Guidelines for Suitability in Lending to Low-Income Households

In December 2014, the Reserve Bank of India published the Charter of Customer Rights as a commitment to protecting the interests of consumers of financial services. The charter includes the Right to Suitability, defined as the principle that “products offered should be appropriate to the needs of the customer and based on an assessment of the customer’s financial circumstances and understanding”. The MFIN and Sa-Dhan, in a joint Code of Conduct, also enshrine a similar principle but specific to the context of lending: “We, as part of the Microfinance Industry promise the customers that we will […] conduct proper due diligence to assess the need and repayment capacity of customer before making a loan and must only make loans commensurate with the client’s ability to repay”. Both the RBI and the SROs directed financial institutions to understand the parameters of suitability within the context of their respective product offerings and to formalize policies to prevent unsuitable sales to customers.

In a new research paper published as part of our Working Paper series, we focus on biggest barrier that financial institutions might face in complying with this directive – a lack of clarity on what may be deemed suitable and how this is to be determined for each client. Towards this end, our new research investigates the nature and incidence of unsuitability in a competitive lending market and the variety of ways in which low-income borrowers may experience or cope with loan-related financial distress. Our findings are both a reality-check on the effectiveness of the current approach to customer protection (particularly the efforts to prevent borrower over-indebtedness) as well as a guide to how, going forward, lenders can institute formal processes to prevent unsuitability.

In our previous writing on this topic, we have acknowledged that successful suitability practices must be iterative and that even at-best, they can in no way guarantee positive outcomes for clients. The focus of both compliance and supervisory efforts must rest instead on understanding patterns in product-client interactions – especially when such interactions result in substantial hardship to clients – and meaningfully improving sales processes to prevent unsuitable sales.

Key Findings

The primary data for this study was collected in a year-long panel survey of 400 low-income households in Krishnagiri district, Tamil Nadu; the full sample included clients of 7+ MFIs and 20+ formal financial institutions. The survey adopted a financial diaries approach and a detailed socioeconomic survey was administered every 4-6 weeks to capture the dynamics of households’ cashflows. The resulting dataset has a primary focus on the details of borrowing and loan servicing but also rich detail on the volatility of occupational income, the frequent incidence of small and large shocks to household budgets and the use of other income sources, resources from social networks and a variety of financial instruments to smoothen consumption, repayment obligations and other expenses.

From the survey, we were able to create a full picture of borrower indebtedness across multiple institution types – perhaps more completely than the credit bureaus for microfinance clients. Comparing the sum of monthly repayment obligations to borrowers’ average monthly incomes, we found that one of every five borrower households in the sample held an unaffordable level of formal debt. If we included informal loans or factored in the volatility of incomes, an even higher proportion held unaffordable levels of debt for a few or all months of the loan tenure. However, the incidence of repayment delays or the proportion of delinquent borrowers was much lower, and only weakly correlated with households’ debt levels. Even at very high levels of unaffordability, borrowers were prioritizing repayments on formal loans over essential expenses, and willing to take on even further unmanageable debt to get through a difficult period.

Further, the average households’ incomes varied month-on-month by as much as 45% and as a result, even borrowers with sufficient year-end surplus were observed experiencing periods of distress and using harmful coping mechanisms comparable to those whose incomes were much lower.

Implications for Suitability Practices

These patterns in borrower behaviour are perhaps not new to experienced practitioners of microfinance and further, may only be a reflection of practices designed to achieve repayment discipline. What is alarming however, is the relative ease with which some over-extended borrowers remained undetected, and were able to continuously receive new formal loans on the same terms as others.

NBFC-MFIs are subject to regulatory directives that restrict the level of indebtedness per client and additionally, a large part of the non-NBFC microfinance lending is also required to be reported to credit bureaus so that it may be available at the time of loan appraisal. Notwithstanding, we find that critical faultlines in the preparation and use of credit reports placed as many as 33% MFI clients in the sample at risk of being mis-sold an unaffordable loan.

More critically, the types of client assessments that inform loan-making are largely unregulated and often do not triangulate borrowers’ actual repayment capacity (relying instead on unverified or indicative measures, peer selection and group enforcement). Our results show that in a mature and competitive market, clients with similar incomes and livelihoods may in fact have very different borrowing portfolios and vice versa. In this scenario, universal lending limits— such as those currently in effect— poorly safeguard customers’ interests.

Instead, determined efforts should be directed towards building market capacity to conduct thorough client assessments and to respond meaningfully to clients’ financial situation. Credit reports urgently need to be strengthened to reflect a comprehensive view of all formal borrowing, without exception. On the lenders’ side, the use of comprehensive “combo” credit reports will still fall short if not also complemented by a robust understanding of what portion of household income can be made available for repayments. Further, clients with unique liquidity constraints or cashflow risks must receive adequate insurance either through appropriate products or through modified terms of service.

This research highlights not only how critical these measures are for borrower well-being, but also the challenges involved in suitably serving low-income households’ financial needs. As a step in this direction, this research outlines two minimum components for suitability assessments –

1. All lenders should ensure that loan amounts are appropriate and the agreed repayment terms are affordable for every borrower given their income flows, outstanding loan repayments (including self-reported informal loans) and critical payment obligations.
2. Lenders must also evaluate the harms of selling standardized products to those borrowers with highly volatile cashflows or those with unique liquidity or flexibility constraints. Uninsured cashflow risks must be provisioned for in the assessment, product design or terms of repayment.

The paper also outlines recommendations for coordinated regulatory, practitioner and research effort that can enable successful implementation. 

The working paper is available online here and we welcome both questions and comments.