1. Prevention of Over-indebtedness

2. What is over-indebtedness?
Sacrifice approach
“A microfinance customer is over-indebted if he/she is continuously struggling to meet repayment deadlines and structurally has to make unduly high sacrifices related to his/her loan obligations” (Schicks, 2010)
Net indebtedness index (NII) approach
“A microfinance borrower to be over-indebted when his/her total debt service is higher than his/her net income during a defined timeframe, whether it is from one or multiple loans” (Cambodia Over-indebtedness study 2013)
Definition of Over – Indebtedness (5 mins) OPTIONAL (As per the market/participants needs)
Default/delinquency approach
A microfinance client is over-indebted if he/she can not repay the loan.

3. Poorly designed repayment schedules Inadequate capacity analysis
Identifying the Causes of Over-indebtedness
Multiple loans
Multiple loans are issued to client, by one or more institutions, due to:
Lack of information on the client’s liabilities
Incentives for loan staff to oversell credit products
Poorly designed repayment schedules
Repayment schedule does not match the client’s business cycles (e.g., agriculture)
Inadequate capacity analysis
The institution relies on guarantees as a substitute for adequate capacity analysis
Highlight main points – 1 min
These are some of the most common causes of over-indebtedness:
The client is issued multiple loans at one or several institutions because:
The institution lacks information on the client’s liabilities (e.g. non-existent credit bureaus), and /or
Loan officers are incentivized to oversell credit products.
Repayment schedules do not match clients’ business cycles (e.g. agriculture).
The institution relies on guarantees as a substitute for adequate capacity analysis.
Accidents, disease, or natural disasters.
Unpredictable events
Accidents, disease, or natural disasters

4. Regardless of education levels, understanding of loan terms is low.
Example from Campaign research
Regardless of education levels, understanding of loan terms is low.
Benin N= 1420
Georgia N=913
Pakistan N= 1000
Peru N=1000

5. How over-indebted clients affect the MFI
Increase in client delinquency
Portfolio provisioning prevents institution from making other loans
Slow and costly legal proceedings for collections
Highlight main points – 2 mins (OPTIONAL)
When an institution has a high level of over-indebtedness among their clients, they will likely have an unhealthy portfolio. These are a few of the most common ways that over-indebted clients affect an MFI:
Increase in client delinquency
Portfolio provisioning prevents institution from making other loans
Slow and costly legal proceedings for collections
Damage to the institution’s image and portfolio
Damage to the institution’s image and portfolio

6. Clients may … How over-indebtedness affects the client
Work longer hours
Reduce consumption
Use savings for loan repayment
Take new loans to pay off current debt
Sell assets, including productive assets
Invest less in productive assets and human capital
Search for help from family, depleting relatives’ assets
Highlight main points – 2 mins
Over-indebtedness is often very difficult for a client to handle. These are several of the ways that over-indebted clients typically deal with their dilemma:
Work longer hours
Reduce consumption
Use savings for loan repayment
Take new loans to pay off current debt
Sell assets, including productive assets
Invest less in productive assets and human capital
Search for help from family, depleting relatives’ assets
Source: DAI

7. Some clients take extreme measures to keep up payments
Example from Campaign research
Some clients take extreme measures to keep up payments
Benin N=1423
Pakistan N=88
Peru N=637
Georgia N=1000

8. MFI Borrowers Prevent Over-indebtedness Consider this:
Carefully establishes the borrower’s ability to afford the loan and repay it.
Are able to handle debt service requirements without sacrificing their basic quality of life.
3 mins
This is the Campaign’s definition of the principle “Prevention of over-indebtendess.” An institution puts the principle into practice by:
Carefully establishing the borrower’s ability to afford the loan and repay it, and
Taking adequate care that non-credit, financial products (such as insurance) extended to low-income clients are appropriate to their needs and means.
If the institution does these two things, borrowers should be able to handle debt service requirements without sacrificing their basic quality of life.
Research and practical experience show that borrowers consistently overestimate their own capacity to repay debt. While borrowers should take responsibility for their borrowing behavior, lenders have a responsibility to carefully assess borrower capacity before making a loan.
Consider this:
Research and practical experiences shows that borrowers consistently overestimate their own capacity to repay debt.

9. Principle in Practice
Over indebtedness is avoided in product design through carefully defined and rigorously assessed eligibility criteria and defining debt threshold limits. There should be rationale for target setting, incentive schemes and senior management should monitor and respond to issues around portfolio quality.
Principle in Practice – 5 mins
A major focus of credit product design is the prevention of client over-indebtedness, as described in the section on that principle. Over-indebtedness is avoided in product design through eligibility criteria and other terms that balance loan size against a client’s capacity to repay. It is important to have benchmarks for loan officer productivity and growth and monitoring targets and hold itself accountable to those targets.

10. CPP#2: Adequate Standards of Care
Define max debt and use cash flow analysis
Approval is NOT based on guarantees & insurance coverage
Repayment capacity analysis is done every time and for every group member
Credit decision process includes at least 1 non- field staff
Policy for cooling off b/w 2 loans and defining pre-payment conditions
Robust internal controls for underwriting
EVERYONE trained on credit process
Policy and well-documented process for loan approvals using appropriate information criteria
Adequate Standards of Care – Indicator wise (15 mins)
First standard has focus on the 'Client underwriting process”. For individual borrowers, an analysis of his or her repayment capacity is the best practice for assessing creditworthiness. This assessment will typically include a careful analysis of the borrower’s existing cash flow, with considerably less emphasis on additional cash flow anticipated as a result of any new borrowing. Collateral and guarantees can be used as a secondary source of repayment and as confirmation of the borrower’s commitment to repay, but the lending decision should be made on the basis of repayment capacity. It is recommended that the methodology for assessing the creditworthiness of individual borrowers be reinforced by a quantitative loan approval limit based on the ratio of available cash flow to debt service payments. This ratio should incorporate a cushion for error and unexpected expenses. It should also be adjusted as needed; for example, during a period of high system-wide delinquency a more conservative ratio may be called for.
In the case of group lending, the methodology for the assessment of creditworthiness can vary by group. The key objective is a clear system for quantifying and monitoring the repayment capacity of group members. Guidance, as well as targeted training if possible, should be provided to the groups for assessing creditworthiness.
For group loan products that use group guarantees, it is important to ensure that the members understand the financial and reputational risks that they face if one of the group members becomes over-indebted and is unable to fulfill its responsibility to the group.
It is also useful to have a qualitative definition of over-indebtedness to help staff keep the main objective in mind and to avoid the rote use of numeric tools. An example of such a definition is a state in which a borrower has to make significant sacrifices to his or her standard of living or business affairs in order to repay debts.
The analytical process for assessing debt capacity should include a requirement for confirming information provided by a potential client, such as reference checks and site visits. This information can be useful for assessing not only the client’s ability to repay but also his or her willingness to repay the loan.
The FI has a sound policy and well-documented process for loan approvals and makes decisions using appropriate information and criteria.
The FI defines the maximum percentage of a borrower's disposable income that can be applied to debt service, including debt from the FI and other lenders, and uses this amount in determining maximum loan amounts and terms. (Note to Certifier: It is up to the FI to set the ratio, provided there is a logical rationale.)
Guarantees, guarantor income and/or insurance coverage are not the main basis for loan approval.
Clients are prohibited from borrowing on behalf of another person.
For enterprise loans, the loan approval process evaluates repayment capacity through a cash flow analysis and review of client indebtedness. The analysis considers income, expenses and debt service related to business and family and any other sources, including informal sources. (Appropriate repayment schedule. Appropriate loan repayment schedules correspond with the borrower’s cash flow. Requiring small, regular payments is the most convenient way to encourage borrower discipline and monitor performance. However, consideration should also be given to the needs of clients with seasonal cash flows, such as farmers, or those who have borrowed to buy equipment that will take time to be able to use effectively. Large bullet and balloon payments should be avoided because they put a burden on the client to accumulate a large sum of money. Large prepayment penalties can also reduce a client’s ability to use loans for productive financial management.)
The repayment capacity analysis is refreshed at each loan cycle to identify changes in the client’s situation.
For loans with a group guarantee, due diligence may be conducted by the FI or group members. For group loans without group guarantees, the FI carries out a repayment capacity analysis for each borrower.
The loan approval process involves at least one staff member other than the one directly involved in the client relationship (e.g., senior loan officer, branch manager, credit committee).
The FI has a policy that defines when clients are permitted to prepay loans. If prepayment is allowed, a cooling off period between two loans is required. ('Procedures for automatic loan renewals or increases should be carefully evaluated to ensure that they do not conceal borrower problems or create problems by allowing clients to over-borrow or ―bicycle‖ loans. Updating client assessments at the time of a new loan request or at an established periodic interval is an important element of these procedures. One sometimes overlooked point is that too small a loan can also inadvertently create problems. Too small a loan can lead to situations in which the borrower seeks additional loans from one or more other lenders, thereby weakening the original loan provider’s relationship with and understanding of the borrower’s financial condition.)
The FI has a rigorous internal control process to verify the uniform application of policies and procedures about client underwriting, and it can produce evidence of corrective measures taken in case of partial or incorrect implementation.
All new staff are trained on loan analysis and the credit approval process and all credit staff receive refresher trainings annually.
If due diligence is conducted by group members, groups are trained on how to conduct due diligence and relevant loan criteria.
The FI verifies that third parties (agent network managers, etc.) train their own representatives on loan analysis and the credit approval process.
The FI uses credit reporting information, when feasible in the local context.
(Market-level initiatives. To be added (financial education and credit bureaus)
Credit bureaus can be useful sources of information about a potential borrower’s other loan commitments and borrowing history. However, it is important to have a realistic understanding of the reliability of this information and to adapt its use accordingly. If credit bureau information is known to be incomplete or out of date, for example, or if there is no credit bureau at all, then it is recommended that calculation of the client’s repayment capacity take into consideration the possibility of additional non-disclosed client debt.
Policy and documented process require timely reporting to credit bureaus and use of credit reports systematically in the approval process for all loans.
When effective credit bureaus are not available, the FI shares data with competitors and uses data from competitors in loan approvals, as feasible in local context.
Credit reporting information is used
Report to & check Credit Bureau
If no Credit Bureau: data exchnaged w/ competitors

11. CPP#2: Adequate standards of care
Senior management and board monitor and respond to heightened OI risk.
Portfolio quality monitored regularly
Track restructured and rescheduled loans
Board reviews OI levels & portfolio quality
In heated markets ; risk mitigating policies
Define PAR levels that trigger extra measures
Sound Portfolio Quality maintained
Total Credit Risk a quarter is < 10%
If >10% then corrective measures taken
Adequate Standards of Care – Indicator wise (15 mins)
FI senior management and board monitor the market and respond to heightened over-indebtedness risk.
The FI's loan officers and branch managers monitor portfolio quality at least monthly to identify areas with high risks of over-indebtedness. Analysis is done by branches, products and client segments.
The FI tracks any restructured, rescheduled or refinanced loans separately.
The FI's senior management and the board of directors review results related to over-indebtedness in the market and the FI's portfolio quality at least quarterly. Measures to prevent over indebtedness are discussed, implemented, and monitored and records of these actions exist.
The FI has a policy on sustainable target growth rates considering the FI's growth capacity and the markets being targeted.
When a risk of systemic over-indebtedness arises in the market, the FI adopts risk mitigating policies, such as slower growth, more conservative loan approval criteria, or limits on total number of loans an individual can have at one time from multiple providers.
The FI defines PAR levels that trigger additional internal monitoring and response.
The FI maintains sound portfolio quality.
Total credit risk  has not averaged more than 10% during any quarter in the past 3 years, including the most recent quarter. (Refer to accompanying spreadsheet to calculate total credit risk. NPL should not include restructured loans. In the accompanying spreadsheet: the FI needs to disclose Restructured total, Restructured 0-30 days and Restructured , in addition to Total portfolio 0-30 days and Total portfolio )
If total credit risk has exceeded 10% at any point in the past 3 years or in the past quarter, the FI demonstrates that corrective measures have been put in place.
The FI incentivizes staff to approve quality loans.
The FI has a policy and documented process in place to determine sales and caseload targets and monetary incentives for credit staff (if used), including flags for caseload levels that signal high risk.
The FI's productivity targets are reasonable as compared to industry benchmarks for similar organizations operating in similar conditions.
The incentive systems value portfolio quality at least as highly as other factors, such as client growth. Targets are aligned with context so that they are achievable.
If loan officer salaries are comprised of a fixed and a variable portion, the fixed portion must represent at least 50% of total salary and it must constitute a living wage. (Certifiers: Note that for models using non-salaried commissioned agents, guidelines will be developed in Phase 3 of the Campaign.)
The FI reviews incentive schemes at least annually to assess whether they are reasonable in comparison to industry benchmarks and market risks.
Staff incentivized to approve quality loans
Policy & procuess to determine sales targets
Reasonable productivity targets
Incentives – balanced & reviewed annually
50% of total salary is fixed andat least a living wage

12. Good Practice: Interview delinquent clients.
Example of Good Practices from Bosnia-Herzegovina
Good Practice: Interview delinquent clients.
Practice
Outcome
Internal audit department conducts regular interviews of a sample of clients who have fallen behind on their payments.
The MFI uses the information to improve its credit procedures and to monitor risk.
Two main areas of investigation:
Did loan officers follow proper procedures to avoid over-indebtedness when issuing credit?
What are the causes of the client’s repayment challenges?
Good Practice – 2 mins
This is an example of an MFI in Bosnia-Herzegovia that uses its internal audit department to prevent and diagnose client over-indebtedness.
[Read through the slide: first, the good practice; then, the practice; then, the outcome].

13. Tools available from the Smart Campaign
Examples from MFIs
What are your examples?

14. Key Messages
FI's senior management review results related to over-indebtedness in the market at least quarterly.
FI verifies that third parties train staffs on loan analysis and the credit approval process.
FI defines PAR levels that trigger additional internal monitoring and response.
FI has rigorous internal control process for credit underwriting process.
In last 3 years, if the Credit Risk > 10% then FI demonstrates corrective actions.
For overheated markets, FI adopts risk mitigating policies, ie slower growth, conservative loan approval.