The regulation of the UK's booming microfinance industry comes with new challenges and some important issues. Nithya Sridharan considers the moral and financial sides of micro-lending.
As of April 2013 the regulation of consumer credit will be passed on from the Office of Fair Trading to the newly established Financial Conduct Authority. The National Audit Office recently convened a meeting with leading subprime lenders Wonga.com, Provident and Fair Finance to discuss and understand their business models. The feedback and review from this meeting is crucial to the regulations. The recent debates unearthed by this review about regulations in the UK's microfinance industry have brought up important issues worth pondering.
All microloans and subprime lenders - including payday lenders, home credit and community lenders - have relatively high levels of compounding. High interest rates are a consequence of operational costs, a de facto result of running a micro-lending business. The difference of opinion on the interest rate appears almost irreconcilable. A poor man borrowing little money for short periods of time would not want to pay high interest rates (but in many cases, is willing to) and micro-lending businesses cannot function without those rates. So, we might question why the business is even allowed to borrow, or how it manages to survive.
Banking is not all inclusive. Subsidies for the underprivileged haven't had great success. Heavy subsidies employed to compensate banks for the risks that they were taking (for example, lending without collateral and transaction costs) weren't effective in channeling credit. There were subsidies to keep interest rates low for poor borrowers. In fact, many of these policies had disastrous outcomes.
In her paper “Credit and Price Policies in Philippine Agriculture”, Cristina David concludes that “credit subsidies through low interest rates worsen income distribution because only a few, typically well off farmers, receive the bulk of the cheap credit. When interest rates are not allowed to reflect costs of financial inter-mediation, wealth and political power replace profitability as the basis of allocating credit.”
In fact, many studies and research in the same area of subsidies for the poor in several ways and in many geographical locations, have not had any significant success. However, the Grameen Bank's success in microfinance - including group lending, saving and insurance - has done what traditional banking failed to do. They cater to the poor and still survive as an entity. Therefore, it is important to inquire into microcredit organisations and their working. According to Jonathan Murdoch's analysis of the effects of microfinance on poverty reduction, microfinance helps reduce poverty. Hence, it is important to have the institution.
The flip-side to the story is the moral hazard. In some cases, microfinance institutes have been accused of using bullying mechanisms for loan recovery. Lack of transparency, lack of facilities and operations to educate the customers have also been cited as reasons against these institutions. There are stories of unethical practitioners, who allegedly encourage poor people in need to take loans they hardly need, spiralling them into a loop of debt.
Regulation should help protect the people that can't protect themselves. However, how should we intervene in the credit markets, so as to not dampen the lenders and help protect the people who need loans? We must filter out unethical practices in the microlending industry, and decide how to identify the players that are unethical.
Our brows furrow at the moral hazard point: how do we know when people are being pushed into debt by microlenders? One way to look at it is by examining the default rates. For example, the rate at which borrowing clients fail to pay after all the mechanisms of payment plans have been exhausted. This can perhaps point at:
a) The microloan lender not making adequate checks or appraisals of the clients before lending. Hence, lending to people that really can't afford to be in debt; or
b) the microloan lender not being able to recover the loan because of undesirable practices (compounding of interest rates on client not being able to pay the money or instalments on time).
What should happen in the latter case, for it to be "ethical"? The microloan lender must find out the reason for the client's default and work with the client to help him or her pay back the loan, rather than spiralling them downwards with more interest rate compounding.
One might ponder whether capping interest rates would help. Capping the microlenders' interest rates too low might lead to a situation where the lenders begin to focus on making more loans, indiscriminately to recover their operating costs. In the free market, high interest rate lenders will automatically get filtered out – provided there is a free market and it is non-monopolistic.
The regulator's role will be to ensure that such a market exists, benefitting all parties involved. The aim of microlenders must be to eventually help the microloan clients to join mainstream banking at some point, and not to keep them at their current economic status. So, a long term decrease in repeat clients could be a favorable parameter to look at, provided the clients have migrated to a better credit rating than to a lower one (and are thus not fit to be clients any longer). Credit rating of individual clients must also be reliable in order to reflect their economic status accurately.
There is hope that the new regulatory model will support and sustain growth in terms of the microlending institutes, and in terms of enabling the successful access of microcredit to people that need it.
Nithya Sridharan has a passion for in-depth financial journalism and developmental economics. She holds an MSc in Risk management and financial engineering from Imperial College London.
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