Creating a Credit Bureau for People Without Credit

In any industry, when an increasing supply serves a stable demand, the market becomes overheated.  The same is true in microfinance.  As more microfinance institutions serve the same number of target clients, those clients begin taking loans from multiple sources, using one line of credit to pay off the others.  All of a sudden, instead of working with a single bank, now the clients have several different banks to choose from, all of which are vying for their business.  And these microfinance banks, while not competitive as those of the private sector, are still looking out for themselves and rarely talk to one another about their client roster.  So there is no way to check whether or not a potential client has another loan outstanding, other than to ask them directly.  And, according to one of the speakers at this conference in Davao, one study in South America showed that 50% of microfinance clients lie when asked about their number of outstanding loans.  When a client has several loans, balancing the repayments becomes trickier and more burdensome.   The end result is a higher rate of default as the market slowly becomes a bubble, which will inevitably burst.

This creates a challenge for everyone involved.  The microfinance institution not only needs to look out for its own interests by keeping defaults to a minimum, but also protect the clients from themselves, in a sense.  Human nature causes people to take advantage of what is available to them.  When multiple institutions offer loans without asking for collateral, of course clients are going to avail themselves.  One loan might be to pay for the business, and the others could be used for “non-productive purposes” – in other words, non-income generating. This reaction isn’t unique to the poor.  Pull out your wallet and check how many credit cards you are carrying.  The last three years have shown us that people are inherently irrational or irresponsible or something else when it comes to their use of credit.

But for the rich (in this case, the rich are defined as people with bank accounts), there is something that is keeping us in line, discouraging us from running up a massive credit card bill.  It is the fact that if we are irresponsible with the way we manage our credit lines, our credit scores will decrease and we will suffer the consequences in the future.  If I want to finance a house or a car in five years, it doesn’t make a lot of sense to buy a TV I can’t afford right now.  So the prospect of accessing credit in the future acts as a deterrent to irresponsible behavior.  The same is true in microfinance.  Since there is no material collateral involved, defaulting on a loan doesn’t mean you are going to lose your home.  But it does mean you won’t be able to get another loan from the microfinance institution, and that is enough to keep default rates below 2% in some cases.  That delicate balance, however, is upset by the introduction of another source of credit.  If there are two banks, the incentive for paying back is diluted, since you can now just go to the other bank for a loan.  They won’t know that you just defaulted on your loan to the other bank, and will be more than willing to take you on as a client.

Interestingly, this is a big problem.  Multiple lending may have led to a delinquency crisis in Nicaragua, Bosnia and Herzegovina, Morocco, Bangladesh, Mongolia, parts of India, and other places.  A host of related conditions lead to this scenario.  Loan officers have a monthly quota for recruitment, so they relax standards for approving new members.  Microfinance institutions want to grow and build their portfolio in order to expand and become increasingly sustainable.  Family members may take loans from different institutions, making it more difficult to determine how much credit the household has outstanding.  The solution is not easy, but there are ways to deal with the problem.

One solution would be to limit the number of microfinance institutions operating in a particular area.  Limit the supply to prevent the conditions for creating a bubble from ever materializing.  But this is counterproductive, since competition means higher levels of service and lower interest rates.  After all, this isn’t Russia (is this Russia, Danny?  This isn’t Russia).  Also, it isn’t really fair to the good clients who can balance multiple credit lines to punish them for the irresponsibility of others.  But the larger issue is that multiple borrowings isn’t the fundamental problem.  Harking back to the example of the rich using credit cards.  Some people can handle ten credit cards.  Controlling the people who cannot is crucial to preserving the balance.  This brings me to the second solution: a credit bureau for the informal banking sector.

What if all of the microfinance institutions in a region got together and agreed to share their client rosters in order to determine whether certain clients are credit-worthy?  In other words, replicate the major credit agencies.  This is the solution, but implementing it is difficult for a lot of reasons.  For one thing, microfinance institutions are wary of making their client lists viewable by their competitors.  Even if the credit bureau is managed by a third-party, it would take convincing for microfinance institutions to submit the information.  For another, it would be costly, increasing the already-high interest rates microfinance institutions charge their clients.  But the third reason, to me, is the most interesting.

Many microfinance clients often don’t really exist.   On paper, that is.  The rural poor don’t have driver’s licenses, they don’t have social security numbers, and they don’t pay taxes.  They effectively live off the grid.  In order to have a credit bureau that relies on more than just the client’s name (according to her), the clients would need to be convinced to some system of tracking.  But why would they want to do that?   Living off the grid has its benefits, after all.  Imagine trying to pull together a list of outstanding loans when all you have to go on is self-reported biographical information.  It would be a nightmare.

So this is a challenge.  I don’t have the answer, but neither does anyone else.  The speaker at the conference closed his talk by putting forward two open-ended questions to which he didn’t have the answer.  First, could the Philippines be on the verge of a microfinance credit bubble?  And secondly, if it is, would we know it?  These are tough questions, as is usually the case with microfinance.

If you are interested in learning more, see Microfinance Hub’s overview of a new credit bureau being set up in Pakistan.

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4 comments for “Creating a Credit Bureau for People Without Credit

  1. john galt
    August 4, 2010 at 9:35 pm

    You have just summarized exactly how the subprime mortgage crisis happened with the exception of using micro-finance loans instead of home loans. Check out the Michael Lewis book “The Big Short”. His description of the predatory loans made for mortgages by loan officers on commission is exactly what you have written.

  2. August 10, 2010 at 5:14 am

    Thanks for the trackback, Josh. I’d like to respond to Mr. Galt’s comment comparing microcredit and sub-prime mortgages. The fundamental difference between the two is that microcredit is for productive purposes whereas sub-prime lending didn’t create any assets in the economy. Secondly, micro lending heavily depends on the repayment capacities of borrowers, and when MFIs risk stepping away from this principle, they decided to setup credit bureaus to check this risk.

  3. September 14, 2011 at 5:29 am

    One the best post Ive ever read for a while! This is very informative! Mortgaging is one of the problems right now that the country is facing so, this is very good! Very good explanation!

    Kudos to you!

  4. November 25, 2011 at 10:59 am

    Multiple lending has really taken its toll on developing small economies. This should be regulated.

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