Freedom to Default: dealing with overindebtedness when all else fails

If there’s one microfinance word that rose above all others in 2011, it’s overindebtedness. As of the time of writing, it racks up the highest count on CGAP blog’s tag cloud (not counting generic terms like “microfinance”).  It seems fitting, then, to start 2012 with a blog post on this very subject. 

When we talk about overindebtedness, it usually comes for the perspective of the industry’s responsibility, whether the MFI, funders, or regulators. Prevention of overindebtedness came up as the most widely evaluated client protection principle in the Smart Campaign’s survey of social rating agencies and microfinance investors.  

This is, of course, all right and proper. It is the industry’s job to practice responsible lending, and avoiding overindebting clients deserves a place at the top of that agenda. But no matter the level of diligence on the part of lenders and financial education provided to clients, some borrowers will still become overindebted – be it because of bad business decisions, destabilizing macroeconomic shifts, or simply a string of bad luck. So what becomes of clients that, despite best efforts, still become overindebted?   

At a basic level, overindebtedness is a problem only to the degree that the client has to repay. It is not, or at least need not be, synonymous with destitution. And yet, today’s microfinance clients often go to great lengths to make repayments – skipping meals, taking their children out of school, and borrowing to make repayments. Eliminating high-pressure collection practices, as advocated by the Smart Campaign, would no doubt help some clients. But much of the sacrifice is client-driven – they don’t want to lose what they view to be a valuable source of credit. They are, put simply, afraid to default. 

What if we could make default a bit easier, more accessible? Is there a way to leverage microfinance clients’ inclination to repay, while empowering them to bring excessive debt levels under control?

MFIs regularly deal with distressed borrowers, and apply a number of mechanisms, including loan restructuring, to facilitate repayment. However, too many MFIs rely on restructuring solely to extend the loan term and lower payment amounts, while still (at least nominally) expecting clients to repay the loan in full at some point in time. This is certainly an appropriate response for clients who are dealing with temporary difficulties or have high, but still manageable, debt levels. However, for severely overindebted clients, this type of rescheduling is both unreasonable and cruel, condemning them to a lifetime of debt that they will never be able to repay, as much as they might struggle to do so.  

Moreover, because overindebtedness in microfinance is so commonly associated with multiple borrowing, loan restructuring runs into a prisoner’s dilemma: since no lender wants to take losses so that other lenders can recoup their loans in full, the result is that lenders adopt an unnecessarily rigid stance that is insufficient to cure the client’s overindebtedness. It is thus important to have a mechanism that can be applied to multiple lenders simultaneously.

Finally, any approach that allows a borrower to reduce her debt must come at some significant cost to the borrower herself, in order to address the issue of moral hazard. Simply put, this cost must be low enough to make it accessible for those trapped in debt, but still be high enough to deter those who are reasonably capable of repaying. In short, what a borrower needs is the ability to declare bankruptcy.  

By that, I don’t mean the legal definition of the term – few emerging markets have personal bankruptcy provisions in their legal codes. Rather, it would be the functional equivalent of bankruptcy – a voluntary declaration by the borrower that would confer upon her a set of specified rights and responsibilities.  

Bankruptcy:  a kindler, gentler default

Personal bankruptcy is a mechanism whereby an individual is able to acknowledge that he has more debt than he can repay. It allows the client to clear the deck and look to the future.  

The economic tumult in the rich world has recently brought bankruptcy to the foreground, with corporate stalwarts like General Motors and countries like Greece taking bankruptcy or similar routes to restructure (and substantially reduce) their debts. And the topic is being prominently reexamined by economists. The Financial Times wonders whether ancient traditions of debt forgiveness reflect a built-in mechanism to avoid accumulating unsustainable debt. Meanwhile, the New Yorker asks, if lenders encourage corporates and sovereigns to renegotiate their debts, why do they balk at individuals doing the same?  

Besides clearing out excessive debt, bankruptcy comes with an implicit promise that borrowers can return to the credit markets. Naturally, such borrowers will face substantial costs, whether through higher risk premiums or temporary moratoriums on borrowing. The latter would work well in the microfinance context, where a bankrupt borrower could be expected to be locked out from borrowing for 1-3 years, after which she would have to start with a small loan, while rebuilding her credit history.  Moreover, such a client would maintain the mark of bankruptcy in her record for a substantial period (perhaps 5-7 years), which should make it more difficult for her to take out multiple loans. However, once this period passes, the client could literally have her slate wiped clean.

There are many ways in which one could implement a voluntary bankruptcy process. Presumably, there would have to be a central registry to maintain and distribute information on bankrupt clients to participating MFIs. This could be housed at the country microfinance association or a credit bureau.  MFIs would also have to include bankruptcy in their client training sessions.  

The process itself should be initiated by the borrower, who would make an official declaration to one of her MFIs, which would in turn report it to the central registry. The declaration would also have to include a list of all outstanding (formal) loans held by the borrower, which would be used to inform her other lenders – something she can also do on her own.  Naturally, this information would also be verified with a microfinance credit bureau, if one exists in the country, to make sure that no outstanding loans are left out.

The heart of the bankruptcy process would be determining the extent of restructuring/rescheduling and implementing the new payment plan. Ideally, this would be adjudicated by a third party, perhaps a debt counseling organization authorized to handle bankruptcies by the country’s microfinance association. In addition to conducting its own evaluation of the borrower’s current repayment capacity, the bankruptcy adjudicator would incorporate information provided by the MFIs.  Its final ruling, including the extent of rescheduling, interest and/or principal reduction, and other changes to the loans would have to be binding on all MFIs (hence the need to have authorization from the country MFI association).  

Once the borrower repays the new amounts due within the designated period, her bankruptcy process would be marked as discharged in the central registry, which would start the clock for the ineligibility period, and, eventually, for clearing the bankruptcy status from her history.  

Bankruptcy has many negative connotations. It shouldn’t. At its best, bankruptcy is a means to clear the past and start anew. Dealing with overindebted borrowers is a case-by-case process, requiring many different approaches. But for many seriously overindebted clients, I can think of few better responses than to enable to declare bankruptcy of their own free will.

Daniel Rozas is a microfinance consultant based in Brussels. Previously he worked at the U.S. mortgage investment company, Fannie Mae.