, which will make the borrowers’ situations even worse (Schicks 2011a, 5). This strategy, at best, delays the material costs of a default.

10.1.3.1.2

Sociological, Psychological, and Physical Consequences

There are also sociological, psychological, and physical consequences of over-indebtedness felt on the individual level. Being associated with debt is negatively connoted in many cultures. In microfinance there are reports about compulsive acts against defaulting clients. In group lending schemes the pressure among peers may accumulate to the unbearable. Smets and Bähre (2004, 228–232) show with several cases how humiliation, scolding and threats of force are common in group lending. Also there have been reports about aggressive collection practices, such as seizure and harassments, of MFIs applying individual lending (Karnani 2007, 52; Hulme 2000, 27). In general, the stigma of being over-indebted may decrease one’s self-confidence. Also a client’s social capital deteriorates due to loss of reputation and standing in the community (Guérin et al. 2014, 144–145). Debt stress and over-indebtedness does not only mark an intervention in one’s private finances but also has serious effects on a person’s life in general. Numerous studies have pointed to correlations between psychological health and debt36_{. Studies show that debt stress correlates} with depression, lack of self-control and general decrease of psychological health (Sweet et al. 2013, 98–99; Brown, Taylor, and Price 2005, 647–648; Webley and Nyhus 2001, 442; Drentea and Lavrakas 2000, 527).

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Webley and Nyhus (2001, 440) point out that clear causal relations between debt stress and psychological health are inconclusive. Debt stress can have a negative impact on psychological well-being but also psychological problems may impact debt levels in a negative sense.

Furthermore, the negative psychological effects caused by debt stress and over-indebtedness may lead to physical problems. Studies report the correlation between over-indebtedness and weak performance and absenteeism of work (Kim and Garman 2003)37. Unfortunately, and as seen in the crises in Andra Pradesh, over-indebted borrowers even committed suicide (Hulme 2000, 27).

10.1.3.1.3

Consequences for Clients Handling Their Debt Well

Finally, negative effects do not only emerge among over-indebted clients but also among borrowers who manage their debt well. If an MFI, in a first phase, shows flexibility in regard to defaulting clients, no-risk borrowers might perceive strategic defaults as a favorable option because they do not fear any repercussions. When a significant part of clients are unable to pay, the government might intervene with debt releases and bailouts. This may even provoke opportunistic behavior from no-risk borrowers and borrowers that face debt stress. Gonzalez (2008, 36) argues that this may have happened in Bolivia during the microfinance crisis from 1999 to 2001 when the government announced debtor consortia and debt releases. There are reports of comparable developments in Nicaragua and India (Schicks 2010, 10).

10.1.3.2

Consequences on the Institutional Level

MFIs face great institutional risks in regard to over-indebtedness among its client base. The main two points are that high numbers of over-indebted clients threaten the financial sustainability of MFIs and potentially diminish their reputation.

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For a more complete literature review on the psychological consequences of debt stress and over-indebtedness, see Sweet et al. (2013).

10.1.3.2.1

Consequences for the Financial Sustainability of MFIs

MFIs have to write-off delinquent loans and these write-offs will translate into definite losses in income statements. Rosenberg (1999, 4) states that if an MFI writes off only five percent of its loan portfolio, the MFI might be lulled in a false sense of security. Rosenberg describes how thin the line between managing and losing control of these apparently moderate default levels is38. Apparently, losses on the outstanding portfolio have negative effects on the financial sustainability of an MFI. This effect is furthermore fed by the additional necessary expenditures (i.e. increased screening monitoring and collection costs) the MFI has to take when confronted with defaulting clients (Rosenberg 1999, 1). Stearns (1991) states that MFIs will rather reschedule and sometimes also refinance loans than write them off in the first place.

Because refinancing and rescheduling convert a delinquent loan into one that is suddenly back on schedule with no arrears (even though the borrower may be just as unlikely to repay as before), they [the MFIs] can disguise serious repayment problems. […] If frequently used, the rescheduling and refinancing of loans can render meaningless any measure of delinquency or repayment, as delinquency rates can be kept very low, and repayments high, even though the portfolio may be of poor quality. (Stearns 1991, 26–27)

One could argue that accepting a certain level of delinquency and therefore hope for late repayments and keeping monitoring, screening and collection costs low might be a worthwhile trade-off. However, Schicks (2010, 10) claims that MFIs cannot absorb a client portfolio that is severely lacking repayments at least not in the long run.

10.1.3.2.2

Reputational Loss as a Consequence

There are also reputational risks MFIs might face if many of their borrowers are over-indebted. These reputational risks are multifaceted. First, if a certain MFI is known for selling bad quality loans, normally low-risk borrowers will react and turn their backs on this institution. The market dynamic behind this phenomenon is adverse selection. As described in Chapter 5.3.2.1.1, adverse selection leads to suboptimal outcomes. Good clients will move out of the market because they are only willing to take out a loan for a certain price and only from an institution that has a good reputation. Therefore, MFIs will, without even knowing, give out loans to riskier clients. Second, also the perception of the general public, the media and government about the MFI’s quality of services is important regarding reputational risks. As seen in Nicaragua, the general public might back delinquent clients and non-repayment movements so a complete collapse of a market can arise. In addition, the media is also capable of ruining the MFI’s reputation. The Wall Street Journal, Times of India, and the New York Times have published critical articles about how certain MFIs contributed to the microfinance crisis in Andhra Pradesh. The MFIs were accused of being partly responsible for the suicides and community banishments that happened during the crisis (Feasley 2011, 3). Also governments may play a key role in regard to the reputation of MFIs by labeling microfinance markets exploitative and intervene with regulations such as interest caps (Feasley 2011, 11–13). Third, bad reputation of particular MFIs or of a whole sector may alienate important partners of MFIs. Donors, investors and development agencies might withdraw their money and make transfers to other MFIs or markets. Fourth, a loss in reputation may eventually lead to a decrease of staff motivation and identification with the employer. This makes „high staff turn-over” likely, which will again add to low quality lending practices (Schicks 2011a, 11; Drexler and Schoar 2014).

10.1.3.3

Consequences on the Systemic Level

Reputation risks and financial sustainability problems are the two most important consequences of over-indebtedness on the institutional level, with the potential to trigger severe systemic effects. As addressed above, the bad reputation of a single MFI can have negative effects on other MFIs and on the microfinance sector as a whole in a country but also on a global scale. Coupled with lower returns on portfolios, there is the eventual risk of alienating investors, development agencies and donors. This can have a global and significant impact on the availability of capital for the microfinance sector. The severity of systemic risks born by over- indebtedness may increase with the microfinance market’s size and its interwoveness with the formal banking sector. In many countries there are formal banks providing standard credit, microcredit services and deposits. Hence, spillover effects are to be taken seriously. If formal banks lose their financial stability savings of average non-borrowing clients will be in danger (Schicks 2011a, 11). The adverse selection problem discussed above may lead to diverse consequences. Either the MFIs continue lending and they may run into lending to risky borrowers, or MFIs are aware of the prevailing over-indebtedness in the market and might temporarily cease the financing of credits (even to credit-worthy individuals) due to the higher probability of picking a risky borrower. Both strategies may have effects on a systemic level. If one considers one of the causes of over-indebtedness, namely the lack of thorough client screening and monitoring, MFIs would have to invest more in these „unproductive uses and activities” (Ardic, Ibrahim, and Mylenko 2011; Brix and McKee 2010; Davel 2013; McKee 2013; McKee, Lahaye, and Koning 2011; DeVaney 2006; Tiwari, Khandelwal, and Ramji 2009; Schicks 2010; Lumpkin 2010; Koning and McKee 2011; Chien 2012; Responsible Finance Forum 2011; Center for Financial Inclusion at ACCION 2013). Money, MFIs normally do not have or want to spend in these situations.