Bankable Frontier Weblog

I recently co-authored a Focus Note for CGAP on Protecting Microfinance Borrowers. Consumer protection is a fast rising issue in microfinance today. The Focus Note provides a primer on the issue especially for the uninitiated. The Note is also complemented by an interview on the subject in the May 2005 issue of the UNDP’s MicroFinance Matters.

For this blog, however, the most interesting questions are: why the issue is attracting such attention; and what does it all mean for the future of microfinance?

In part, microcredit is a victim of its own success, in two senses at least. First, the number of micro-borrowers has grown substantially in a number of countries. This in itself ensures that the absolute number of consumer complaints about lenders will rise; and also that politicians will pay more attention since more voters are affected by it. Second, not only is it likely that the absolute number of complaints has risen, but the proportion of complaints has probably risen as well—although very few countries actually have the mechanisms to track this quantitatively. This is because later entrants to the sector have typically been more commercially driven than the early pioneers who often had strong social development motivations. This has raised the potential for abuse, as hard sell and hard collection techniques have prevailed in some places.

Traditionally, interest rate ceilings were widely used as a crude form of borrower protection. The logic was that, if interest rates were at least kept low, the extent of abuse of borrowers would be limited. Here too, the microfinance movement has had some success: it has demonstrated that higher interest rates are not necessarily associated with exploitation; in fact, they usually go with greater access. Conversely, interest rate ceilings have little protective effect; if anything, they result in credit being rationed from poorer and less credit worthy borrowers; and may drive rationed borrowers into the informal or illegal sector where they have no formal protection at all. For a useful summary of these arguments, see the recent CGAP Occasional Paper by Helms and Reille. In response, some countries abandoned their rate ceilings, while others opened special lending windows. An example of the latter is South Africa’s Usury Act exemption which removed rate caps for micro loans only.

Recent studies across developed credit markets also confirm the effect of interest rate controls. In 2004, the UK’s DTI commissioned research on credit markets in the US (where regulation varies by state), UK, Germany and France. The report concluded that “rate ceilings affect the availability of dedicated sub-prime (lending) models and create credit exclusion for those who cannot access the credit mainstream.”

If interest rate ceilings are increasingly less defensible as means of consumer protection on theoretical and practical grounds, then the burden of protecting vulnerable consumers falls on other approaches, such as standardized disclosure, enhanced consumer financial literacy, prohibitions or limitations on certain marketing, underwriting and collection practices. These approaches are described in the CGAP Focus Note. At least such measures target more closely the root causes of exploitation.

But the measures are also often complex and harder to enforce than simple rate ceilings. Hence, the enduring popularity of rate controls among politicians in developing countries, notwithstanding the theoretical and practical grounds for abandoning them. New interest in forms of rate control has been heard by politicians in countries ranging from Bangladesh to Uganda. In both of these countries, microlending has thrived in part because of the absence of such controls.

The likely outcome in many places may be laws which give the power to control rates, since politicians are unlikely to want to cede this, while imposing other obligations on lenders. The power to control may not be exercised initially or may be used to set relatively generous ceilings by means of regulation.

A prototype of this approach is the National Credit Bill tabled in the South African Parliament in early June 2005. This Bill replaces all previous credit legislation in the country. It combines both the capacity for rate ceilings (to be decided through regulation) and comprehensive protective measures to be enforced through a new Credit Regulator. This approach to consumer protection, expected to be passed into law later this year, is probably the most comprehensive among developing countries. However, the Bill has attracted substantial criticism from industry from industry over the new costs of compliance which it imposes on lenders. In Parliamentary hearings this month, government has defended its approach as being reasonable.

The outcome of these hearings, leading to the final form of the Act, will be worth following; as will be the process of establishing the new credit regulator in 2006. This legislation is likely to influence thinking in other parts of the developing world on the subject of borrower protection, and as such represents one possible future for the microfinance sector.