21
Mar

The P2P Lending Market in China: A Parable for Indian Policymakers – Part 2

By Varun Aggarwal, IFMR Finance Foundation

In the first post of this two-part series, we tracked the explosive rise of the P2P lending market in China, which took place in the absence of any regulations. In this post we look at the series of regulatory measures introduced by the Chinese authorities in the wake of high profile platform failures and mounting outstanding debt levels.

Changes in the Regulatory Environment  

The China Banking Regulatory Commission (CBRC) first began addressing the issue of P2P regulation in official speeches in 2014. The speeches marked “red lines” lenders should not cross and outlined principles for the industry.[1] However, it was not until July 2015, with outstanding P2P loans at 200 billion RMB that the first intentions to regulate the industry were articulated. The People’s Bank of China (PBOC) (the Central Bank) along with the China’s State Council and other key financial regulators such as the China Securities Regulatory Commission and China Insurance Regulatory Commission jointly issued the Guiding Opinions on Promoting the Healthy Development of Internet Finance [2] to encourage financial innovation, promote the healthy development of Internet finance, clarify the regulatory responsibilities, and regulate market order. The CBRC was officially made responsible for formulating and administering policies on the behavioural supervision of P2P lending platforms. Some of the key proposals included the following:

  • P2P platforms were to become “information intermediaries” and not financial intermediaries as was the prevalent industry practice.
  • In order to put a stop to fraudulent platform operators stealing funds, all client accounts were to be parked at custodian banks.
  • Platforms were also precluded from offering “credit enhancement” or guaranteed returns by covering losses themselves.

In 2016, a PBOC-led group of regulators began a rectification campaign for the Internet finance sector. Local governments were given orders to survey the online lenders, crowdfunding platforms, private equity funds, and more complex financial firms operating in their jurisdiction to get a clearer picture of what regulation is needed. Major cities stopped registering new firms in this field, stricter rules on advertisements came out, and reports even circulated of internet finance firms being ordered to vacate office buildings in busy districts due to fear that they would become targets for protests staged by defrauded investors if the platforms failed.[3]

Based on the 2015 Principles, on 24 August 2016, the CBRC, the Central Ministry of Industry and Information Technology (MIIT) and the Cyber Administration of China (CAC) jointly released the Interim Measures on Administration of the Business Activities of Peer-to-Peer Lending Information Intermediaries (the “Interim Measures”).[4] The Interim Measures comprise the first comprehensive legal framework specifically regulating peer-to-peer lending activities in China.[5]

Under the new rules, an “internet lending information intermediary” – namely a P2P lending platform – means a validly established company that specialises in acting as an intermediary provider of online lending information – “online lending” means direct lending made amongst individuals through an Internet platform. Individuals include natural persons, legal persons, and other organisations.[6] [7]

Some of the key requirements of the Interim Measures included:

  1. The capping of the total amount that an individual can borrow on a single platform at RMB200,000 (~29,000 USD), and RMB1 million (~143,000 USD) on multiple platforms. The respective caps for a corporate entity are RMB1 million and RMB5 million (~718,000 USD).
  2. P2P lending platforms must now hold borrower and lender funds in custodian accounts with ‘registered financial institutions’ instead of in the platform itself. The custodian account acts as the fund transfer mechanism between lenders and borrowers, and serves as an escrow account for all transactions between both sides.[8]
  3. Other operational obligations on platforms included filing with local financial supervisory authorities[9], obtaining permits from relevant telecommunications authorities and releasing of, for public record, information on direct lending and borrowing transactions.
  4. The scope of operations was demarcated — prohibiting P2P lending platforms from selling asset-backed securities or financial instruments such as insurance, trust products and wealth-management products and the prohibition of conducting offline promotion of financing projects.
  5. Standards for data management were put in place — focusing on proper KYC and data protection.[10]

The Interim Measures provide a 12-month transitional period for existing P2P lending platforms to achieve compliance.

The new rules also set out authority among Chinese regulatory agencies — financial regulators at the provincial and city level will be primarily responsible for registering and overseeing P2P lending platforms. This offers the benefit of more direct supervision; however China experts[11] highlight graft and fraud among mid-level bureaucrats as being still relatively common at the local level.

Other major criticisms of the measures centered on the absence of reporting requirements to a centralised database which records all P2P lending information (or an equivalent credit bureau).[12] This makes enforcing the borrowing cap impractical, as platforms cannot ascertain the aggregate outstanding debt of a borrower across multiple platforms.[13] [14]

Nonetheless, in the long run, regulators believe that the ‘Interim Measures’ should help to ensure a healthier and a more sustainable market. These measures may likely bring about a reshuffling and consolidation of market players.

Lessons for Indian Policymakers

The P2P lending industry in India is tiny compared to China. At the end of 2015, for instance, there were 38 P2P lending platforms operating in India — compared to 2200 in China. But 20 of the new online P2P lending platforms were launched in 2015, suggesting that the market is starting to take off in India. In fact, projections expect India’s P2P lending market to swell to USD 4-5 billion in the next 5-6 years.[15]

On April 28, 2016, The Reserve Bank of India (RBI) issued a public consultation paper on P2P lending regulations in India. Though the paper only states the proposed rules and solicits feedback/comments, it does give an idea about the RBI’s stance towards P2P lending — IFMR Finance Foundation conducted a detailed analysis in their response to the RBI’s consultation paper.

Nonetheless, the risk-ridden rise of the Chinese P2P lending market — characterised by explosive growth and spectacular platform failures — and the consequent attempts to regulate it, are relevant and timely parables for Indian regulators. Some of the key lessons from the Chinese experience are:

  1. Clarifying the definition of a P2P lending platform and demarcating the scope of its business activities. For instance, the China regulations clarify internet finance to include incorporated businesses as lenders, besides individuals. Furthermore, P2P lending platforms were prohibited from taking deposits from members of the public or creating asset pools, selling wealth management products and transferring debts by issuing asset – backed securities.
  2. P2P platforms should not be allowed to promise guaranteed returns to its lenders (as envisaged already in the RBI consultation paper). Chinese regulators have prohibited platform guarantees for borrowers (unless facilitated through a third party, such as a bank).
  3. Proactive supervision of platforms’ lending activities and practices — by utilising mystery shopping and periodic filings with relevant authorities.
  4. Need for implementing public disclosure of characteristics of the assets under management (AUM) such as number of loans, outstanding amounts, NPA ratios. In China, platforms are required to publically disclose information on direct lending and borrowing transactions; although it is unclear whether there is a requirement to disclose asset quality numbers.
  5. Need for prudential requirements (in some form of a backstop) for systemically important platforms proportional to the total volume of lending activity being conducted. Chinese regulations have not incorporated such a requirement while UK has this for its loan-based crowd-funding platforms.[16] The RBI consultation paper considers a leverage ratio but it is unclear how the ratio will be applied since neither liabilities nor assets reside on the platform’s balance sheet.
  6. Retail borrowers and retail lenders need to be provided with additional protections against being missold unsuitable products (loans and debt investments respectively). While the Chinese authorities require platforms to offer financial consulting services, it is unclear what these services involve. The UK’s FCA has taken steps to ensure suitability requirements on P2P platforms:
    • For Borrowers: The FCA’s Handbook on Responsible Lending specifies that “a firm, with respect to operating an electronic system in relation to lending in relation to a prospective borrower under a P2P agreement”, “must undertake an assessment of the credit-worthiness of the prospective borrower[17]. Furthermore, providers have to highlight[18] key risks to the borrower such as the consequences of missing payments or under-paying.
    • For Lenders: FCA specifies that where lenders have the choice to invest in specific P2P agreements, platform providers should provide information regarding the details of the creditworthiness assessment of the borrower carried out.[19] Moreover the FCA has mandated platforms to disclose[20] all relevant information to enable potential investors to make informed decisions on whether or not to invest.
  7. Ensuring that all loan disbursements and loan performance details are reported mandatorily to credit bureaus. This requirement is currently absent in China.
  8. Allowing P2P platforms to have access to credit bureaus records. Chinese P2P platforms have access to records of existing personal or business credit from traditional and non-bank financial institutions, including credit information from the central bank’s national credit-registry system.
  9. In order to facilitate secured lending on platforms, there is a need to provide access to platforms to the CERSAI asset registry, potentially include them under the ambit of SARFAESI Act; Chinese P2P platforms have access to the central bank’s national ‘movable assets’ registry information for accounts receivables.[21]
  10. As Platforms store and handle sensitive datasets there is an urgent need for proper data protection and security standards. Currently China’s regulations are focused solely on the accuracy of data being collected; however more detailed implementing rules are expected to be issued on data privacy and technological standards.[22]
  11. Platforms should be stopped from using misleading promotions of services — UK[23] authorities, for instance, actively monitor financial promotions on platform websites and take action where firms do not meet their standards. The FCA has also released a guide on financial promotions in social media.[24] Chinese regulators have prohibited the offline publicising or recommending of projects that need funding (only electronic channels such as internet, fixed-line telephones, and mobile phones or via entrusting or authorizing a third party, are permitted), although the rationale behind this prohibition is ambiguous.[25]

 —

About the Future of Finance Initiative:

The Future of Finance Initiative (FFI) is housed within IFMR Finance Foundation and aims to promote policy and regulatory strategies that protect individuals accessing finance given the sweeping changes that are reshaping retail financial services in India – including those driven by Indiastack, Payments Banks, mobile usage and the growing P2P market.



[1] See:https://piie.com/blogs/china-economic-watch/p2p-series-part-2-regulating-chinas-plethora-p2p-players
[2] See:http://hkmb.hktdc.com/en/1X0A34J5/hktdc-research/China-Issues-Guidelines-on-Development-of-Internet-Finance
[3] See:https://piie.com/blogs/china-economic-watch/p2p-series-part-2-regulating-chinas-plethora-p2p-players
[4] For an English translation of the measures see: http://en.pkulaw.cn/display.aspx?cgid=278756&lib=law
[5] See:www.linklaters.com/pdfs/mkt/shanghai/A32461989.pdf
[6] See: www.linklaters.com/pdfs/mkt/shanghai/A32461989.pdf
[7] See: https://hk.lexiscn.com/law/law-english-1-2917482-T.html
[8] The CBRC recently issued the Guidelines for Online Lending Fund Depository Business; for more see: http://hkmb.hktdc.com/en/1X0A99GT/hktdc-research/CBRC-Issues-Guidelines-for-Online-Lending-Fund-Depository-Business
[9] For the purpose of these Measures, “local financial regulatory authorities” means the departments of all provincial people’s governments which undertake the functions of local financial regulation. See more: http://en.pkulaw.cn/display.aspx?cgid=278756&lib=law
[10] See: https://hk.lexiscn.com/law/law-english-1-2917482-T.html
[11]See: http://www.nasdaq.com/article/new-rules-for-chinese-p2p-lenders-designed-to-minimize-fraud-slow-industry-growth-cm719480
[12] Although there have been suggestions that the CBRC will build a centralised database on the online lending industry. See more: https://www.nri.com/~/media/PDF/global/opinion/lakyara/2016/lkr2016235.pdf
[13] See: www.linklaters.com/pdfs/mkt/shanghai/A32461989.pdf
[14] See: http://www.globaltimes.cn/content/1003315.shtml
[15] See: http://www.business-standard.com/article/pti-stories/startup-sees-peer-to-peer-lending-market-growing-big-in-india-116020700125_1.html
[16] See: https://www.fca.org.uk/publication/policy/ps14-04.pdf
The volume- based financial resources requirement calibration placed by FCA on P2P platforms is the sum of:

  1. 0.2% of the first £50 million of the total value of the total loaned funds outstanding
  2. 0.15% of the next £200 million of the total value of the total loaned funds outstanding
  3. 0.1% of the next £250 million of the total value of the total loaned funds outstanding
  4. 0.05% of any remaining balance of the total value of the total loaned funds outstanding above £500m

[17] See: 5.5, https://www.handbook.fca.org.uk/handbook/CONC/5.pdf
[18] See: https://www.handbook.fca.org.uk/handbook/CONC/4/3.html?date=2016-07-01
[19] See COBS14.3.7A (4) in: https://www.handbook.fca.org.uk/handbook/COBS/14/3.html
[20] See: https://www.fca.org.uk/publication/thematic-reviews/crowdfunding-review.pdf
[21] See: http://www.accaglobal.com/content/dam/ACCA_Global/Technical/manage/ea-china-p2p-lending.pdf
[22] See: www.linklaters.com/pdfs/mkt/shanghai/A32461989.pdf
[23] The FCA highlights concerns regarding promotions that compare P2P lending in equivalence to holding money on deposit –as investors should understand that there are greater risks involved and they may lose some or all of their money. For more see: https://www.fca.org.uk/publication/thematic-reviews/crowdfunding-review.pdf
[24] See: https://www.fca.org.uk/publication/finalised-guidance/fg15-04.pdf
[25]A plausible reason could be the prevalence of offline-online business models in China, where providers would promote their online services to customers through offline means.

16
Mar

The P2P Lending Market in China: A Parable for Indian Policymakers – Part 1

By Varun Aggarwal, IFMR Finance Foundation

Since 2011, China’s P2P lending market has witnessed unprecedented growth. However, numerous high profile platform failures prompted the Chinese authorities to come out with a host of regulations at the end of 2016. This post is the first in a two-part series and takes a brief look at the explosive rise and the subsequent failures in the Chinese P2P lending industry.

China’s peer-to-peer (P2P) lending sector has emerged as the largest digital alternative finance sector in the world. In China, digital financial services, such as P2P lending, are generally referred to within the broad category of Internet Finance. This taxonomy includes both traditional financial institutions that have moved online and non-traditional financial platforms offering online financial products and/or services.

Box 1: Disaggregation of P2P Lending in China[1]

The Initial Boom

The first online P2P lending platform, ppdai.com, was established in China in August 2007. However, 2013 is widely seen as the watershed year for marketplace/peer-to-peer lending[2] in China.[3] Between 2013 and 2014, the market grew, in terms of lending volume, at a rate of 337% per annum, peer-to-peer (P2P) lending topped USD 100bn in China in 2015, soaring 248.3% versus the previous year. The number of active users of P2P also surpassed 9 million in 2016[4].

Box 2: Annual Outstanding Through P2P Platforms

Box 3: Lending Volume of P2P Industry

The number of platforms trading between 2013 and 2016 also increased rapidly: 800 platforms were trading at the end of 2013, 1575 by the end of 2014, and 2,364 as of March 2016.[5] [6] In comparison the P2P Lending market has developed much more slowly in UK and US, despite the first platforms in these countries predating China.

The Subsequent Busts and Consolidation  

However this explosive growth led to a large number of “incidents” and platform collapses involving cash shortages, defaults, fraud and closures. These incidents have inflicted huge financial losses on lenders and the wider public, and led to instances of social unrest in certain areas of China. For instance Anhui province-based Ezubao, which until January 2016 was one of the top 10 largest P2P lending platforms in China, was shut down in early 2016 and 21 of its executives arrested for scamming 900,000 individual investors out of USD 6.7 billion. An estimated 95% of all borrower listings on Ezubao were fraudulent and the top executives used investor money to enrich themselves.[7] Other cases of fraud saw company bosses launching P2P platforms to fund their own businesses.

Box 4: Number of Operational Platforms vs ‘In Trouble’ Platforms[8]

During the first half of 2016, 515 P2P platforms were shut down.[9] By the end June 2016, there were 1,778 troubled P2P platforms, accounting for 43.1% of the total, according to the China Banking Regulatory Commission (CBRC).[10] Furthermore the number of newly created P2P lending platforms in China had declined at a rate of over 50% in April, compared to a growth rate of nearly 80% back in May 2015.[11] The number of platforms experienced a year-on-year decrease for the first time in the short history of P2P lending in China.

China’s financial authorities had initially enabled the P2P Lending Industry’s growth, and were content to let things develop without any government intervention. However, the increasing number of platform failures forced their hand and 2016 saw the introduction of a whole host of measures to regulate and guide the market. These measures — called the ‘Interim Measures’ — put a stop to some of the predatory and cavalier practices of P2P platforms and introduced provisions to control risks.

Some Determinants of the Chinese P2P Market: 2007 -2016

Four factors were instrumental in driving the growth of China’s Online P2P Lending Industry at an unparalleled speed: an open and supportive regulatory environment, enormous demands for inclusive finance from under-served segments, innovative business models and the entry of mainstream financial institutions in the market. But many of these factors also contributed to the building of customer and systemic risk in the sector which culminated in the series of platform failures.

  1. The regulatory environment

The Chinese government has been extremely forthcoming in its support for P2P platforms and internet finance in general. In recent years Chinese Premier Li Keqiang made multiple calls of support in the Report on the Work of the Government over 2014/15, stating that “Internet-based finance has swiftly risen to prominence”, with the imperative “to encourage the healthy development of … Internet banking”.[12]

Chinese platforms operated in a regulatory vacuum until 2016. They registered themselves as some variant of “information services” companies with the local Industry and Commerce office, then opened up their websites soliciting borrowers and investors with no official standards for disclosure and no formal regulation from the central bank or banking regulator.[13] It was unclear which watchdog agency should regulate the industry. Consequently, due to the fact that P2P platforms are not subject to any market entry rules, industrial criteria or regulatory monitoring, they had grown extremely fast.

But this loose environment was a double edged sword. While it created room for companies to build new financial products in traditionally underserved areas like consumer finance and small business loans despite the lack of reporting to credit reporting agencies, it made it easy for bad actors to defraud unwary investors. Interest rates were higher than those offered by banks, and returns to retail investors were high too — averaging around 13.29% in 2015.

  1. Limited financial services available for low income customers

Since the start of the policy era of market ‘reform and opening’ in the 1980s, a few massive State-Owned Commercial Banks (SOCBs) have dominated China’s financial system. These large banks have predominately financed large state-owned enterprises and government-related borrowers. Furthermore, the traditional credit market in China is subject to various restrictions such as interest rate caps and exchange rate caps.[14]

In order to increase the supply of credit SOCBs had initiated many schemes, however there remains a large ‘institutional gap’ when funding smaller enterprises, poorer individuals and household. According to data from People’s Bank of China, only 25.1% of individuals have got personal loan approvals from traditional banking institutions in 2014.[15] This has been largely attributed to the difficulty in accessing traditional banking institutions, complex and cumbersome application process and overtly strict eligibility criteria for wealth management products.

These under-served customers had an eager appetite for online P2P lending to fulfil their needs. Many P2P lending providers had also moved into consumer financing by offering a diversified range of lending services in areas where traditional banks have been too slow to operate – such as car financing, education and training, as well as mortgage financing.[16]

  1. Entry of mainstream financial institutions and other large enterprises in the market

Since 2014, state owned enterprises, private equity and mainstream financial institutions such as SOCBs gradually became involved in the P2P lending sector by buying equity stakes in the platforms. This swelled the average registered capital of P2P platforms to RMB 27.84 million (~ USD 4 million) in 2014, almost double the 2013 average. This enabled many platforms to take a trial and error approach to expand their customer base by offering low-price or even free services.[17]

  1. Innovative Business Models

In order to attract enough investors, P2P companies offered various investor-protection plans, and security schemes to guarantee the repayment of the principal and interest. And thus, platforms in China devoted a large pool of money and resources to building up offline risk control teams, thereby forming a so-called online to offline (O2O) business model.

While the Internet was used to obtain funding, offline processes were used to educate and consult with individual investors. Due to the relative lack of comprehensive credit information about borrowers, providers relied on offline modes for soliciting them and for carrying out credit investigations. However, many P2P platforms did not have specialised risk controls and credit check teams.[18]

A survey done by the Association of Chartered Certified Accountants (ACCA) captures the following distinctions amongst P2P lending provider business models in China, explained below[19] :

Box 5: Different P2P Lending Provider Models in China

These measures drastically increase the operational costs of P2P lending, contributing to the relatively higher interest rates compared to the commercial lenders in China.[20]

Box 6: P2P Loans for Home Mortgage Down Payments[21]

The P2P lending industry has been a source for loans for down payments on homes. These P2P loans typically mature in 90 days and carry interest rates of up to 12%. Speculators applied for multiple mortgages from banks, increasing the overall systemic risks to the Chinese financial system. Many experts are worried that property speculation in China’s four biggest cities — Beijing, Shanghai, Guangzhou and Shenzhen — has reached new highs, largely due to unregulated P2P financing.[21] For instance, Lianjia.com, a Beijing-based real estate company and P2P lender which shut down in mid 2016, had lent up to RMB 3 billion (USD 430 million) alone.


In the aftermath of these developments, the “Interim Measures” from Chinese authorities were aimed at the controlling the damage from platform failures. In the next post, we will analyse these measures and look at the subsequent lessons for Indian policymakers.

About the Future of Finance Initiative:

The Future of Finance Initiative (FFI) is housed within IFMR Finance Foundation and aims to promote policy and regulatory strategies that protect individuals accessing finance given the sweeping changes that are reshaping retail financial services in India – including those driven by Indiastack, Payments Banks, mobile usage and the growing P2P market.



[1] Source: https://home.kpmg.com/au/en/home/insights/2016/03/harnessing-potential-asia-pacific-alternative-finance-benchmarking-report.html
[2] Debt crowdfunding is more commonly known as peer-to-peer lending (P2P lending). It is the practice of matching borrowers and lenders through online platforms. The online lending company provides the platform for lending transactions. The borrower’s need for funding is published on the platform after a vetting process, and lenders provide funding. Another commonly used term for debt crowdfunding is market place lending, this is to allay confusion caused due to the increasing presence of institutional lenders on peer-to-peer lending platforms.
[3] See: https://www.jbs.cam.ac.uk/fileadmin/user_upload/research/centres/alternative-finance/downloads/harnessing-potential.pdf
[4] See: http://www.iresearchchina.com/content/details7_26454.html
[5] See:http://www.globaltimes.cn/content/1003315.shtml
[6] As until recently there was no explicit requirement for P2P lending platforms to make regulatory filings or register with a regulator, the numbers and scale of P2P lending companies in China can only be calculated on the basis of some incomplete data.
[7] See: http://www.lendacademy.com/massive-7-6-billion-fraud-large-chinese-p2p-lending-platform/
[8] Source: WDZJ.com
[9] See: http://www.globaltimes.cn/content/1003315.shtml
[10] See: http://www.globaltimes.cn/content/1003315.shtml
[11] See: https://www.chinamoneynetwork.com/2016/05/26/chinas-p2p-lending-market-is-a-scammers-paradise
[12] See: http://www.mckinsey.com/industries/financial-services/our-insights/whats-next-for-chinas-booming-fintech-sector
[13] See: https://piie.com/blogs/china-economic-watch/p2p-series-part-1-peering-chinas-growing-peer-peer-lending-market#_ftn1
[14] See: https://www.brookings.edu/wp-content/uploads/2016/06/shadow_banking_china_elliott_kroeber_yu.pdf
[15] See: http://www.iresearchchina.com/content/details7_26454.html
[16] See: http://www.accaglobal.com/content/dam/ACCA_Global/Technical/manage/ea-china-p2p-lending.pdf
[17] See: http://www.mckinsey.com/industries/financial-services/our-insights/whats-next-for-chinas-booming-fintech-sector
[18] See: http://blog.lendit.com/wp-content/uploads/2015/04/Lufax-white-paper-Chinese-P2P-Market.pdf
[19] See: http://www.accaglobal.com/content/dam/ACCA_Global/Technical/manage/ea-china-p2p-lending.pdf
[20] See: https://ssrn.com/abstract=2827356
[21] See: https://www.ft.com/content/2cd149d0-e999-11e5-bb79-2303682345c8

31
Jan

All’s well that repays well? Not necessarily.

By Vaishnavi Prathap, IFMR Finance Foundation

The past year has seen many commentaries on the rapid expansion of microfinance in India warning of the imminent consequences of unbalanced growth. The most striking statistic in this context — that the average client’s dues more than doubled in just four years (between 2012 and 2016), far outpacing only moderate growth in numbers of branches, employees or clients, and surely clients’ incomes — was estimated from data that, at best, captures only a large proportion of the microfinance market. While this has triggered ruminations of an emergent repayment crisis, these fears have been tempered on two grounds. First, the enforcement of new regulations since 2012 limit the risk of client over-indebtedness. Second, delinquencies have consistently remained low over the expansionary period, and wherever reports of distress have surfaced, they seem mostly uncorrelated with the sector’s growth rate.

But do these arguments show us the full picture? Considered against primary evidence from the financial diaries of low-income households in India, we find that often they do not. The data, collected by IFMR Finance Foundation during a study supported by the CGAP Customers at the Center Financial Inclusion Research Fund, provides rich detail on the financial lives of borrowers in a competitive and mature microfinance market. It reveals that the indicators cited by both arguments above are poorly correlated with the incidence of over-indebtedness and with the ways in which borrowers experience and cope with repayment distress.

Timely repayments and borrower distress are not mutually exclusive

Aggregated data from lenders’ administrative records, such as delinquency estimates published by credit bureaus, have traditionally served to indicate portfolio quality. When delinquencies are low, it is interpreted as a signal of positive borrower outcomes. However, the repayment record may not fairly represent borrowers’ experiences if lending practices emphasize timely collection above all else.

The financial diaries of over-indebted borrowers illustrate this fact. Of the 400 households we studied, nearly one of every five borrowers reported repayment obligations higher than they could reasonably afford, given their incomes and minimum living expenses. Yet, as many as 85 percent of those over-indebted borrowers never missed a repayment on formal loans, arguably since they had strong incentives (both institutional and social) to do so.

Further, the records submitted to bureaus seldom distinguish between repayments made by the client and payments made by group members on her behalf. Thus, perhaps as an unintended consequence of the design of joint liability, the administrative data reveal few meaningful insights at a sector-level on borrowers’ distress or well-being.

Not consumption smoothing but repayment smoothing

How is it possible for so many borrowers to consistently avoid delinquency while carrying multiple, unaffordable loans? The data suggest they are using several coping mechanisms, such as lowering consumption or postponing essential expenses; raising resources from friends and social networks; and using large formal loans when available to settle old debts, including smaller informal ones accrued in past months. This use of coping mechanisms in the face of shocks is not unlike previously documented evidence. Low-income households use a variety of strategies to insulate their consumption and standard of living from the risk of volatile incomes; alternatively, they try to minimize the impact of income volatility by diversifying their occupations and resources. These strategies have a limited ability to protect households from poverty, and it has been shown that severe or persistent shocks are a major cause for chronic poverty.

The use of coping mechanisms by over-indebted borrowers differed from these practices in one regard — the incidence of coping behavior was highly correlated with the unaffordability of household debt and appeared to revolve around insulating repayments rather than consumption. Borrowers with more unaffordable debt used negative coping mechanisms more often and to a greater degree than others. Their financial behavior was not unlike the expected response to an income or health shock. But in this case, the shock came in the form of multiple non-negotiable loan repayments. Unlike a random occurrence, these “repayment shocks” persisted month after month.

Additionally, not only was the level of debt correlated with distress, but also with certain product features embedded in the loan contract. For example, a subset of borrowers experiencing highly volatile cash flows might have more trouble meeting repayments at certain times of the year. We found that these borrowers, for whom repayments were occasionally unaffordable (when calculated against a given month’s income instead of the average), experienced higher levels of distress, almost on par with those for whom the repayments were almost always unaffordable.

The implication for microlending is that poorly matched repayment schedules and other product features could be just as harmful as too much debt — and more harmful if combined with high levels of debt. This is a critical dimension of the experience of over-indebtedness, yet it is often overlooked.

New lending rules to prevent unsuitable loans

It is evident from the observed level of financial distress that current practices to prevent over-indebtedness are not effective. In fact, critical fault lines in their implementation have created an environment where unsuitable credit remains the primary coping mechanism even for over-indebted borrowers. It is also concerning that they focus heavily on limiting the amount of client debt while ignoring other aspects of borrowers’ cash flows that are significant in mediating financial distress. These include large seasonal or cyclical effects for specific lines of income or, even more generally, total income volatility (the median household in our sample experienced monthly income swings as high as plus or minus 45 percent) as well as large and significant uninsured (but insurable) risks.

Beyond better repayment assessments

Microfinance in India is no longer dominated by monopolistic or mono-product markets. With the licensing of several large lenders as small finance banks, the expectation is now that low-income households will have access to better financial services. This means not only easier access to a wider set of services, but services provided by institutions that are better equipped to respond to low-income households’ primary needs and vulnerabilities.

Many have argued that the continued success of lending to low-income households will require the evolution of robust mechanisms to assess clients’ capacity to deploy credit and manage repayments. By itself, this will not be enough to prevent borrower distress since repayments alone do not signal that a loan is suitable.

Lenders must also adequately detect clients’ cash-flow vulnerabilities and respond to them with appropriate design and service improvements, complementary savings and insurance products, flexible repayment schedules where appropriate, and best practices for delinquency management.

Read the latest version of the paper here. This article first appeared on the CGAP blog.

19
Jan

Guidelines for Suitability in Lending to Low-Income Households

By Vaishnavi Prathap, IFMR Finance Foundation

Img_1In December 2014, the Reserve Bank of India published the Charter of Customer Rights as a commitment to protecting the interests of consumers of financial services. The charter includes the Right to Suitability, defined as the principle that “products offered should be appropriate to the needs of the customer and based on an assessment of the customer’s financial circumstances and understanding”. The MFIN and Sa-Dhan, in a joint Code of Conduct, also enshrine a similar principle but specific to the context of lending: “We, as part of the Microfinance Industry promise the customers that we will […] conduct proper due diligence to assess the need and repayment capacity of customer before making a loan and must only make loans commensurate with the client’s ability to repay”. Both the RBI and the SROs directed financial institutions to understand the parameters of suitability within the context of their respective product offerings and to formalize policies to prevent unsuitable sales to customers.

In a new research paper published as part of our Working Paper series, we focus on biggest barrier that financial institutions might face in complying with this directive – a lack of clarity on what may be deemed suitable and how this is to be determined for each client. Towards this end, our new research investigates the nature and incidence of unsuitability in a competitive lending market and the variety of ways in which low-income borrowers may experience or cope with loan-related financial distress. Our findings are both a reality-check on the effectiveness of the current approach to customer protection (particularly the efforts to prevent borrower over-indebtedness) as well as a guide to how, going forward, lenders can institute formal processes to prevent unsuitability.

In our previous writing on this topic, we have acknowledged that successful suitability practices must be iterative and that even at-best, they can in no way guarantee positive outcomes for clients. The focus of both compliance and supervisory efforts must rest instead on understanding patterns in product-client interactions – especially when such interactions result in substantial hardship to clients – and meaningfully improving sales processes to prevent unsuitable sales.

Key Findings

The primary data for this study was collected in a year-long panel survey of 400 low-income households in Krishnagiri district, Tamil Nadu; the full sample included clients of 7+ MFIs and 20+ formal financial institutions. The survey adopted a financial diaries approach and a detailed socioeconomic survey was administered every 4-6 weeks to capture the dynamics of households’ cashflows. The resulting dataset has a primary focus on the details of borrowing and loan servicing but also rich detail on the volatility of occupational income, the frequent incidence of small and large shocks to household budgets and the use of other income sources, resources from social networks and a variety of financial instruments to smoothen consumption, repayment obligations and other expenses.

From the survey, we were able to create a full picture of borrower indebtedness across multiple institution types – perhaps more completely than the credit bureaus for microfinance clients. Comparing the sum of monthly repayment obligations to borrowers’ average monthly incomes, we found that one of every five borrower households in the sample held an unaffordable level of formal debt. If we included informal loans or factored in the volatility of incomes, an even higher proportion held unaffordable levels of debt for a few or all months of the loan tenure. However, the incidence of repayment delays or the proportion of delinquent borrowers was much lower, and only weakly correlated with households’ debt levels. Even at very high levels of unaffordability, borrowers were prioritizing repayments on formal loans over essential expenses, and willing to take on even further unmanageable debt to get through a difficult period.

Further, the average households’ incomes varied month-on-month by as much as 45% and as a result, even borrowers with sufficient year-end surplus were observed experiencing periods of distress and using harmful coping mechanisms comparable to those whose incomes were much lower.

Implications for Suitability Practices

These patterns in borrower behaviour are perhaps not new to experienced practitioners of microfinance and further, may only be a reflection of practices designed to achieve repayment discipline. What is alarming however, is the relative ease with which some over-extended borrowers remained undetected, and were able to continuously receive new formal loans on the same terms as others.

NBFC-MFIs are subject to regulatory directives that restrict the level of indebtedness per client and additionally, a large part of the non-NBFC microfinance lending is also required to be reported to credit bureaus so that it may be available at the time of loan appraisal. Notwithstanding, we find that critical faultlines in the preparation and use of credit reports placed as many as 33% MFI clients in the sample at risk of being mis-sold an unaffordable loan.

More critically, the types of client assessments that inform loan-making are largely unregulated and often do not triangulate borrowers’ actual repayment capacity (relying instead on unverified or indicative measures, peer selection and group enforcement). Our results show that in a mature and competitive market, clients with similar incomes and livelihoods may in fact have very different borrowing portfolios and vice versa. In this scenario, universal lending limits— such as those currently in effect— poorly safeguard customers’ interests.

Instead, determined efforts should be directed towards building market capacity to conduct thorough client assessments and to respond meaningfully to clients’ financial situation. Credit reports urgently need to be strengthened to reflect a comprehensive view of all formal borrowing, without exception. On the lenders’ side, the use of comprehensive “combo” credit reports will still fall short if not also complemented by a robust understanding of what portion of household income can be made available for repayments. Further, clients with unique liquidity constraints or cashflow risks must receive adequate insurance either through appropriate products or through modified terms of service.

This research highlights not only how critical these measures are for borrower well-being, but also the challenges involved in suitably serving low-income households’ financial needs. As a step in this direction, this research outlines two minimum components for suitability assessments –

  1. All lenders should ensure that loan amounts are appropriate and the agreed repayment terms are affordable for every borrower given their income flows, outstanding loan repayments (including self-reported informal loans) and critical payment obligations.
  2. Lenders must also evaluate the harms of selling standardized products to those borrowers with highly volatile cashflows or those with unique liquidity or flexibility constraints. Uninsured cashflow risks must be provisioned for in the assessment, product design or terms of repayment.

The paper also outlines recommendations for coordinated regulatory, practitioner and research effort that can enable successful implementation. 

The working paper is available online here and we welcome both questions and comments.