Improving the impact of microcredit for SMEs

Access to microcredit is a key enabler of poverty reduction and economic growth as it supports small businesses and entrepreneurs to get their businesses off the ground, and sustains them through natural seasonality or difficult times. This can help rice farmers in the Philippines buy fertiliser or garment manufacturers in Bangladesh buy sewing machines – essentially enabling a stronger and more resilient private sector in emerging markets.

Whilst account ownership has reached 71 percent in developing countries[1], there is much to be done when it comes to lending. 41 percent of formal Micro Small and Medium Enterprises (MSMEs) have unmet financing needs, equating to a c. USD 5 trillion finance gap[2].

But with high profile issues concerns around aggressive marketing and over-indebtedness, how can responsible lending practices help investors manage the risks inherent in this space?

Rise of digital credit

In 2006, the Nobel Committee awarded the Nobel Peace Prize to Muhammad Yunus and Grameen Bank, declaring micro credit “an ever more important instrument in the fight against poverty”. Since then the industry has grown, particularly in the last decade as digital solutions were introduced. Digital credit has transformed the credit sector and has given millions of historically unbanked individuals access to formal loans for the first time. In Kenya, for example, digital loans now outnumber traditional loans by a factor of 10:1[3].

When algorithms are well-developed, digital lending enables a broader geographic reach and can reduce human bias in decision-making[4]. Predicting credit risk and deciding to accept or reject prospective borrowers can also be enhanced using algorithms. On the other hand, biases can be accentuated if algorithms are poorly written[5], so it is key for lenders to know which variables are being considered in their credit scoring models and how these variables are affecting borrowers’ scores[6]. Nevertheless, digital credit is an attractive alternative for the lender because it significantly lowers costs[7]. This should theoretically lower interest rates for marginal borrowers.

Over-indebtedness and its risks

The data shows that irresponsible lending and the mis-selling of credit is far more prevalent in the digital credit market than offline[8].  This in turn contributes to the rise in over-indebtedness, which can be problematic for all stakeholders. When debtors face difficulties in meeting their loan commitments, it causes an increase in non-performing loans for lenders and weakens their balance sheets. As a result, credit becomes less available to marginal borrowers as lenders become more wary about lending.  Furthermore, if those who are over-indebted do not receive support, they are likely to suffer from further financial exclusion; it will be harder to get a phone or internet subscription, take out insurance, or find a job[9].

For over-indebted micro-borrowers in Tanzania, for example, this has left them unable to meet basic needs due to loan repayment expenditure, with 75% or more of their monthly income directed towards servicing debts[10]. This demonstrates the adverse multiplier effect that over-indebtedness causes amongst emerging economies.

Best practice guidelines for responsible lending

Responsible lending aims at ensuring a high level of consumer protection whilst maintaining or improving uptake of credit agreements. The accompanying practices seek to prevent marginal borrowers[11] from unsuitable credit contracts that can lead to problems of over-indebtedness.

The Social Performance Task Force (SPTF)[12] and CERISE[13] have come together to create the Client Protection Standards, which reflect best practices in consumer protection. These principles are standardised across 8 key areas of focus: product design and delivery, prevention of over-indebtedness, transparency, responsible pricing, fair and respectful treatment of clients, privacy of client data, mechanisms for complaint resolution, and governance and HR.

These standards aim to act as a robust and consistent means to track and monitor lenders’ practices, policies, and systems for continuous improvement. In the last 3 years, over 150 financial institutions operating in emerging markets have been certified as successful in implementing and upholding the Client Protection Standards in their practices[14].

While responsible lending considerations are relevant throughout the lending cycle, we believe focusing efforts initially on the pre-contractual stage is likely to yield the biggest return in added value. It also helps to establish a positive borrower-lender relationship from the outset. Based on a review of the academic literature, the following factors are most important at the pre-contractual stage:

  • Provide pre-contractual information at least 48 hours before the borrower concludes a credit contract[15]. This allows the borrower enough time to assess whether the loan offer is suitable and to also compare different credit products.
  • Pre-contractual information should be simplified and only focus on the key features of the offer. This can be achieved many ways; one approach is to introduce new consumer-tested rules on the content, format and presentation of the pre-contractual information provided to marginal borrowers. This aims to ensure that all key information is received, and that none of the information presented is misleading or overlooked.
  • Improve borrowers’ financial literacy; this upskills and encourages them to better understand the products and services they are interacting with. It also empowers marginal borrowers to make informed decisions and play an active role in the borrowing process[16].

We believe that the Client Protection Standards should eventually be adopted by all responsible lenders. The implementation costs are likely to be one-off and should reduce the incidence of defaults and save money in the long term[17]. It will help companies stay one step ahead of regulation. Furthermore, commitment to these standards can highlight a company’s merits as a sustainable financial service provider to potential funders and partners.

What this means for Arisaig

Our due diligence processes include conducting a Sustainability Risk Management (SRM) assessment, which considers a company’s strategy, disclosure, and performance on material ESG issues. For companies involved in digital credit, this includes an assessment of responsible lending practices. In addition, as part of our impact measurement and management framework, we track metrics (informed by the GIIN’s IRIS+ system) that help us monitor whether the companies are continuing to lend in a responsible and sustainable manner, such as number of clients, customer satisfaction, average loan disbursement size, annualised effective interest rate charged, and rate of non-performing loans (NPL).

More recently, we have created a Responsible Lending Engagement Pack, which sets out the good practices that we wish to see our investee companies adopt. This will form the basis of engagement on the topic and has already led to a detailed discussion with one holding (a large mobile money provider) on its digital lending practices.

We believe companies providing fintech solutions to MSME credit still have huge potential to create positive social impact in emerging markets and can be prime examples of Purposeful Growth. However, concerns around unethical lending practices and the rise of over-indebtedness need to be addressed head-on, particularly while regulation is still catching up to innovation.

[1] https://www.worldbank.org/en/publication/globalfindex

[2] https://www.smefinanceforum.org/data-sites/msme-finance-gap

[3] The Impact of Digital Credit in Developing Economies: A Review of Recent Evidence (escholarship.org)

[4]Automation in Small Business Lending Can Reduce Racial Disparities: Evidence from the Paycheck Protection Program by Sabrina T Howell, Theresa Kuchler, David Snitkof, Johannes Stroebel, Jun Wong :: SSRN

[5] This is especially notable in emerging markets where there is often less regulation and oversight of what data are used and how it is used.

[6] Algorithm Bias in Credit Scoring: What’s Inside the Black Box? (cgap.org)

[7]https://www.regjeringen.no/globalassets/upload/fad/kampanje/dan/regjeringensdigitaliseringsprogram/digit_prg_eng.pdf

[8] Consumer-credit-market-study-V13.pdf (finance-watch.org)

[9] The Legacy of Economic Recession in Terms of Over-Indebtedness: A Framework and Review of the Evidence

[10] Full article: An assessment of over-indebtedness among microfinance institutions’ borrowers: The Tanzanian perspective (tandfonline.com)

[11] Here we define and use marginal borrowers to represent the merchants and consumers who are not well catered by the traditional banking sector;

[12] SPTF is a global non-profit organisation that seeks to develop and promote standards and good practices for social performance management to make financial services safer for clients.

[13] CERISE is a French non-profit organisation that promotes responsible, inclusive and ethical finance and works with various actors in the sector to co-create free social standard and social assessment tools.

[14] The certification process assesses compliance with each indicator of the framework and takes a total score.

[15] Consumer-credit-market-study-V13.pdf (finance-watch.org)

[16] final-report-on-over-indebtedness-of-european-households-synthesis-of-findings_december2013_en.pdf (europa.eu)

[17] final-report-on-over-indebtedness-of-european-households-synthesis-of-findings_december2013_en.pdf (europa.eu)

Disclaimer:

This material is being furnished for general informational and/or promotional purposes to professional investors only. The views expressed are those of Arisaig Partners and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact, nor should any reliance be placed on them when making investment decisions. This material does not constitute independent research and is not subject to the protections afforded to independent research.

The statements and views expressed herein are subject to change and may not express current views. Arisaig Partners makes no representation or warranty, express or implied, regarding the accuracy of the assumptions, future financial performance or events. Emerging markets are generally more sensitive to economic and political conditions than developed markets and may be more volatile and less liquid than other investments.

All information is sourced from Arisaig Partners and is current unless otherwise stated. Issued by Arisaig Partners (Asia) Pte. Ltd. Not for public use or distribution. Arisaig Partners (Asia) Pte. Ltd is licensed and regulated by the Monetary Authority of Singapore.

Sign up to request our research