Lines of Credit for the Poor: Are They Safe

Should financial institutions offer lines of credit (such as overdraft facilities) for the very poor? The question is prompted by some comments on a couple of my earlier posts, in which concern is expressed that banks have used overdraft facilities to push poorer households into overspending and overextending, resulting in significant overdraft fees and interest, to the enrichment of the banks’ bottom line but the impoverishment of the account-holder. In effect, the overdraft limit is seen as a form of predatory lending that particularly takes advantage of poorer households.

Does predatory lending exist? Of course. Even among banks? Yes in some cases. But need unsecured credit lines be predatory, or can they be relevant and appropriate for poor households?  I would argue that they can and should be included in the financial management toolkit of the poor, at least in principle. What does it take for a line of credit to be legitimately extended to the very poor?

First of all, what do I mean by “line of credit” in this context? Investopedia defines it as “An arrangement between a financial institution, usually a bank, and a customer that establishes a maximum loan balance that the bank will permit the borrower to maintain. The borrower can draw down on the line of credit at any time, as long as he or she does not exceed the maximum set in the agreement.” There may be a fee associated with establishing and maintaining a line of credit whether utilized or not, but often not (e.g. an approved overdraft limit).

Properly underwritten, loans taken under a line of credit are no riskier to the bank or to the customer than any other type of loan. But there are significant advantages for a poor household. The loan is available, generally speaking, on a moment’s notice, particularly if associated with a mobile finance product set. In other words, the initial loan documentation has in effect been completed prior to the loan being needed, which avoids significant delay (and also reduces cost for the financial institution). The best known example is probably the facility offered by Commercial Bank of Africa as a part of M-Shwari, where the a small line is established initially based on mobile phone history and then increased based on savings behavior.

For a poor household, financial management means juggling variable and sometimes unpredictable income flows to cover immediate daily needs while providing for future planned and unplanned expenses. The usual informal mechanisms (family, friends, microcredit, pawn shop, etc) have limitations and drawbacks, and are sometimes not sufficient to meet needs. Some of these sources may or may not have available funds when needed, may result in unwelcome social obligations, may be unexpectedly expensive, or may have social stigma attached to them. Access to a sure, secure, and confidential additional source of short-term funds can be a huge benefit, as has been shown by the take-up rate for the few commercial products currently available.

So, what precautions are necessary for these lines of credit to be safe both for customers and for financial institutions?

1. Products should be designed primarily with the customer in mind. There is a requirement for flexibility that goes with the high degree of uncertainty in financial management by the poor. Lines of credit will be used appropriately if they meet needs appropriately. Abuse will occur, of course, but products can be designed with clarity around the implications of overuse. It is not a financial institution’s job to protect a consumer from bad decisions, but it is their job to ensure that the implications of decisions are clearly understood.
2. There is no substitute for good solid credit risk processes, underwriting methodologies,  and credit reporting. These protect the financial institution, but also are a form of protection against providing inappropriately high levels of credit that may routinely overstretch a household’s ability to repay. (Does anybody remember sub-prime mortgages in the US?)
3. Marketing and communication to households utilizing lines of credit needs to be clear, simple and readily accessible. Where literacy is low, audio disclosures in simple local language should be available, even if agent networks are used for initial enrollment in the facility.
4. As with all forms of credit, there is a need for government driven consumer protection agencies that will monitor financial institution lending practices, and provide an accessible, easy and confidential mechanism for consumer complaints.

It will be interesting to see how far the M-Shwari approach goes (both within and outside Kenya), how sustainable it is in terms of financial institution profitability, and what consumer protections are developed by countries in which mobile lines of credit for the poor become widespread. There is potential for a valuable additional financial management tool for the world’s poorest households, if sufficient care is taken to keep it safe.