Rhys David says over-indebtedness is more about the way finance is provided than about the behaviour of borrowers
Why do people get into debt? The conventional answer would look to developments in the wider economy. Unemployment, a weak labour market that has made it difficult for wages to keep pace with inflation, and in Wales for example, a drop in take home pay in the public sector as a result of public expenditure cuts. All have made life more difficult for many. Lending rates for borrowers, too, have crept back up despite the historically low bank rate and the huge injections of money into the economy through the Government’s Quantitative Easing programme.
There is a temptation, of course, to blame indulgent, reckless or even fraudulent behaviour on the part of consumers, keen to make the latest purchases regardless of whether or not they can afford them, maxing out on a walletful of credit cards until juggling repayments is no longer possible.
Alternative finance for Welsh micro businesses
Tuesday 23 October 2012
Micro-businesses employing fewer than 9 people account for the vast majority of businesses in Wales – 193,010 in 2011, or 94.5 per cent. Yet these businesses – the main growth engine of the Welsh economy – are experiencing severe problems in obtaining finance from conventional banks. Even where they are successful they often have to pay over the odds for investment funds. This conference asks whether the model we have for channelling resources to micro businesses is appropriate. Are there alternatives sources of finance and better methods of distribution available to us? Are their lessons to be learnt from other countries, especially Germany and the USA? The conference will examine the role of asset-backed finance, peer-to-peer lending, business angels and community development finance institutions. It will also provide case studies of businesses which have faced and overcome problems in the various micro-finance sectors. How can more micro-businesses benefit? Keynote Speakers:
For more information and to register click here.
However, as a recent Magdalene College, Cambridge international symposium on Debt and Counselling heard, in both developed and developing countries the role of the financial system in generating over-indebtedness needs to be better understood. Put bluntly, during an upswing in the credit cycle – when there is more money to lend – banks’ own growth targets, marketing campaigns, credit policies and loan officer incentives create a situation where consumers end up taking on more debt than they can reasonably sustain. As Gabriel Davel, a South African regulator told the symposium, over-indebtedness is primarily the result of supply side factors and credit provider behaviour.
Yet, while the effect on households is bad enough in itself, debt stress can also threaten the viability of financial institutions themselves and create a risk of collapse across the whole financial system, as the crisis that erupted in 2008 has shown. It therefore has to be taken very seriously by Governments.
Credit growth cycles start, Davel explained, when a lending methodology is developed that is cost effective and can ensure high levels of repayment. A cheap model for loan disbursement, administration and repayment collection, IT infrastructure developments, automated or delegated decision making systems, networks of agents, and aggressive commission structures will all play a part. Favourable conditions such as these will attract providers whether in the form of banks in developed countries or micro-finance institutions in less sophisticated economies, where credit may also start to flow from donor organisations.
Rapid market growth is then likely to occur and individual debt levels will escalate. For an extended period defaults may remain low as a result of the liquidity provided by multiple lenders and multiple loans to the same clients. A tipping point will be reached, however, where even further borrowing cannot prevent escalating default: banks start to chase arrears and rein in credit; defaults escalate as access to new credit dries up; banks that can collect their debts do so; those that cannot have to default. To make matters worse the original credit growth phase is likely to have been concentrated in time with the result that defaults will also occur over a short period, affecting a number of different institutions at the same time.
According to Davel, the main triggers that lead people to take on more debt than they can reasonably expect to repay, are, external. These could be job loss, relationship breakdown, paying children’s education fees, death or illness in the family, or in less advanced countries natural events such as crop failure. Or it could be an event that affects the community as a whole such as a factory closure.
Yet if individuals cannot help wanting or needing to borrow, this still does not explain why financial institutions are willing to lend, even though the outcome could be disastrous for all concerned, including the institution itself. According to Davel, lenders determine the profile of the clients that they service and the extent of indebtedness they tolerate through the definition of its target market. Indeed, to a great extent indebtedness is determined by the marketing strategy a lender adopts, the credit criteria it sets, the growth targets it aims for, and the commissions it pays to its loans officers.
But there is a further twist. Financial institutions often appear willing to continue to lend even when there must be suspicions that clients are over-indebted. Caution is overridden because in a high interest rate environment lending may remain profitable even when there are high default rates. This undermines lenders’ incentives to curtail lending despite signs of increasing default.
If institutions have the ability to deduct loan repayments from a borrower’s salary or has access to other preferential collection techniques, this will also give an excuse to ignore warning signs and adopt a ‘devil take the hindmost’ approach. The income to be earned from penalty interest, penalty fees and the ability to add debt collection charges may also provide an incentive to extend credit to clients who are already over-indebted.
Government are also implicated. Their light touch regulation, which they hope will promote financial inclusion or to promote greater home ownership, often contributes to institutional recklessness. This was seen in the sub-prime crisis in the US and similar problems in the UK, affecting particularly RBS, Northern Rock and HBOS, as well as among banks and micro-finance organisations in South Africa, Nicaragua, Morocco, Bosnia Herzegovina, India and a number of other countries over the last 10-15 years.
The paradox, as Davel pointed out, is that if a credit provider’s strategy results in a significant number of consumers becoming over-indebted, the value in terms of financial inclusion is limited. Preventing the activities of predatory lenders from creating unsustainable debt levels that would undermine the long-term stability of the credit market would by contrast be of value to the goals of financial inclusion.
So what can be done to prevent the whole cycle that followed the fall-out from the 2008 world financial crisis starting all over again? How can we prevent the over-indebtedness both among the rich consumers of the West and their poorer counterparts in the developing world being repeated?
In the EU a relatively recent Consumer Credit Directive includes an obligation on credit providers to assess the creditworthiness of consumers, as does the Dodd-Franks bill in the US. In South Africa the National Credit Act has put severe limitations on sales and marketing practices and on interest rates and fees. Interestingly, the Act includes what is known as an ‘In Duplum’ rule, a Roman Dutch law principle which rules that the interest and fees on a credit agreement that is in arrears may never exceed the outstanding balance on the credit agreement at the date when it went into arrears.
What is clear is that when credit does become much less tight, as it undoubtedly will at some point in the future, regulation will need to be fully in place and implemented to ensure signs of distress are picked up early and that lending is held at responsible levels. Systems need to be put in place to prevent excessive credit bringing the world to the brink of economic chaos again.