In Mexico, the microfinance sector has been growing at an unprecedented pace which allowed it to penetrate deep into the population of Mexico. Although the number of microfinance institutes has grown rapidly, it is highly concentrated in the poorer states of the country. One outcome is the increased amount of loans taken out by the people. It is already difficult for low-income households to pay off one loan but when there are multiple loans, they spiral into a deeper, more acute state of poverty.
As the abundance of over-indebtedness is spreading across the population, researchers and policymakers are concerned about the sustainability of the whole microfinance industry. At this point, the negative impacts are mounting up and threatening the entire industry into collapsing. In this article, we shall discuss the atmosphere of the microfinance industry in Mexico, how it impacts the population and the industry, and what steps the concerned bodies can take to tackle the situation.
State of the Microfinance Industry in Mexico
In Mexico, the expanding microfinance industry has proved to be extremely useful to the poorer section of the community by making more credits available to the people. In fact, credit has become far more widely available to low-income people in Mexico over the past ten years. This is in part a result of improved regulatory practices in the financial industry.
However, the greater availability of credit resulted in more people taking out loans. In most cases, households, individuals, or businesses have multiple loans to their names, racking up their overall debt. This is a highly undesirable situation. As the need for microfinance for all in the wake of Typhoon Haiyan is felt, it is extremely important to maintain proper microfinance conditions in other risky countries.
A study conducted by Foundation for International Community Assistance (FINCA) to assess the situation in Mexico brought up some behavior patterns that are persisting which affect the over-indebtedness in the economy.
- Over-extended borrowers continued to apply for new loans and they often receive these additional loans. The market is now saturated with borrowers with multiple loans to their name and who are already in arrears in one or more of their previous loan statuses.
- Due to the saturation of over-indebted borrowers and malpractice among lenders, responsible lenders are finding it difficult to acquire qualified customers. First, there are simply not enough borrowers to go around who do not have some debt to their name.
- Moreover, corrupt practices by the money lenders such as delaying credit reports, disseminating false information regarding rival financial institutes, promoting false advertisements to lure customers, and incomplete information provided to customers, all contribute to keeping the economy heavily steeped in over-indebtedness.
- Borrowers take out loans to provide for essential needs. Since the majority of the population has substantially low income, they cannot afford to save up for important things like education, emergencies, and helping out a needy relative. Rarely the money taken out from loans is used for extravagance.
- The economy is full of borrowers who have every intention of paying back their loans. Despite the amount of debt, they are in or even if they were taken advantage of, the borrowers are generally honest people who are taking steps to remedy their situation.
- All the blame for an over-indebted economy is not simply on the borrowers. It is identified by the money lenders that bad lending can be converted into good business. This understanding has led to the relaxation of oversight. Also, due to the massive increase in the variety of money lenders and the total volume of loans, borrowings are highly encouraged even if the borrower seems to be unable to pay back the loaned amount.
What are the Risks Associated with Over-indebtedness?
In Mexico, malpractice among lenders, a higher concentration of microfinance institutes in relatively smaller geographical locations, and the greater need and subsequent availability of credit for the poorer section lead to greater over-indebtedness. The grim statistics that are evident in the Mexican economy are that a large portion of new loan applicants in Mexico already have open loans, and just under half of them are already behind on their payments.
Growing evidence of overindebtedness and credit bubbles in various parts of the nation is a problem that, if ignored, could result in serious issues. The issues can broadly be summarized in the following points:
- The purpose of a microfinance institute is to provide responsible, convenient and trusted financial solutions for the poor section of society. In fact, the microfinance industry is crucial in tackling five challenges to accelerate financial inclusion.
- As a social responsibility of the industry, it is not desirable to see the poor community continually take credit and fall into a deeper trap of unstable financial conditions. This is more likely to increase social, economic, and psychological problems for the client.
- The development of financial services in a country is entirely dependent on the relationship between the microfinance institute and its clients. However, with widespread over-indebtedness among clients, it is more likely to lead to defaults that have adverse financial impacts on both the microfinance industry and its investors.
- As a result of over-indebtedness, the microfinance institute gained a negative reputation. The reputational damage to the microfinance institute, and the industry at large leads to problems such as fewer donations, and lack of confidence from funders, and it may even affect the microfinance industry in other countries.
- Reputational damage to the microfinance industry in one country has a contagious effect on other microfinance industries in other countries. This will ultimately put a halt to all the positive impacts of the microfinance industry.
The risks of over-indebtedness are so high that it is absolutely crucial to mitigate over-indebtedness before it becomes a problem. In fact, it is time to ditch impact investing unproductive self-analysis and recognize the early signs that need to be identified to initiate mitigation strategies.
The macro-level indicator covers the signs that are evident at the country level such as Gross Development Product (GDP) per capita growth, remittances, inflation, political and economic stability, corruption, and governance.
Microfinance Market Indicator
The microfinance market indicators include factors such as market penetration, number and size of microfinance institutes, loan portfolio growth rates, client numbers, quality and use of credit information systems, commercial bank involvement, level and trends in competition, investment flows, and the liquidity positions of microfinance institutes.
Microfinance Institute Level Indicator
At the microfinance institute level, factors such as average loan balance per borrower, loan requirements and lending methodologies, Loan Officer productivity, client-staff ratio, growth and market targets, cases of multiple lending, and the existence of consumer lending.
Problems of Unregulated Lending
Overall the Mexican market is saturated with microfinance institutes but on closer inspection, it is revealed that they only penetrate a thin region of the Mexican economy. As the main demographic of the microfinance industry is the low-income section of the community, the greater concentration is naturally in the poorer states of Mexico like Chiapas, Oaxaca, and Veracruz. Consequently, these states also have the lowest Human Development Index.
As a consequence of the greater saturation of microfinance institutes, the market is extremely competitive. However, this has resulted in the dramatic expansion of both the overall amount of loans in the industry and the quantity and diversity of lenders. In any other cases, institutions with sound credit policies would refrain from providing unsafe loans out of concern for write-offs and administrative expenses.
However, the lenders in Mexico are observed to lend money even to borrowers with high amounts of unpaid loans. This is likely to be the effect of the high interest rates in the microfinance industry which allows some lenders to shift the costs of risky loans onto borrowers. As a result, bad lending is becoming big business, while consumers are bearing the costs. Such irresponsible lending by microfinance institutes leads to devastating results for the clients and the microfinance industry in the long run.
In fact, a survey executed by the Microfinance CEO Working Group (MCWG) which used credit bureau data from FINCA Mexico, discovered that over 74% of new consumers applying to FINCA already have loans from other sources (around 55 percent have one or two, and 19 percent has three or more loans). In addition, 44% of the consumers who had outstanding loans at the time of application were already behind on their payments.
The immediate effects of unregulated lending are as follows:
- Borrowers who are unable to pay off their previous loans will continue to take out loans and incur greater debt in the process.
- The market will have high rates of over-indebtedness that will lead to defaulters.
- Without proper checks on lending practices, the money lenders are more likely to exploit the customers who will have poorer financial status as a result.
- The unregulated lending practices will allow more microfinance institutes to crop up and reduce market quality.
Prevention is Better Than Cure: Measures to Curb Over-Indebtedness
As every party (client, investors, people who are working for microfinance institute) in the transaction of microfinance is a potential “risk owner”, it is extremely crucial to limit the risk in the deals to prevent a complete structural collapse.
It is very hard to remedy the state of the economy once it is riddled with over-indebtedness. The best way forward is to instill precautionary measures within the system to prevent over-indebtedness altogether. There are broadly three lines of defense in any microfinance institute against over-indebtedness.
Operational Front Line
The operational front line comprises the staff working in any microfinance institute. Since they are the first point of interaction for the customers, it gives them the most responsibilities in effective risk management. The checks and rules established at this stage should be sufficiently robust to ensure that the client, the microfinance institute, and the investor are at minimum risk.
The particular areas where the staff in microfinance institutes need to focus to limit the risks taken by all the parties involved are as follows:
- All material risks need to be identified beforehand, and the level of risk assessed, monitored, and reported.
- The mitigating policies need to be specifically outlined and adhered to. This also includes the key internal controls.
- The policies and requirements which are essential in the mitigation process need to be communicated to all the participants and all the operations should be transparent.
- Making sure that all the policies that regulatory bodies have decided to safeguard the risks are implemented.
- Monitoring the live risk of material issues and making sure that mitigation strategies are being implemented.
- A regular survey to identify new and emerging risks.
- Monitoring the effectiveness of existing controls and making improvements to them.
Risk function refers to the activities of anyone who is involved in the assessment and mitigation of risk management within the organization. The job of the risk function is to provide the right tools, structures, and forums to assess the risk and make transparent decisions based on that assessment. This defense continually updates the risk involved in several investments, the effectiveness of mitigation practices, and improvements on present rules.
The main roles of the Risk function are as follows:
- Outlining the overall framework for managing risk for the organization with clearly defined guidelines to measure risks effectively.
- Ensuring the effective communication and implementation of the Risk Management Framework.
- Developing and executing related governance and reporting processes to support the functioning of the Risk Management Framework.
Internal and External Audit Function
Audit functions by internal and external auditors have a systematic and disciplined approach to assess the effectiveness of the Risk Management, control, and governance process. The external auditors have the responsibility to determine the accuracy of the microfinance institute’s accounting records and assess whether the reports provide a true and just view of the microfinance institute’s financial status. In fact, this third line of defense holds the other two lines of defense accountable for their responsibilities.
Frequently Asked Questions
Q1. What is over-indebtedness in microfinance?
In microfinance, the customer base is composed mainly of low-income people. But in order to meet ends, they take credit from different sources but fail to repay the loan in time or in full. This results in over-indebtedness. The level of over-indebtedness in the microfinance industry is indicated by the stock of outstanding debt, the ratio of debt to household assets, bankruptcy, and the personal measures of hardships that borrowers face in repaying loans.
Q2. What are the three causes of over-indebtedness?
The causes for non-repayment of loans which eventually leads to over-indebtedness vary from household to household. But it can be broadly summarized in the following points:
- An increase in the cost of debts – when the cost of debts becomes too high and the poor households cannot afford to pay off the loans with their meager income.
- Decrease in income – a reduced income means that there is less money left over from paying bills and other essentials to pay off the loans.
- Increase in the cost of living – an increase in the living cost means that the discretionary income is reduced leaving less money to pay off loans.
Q3. What is the risk of over-indebtedness?
The risk of overindebtedness affects both the clients and the microfinance institute. In fact, the impact of over-indebtedness on a macroeconomic level is quite detrimental. The risks involved in over-indebtedness are as follows:
- The poor community forming the client base of the microfinance industry tends to get poorer when they have a rising amount of debt which completely defeats the purpose of the whole microfinance industry.
- When over-indebtedness becomes too common among people, it leads to a growing number of defaulters. This is financially detrimental to microfinance institutes and their investors.
- On a macroeconomic level, it damages the reputation of microfinance institutes which results in a reduced number of donations and poor market growth.
In Mexico, over-indebtedness is becoming a serious problem as a result of unregulated lending practices, over-saturation of markets with microfinance institutes, low income of the majority, improper implementation of mitigation strategies, etc. There are many indicators to gauge the actual status of over-indebtedness in the country. These indicators can provide insight into the mitigation strategies that will prove to be useful to contain the situation.
In short, the mitigation strategies need to be designed with careful consideration and make sure that the governing bodies, concerned organizations, microfinance institutes, and regulatory bodies follow through on the implementation. Simply framing a mitigation policy is not enough to curb the situation, the proper execution and regular evaluation of the policy’s effectiveness are equally important.
- Elizabeth Jones is one of our editorial team’s leading authors on credit card offers, services & more. With over two decades of experience in the consumer credit industry and as a nationally recognized credit expert, Elizabeth provides in-depth analysis of both traditional & alternative forms of credit. Elizabeth regularly appears on many major media outlets including NBC Nightly News, Fox Business Network, CNBC & Yahoo! Finance. She is also a frequent contributor to Forbes Magazine. As a highly appreciated author for our exclusive Editorial Team, Elizabeth strives to provide readers with a trustworthy advice on how to manage their credit accounts while staying informed on the latest offers in the marketplace.
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