33457 FocusNote NO. 27 MAY 2005 PROTECTING MICROFINANCE BORROWERS Around the world, the microfinance community is paying more attention to con- sumer protection. Controversial topics, such as high interest rates and the over- indebtedness of borrowers, have raised public concern for poor consumers in coun- The authors of this Focus tries far and wide, from Bolivia to Bangladesh to South Africa and beyond. Yet Note are David Porteous, relatively little is known about how consumer protection might apply to financial consultant, and Brigit Helms, lead microfinance services for the poor. specialist, CGAP. The very success of microfinance in demonstrating that poor people can and do repay loans has encouraged commercial lenders to enter some markets, and more CGAP, the Consultative Group to Assist the Poor, is a consor- commercialization is expected in the future. Increasing commercialization has height- tium of 29 development agen- ened awareness of consumer issues. While greater competition is likely to expand cies that support microfinance. access to financial services to more and more people, it may also open the market to More information is available on the CGAP web site: lenders who are less concerned with socially-responsible lending principles than are www.cgap.org. specialized microfinance institutions (MFIs). As a consequence, vulnerable borrowers are being more exposed to potentially abusive lenders. This is attracting the attention of regulators and politicians. Moral arguments for consumer protection in microfinance focus on the imbalance of power between lenders and borrowers. Individuals who are functionally illiterate, first-time consumers, or different in language or ethnicity from the staff of financial institutions are particularly vulnerable. Even middle-income, relatively educated bor- rowers may be insufficiently informed about their rights and can be pressured into making poor borrowing decisions. In addition to the moral arguments, there may also be strategic reasons for pro- moting or supporting consumer protection. A number of countries have imposed or are considering imposing interest rate ceilings in the name of protecting clients.1 Unfortunately these ceilings end up hurting the poorest and most vulnerable cus- tomers by shrinking their access to credit. Enhanced consumer protection measures can be a more constructive alternative to new or lowered interest rate ceilings. Lenders and policy makers alike may prefer this alternative if it avoids undermining the viability of the sector as a whole with artificially imposed rate ceilings. 1For more information on the impact of interest rate ceilings on poor borrowers, see Brigit Helms and Xavier Reille, Interest Rate Ceilings and Microfinance: The Story So Far, CGAP Occasional Paper, no. 9 (Washington, DC: CGAP 2004). Building financial services for the poor Most developing countries do not have the know their rights and make wise, educated elaborate legal or regulatory frameworks for con- decisions. The main categories of consumer pro- sumer protection found in developed countries. tection measures are disclosure requirements, Thus the growing interest in applying consumer lender practice prohibitions and requirements, protection to microfinance has little grounding in mechanisms for handling complaints and disputes, concrete experience. The purpose of this note is to and consumer education. shed some light on what is known so far and raise These measures may be applied in different ways some issues for the debate moving forward. The throughout the lending cycle. (See examples in note defines and discusses the elements that make box 1.) up consumer protection. It assesses the two pri- Disclosure Requirements mary approaches to enforcement of such meas- ures--voluntary codes and state regulation-- in The basis for all consumer protection measures is adequate disclosure of lending terms and condi- the context of developing countries. tions. Disclosure, or "truth-in-lending," laws exist What Is Consumer Protection? in many countries. They typically require that lenders clearly state interest rates and loan terms in Consumer protection encompasses all the means contracts and other publicly accessible documents, necessary to safeguard the interests of consumers as these examples show: (in the case of microcredit, usually poor borrowers In Central Africa, the 2002 microfinance law in developing countries) and empower them to requires MFIs to disclose annual percentage Box 1 Consumer Protection across the Lending Cycle Stage in Cycle Risk(s) of Lending Abuse Examples of Protective Measures Before sale Incorrect or misleading advertising Require that all fees be declared and interest rates stated (e.g., of interest rates on loans) in a standardized format Inappropriate sales techniques (e.g., Prohibit certain types of marketing hard selling through home visitation) Kickback requests Monitor lending behavior to eliminate kickbacks At time of sale Inappropriate contract wording Require (or prefer) standardized contracts with full disclosure of costs and other terms Reckless lending (e.g., without due Set laws that criminalize reckless lending reference to the borrower's ability to repay) Unfair discrimination in lending decision Require that reasons be given for rejection Penalties imposed for loan cancellation Require a mandatory "cooling-off" period during which within a few days of the sale the borrower can cancel the loan without penalty After sale Inaccurate recording of borrower Require lenders to provide regular statements of payments account Illegal payment collection methods Require lenders to follow legal process for collections Actions against a borrower who has no Implement dispute-resolution procedures outside of court legal recourse or defense Abusive behavior in the collection process Prohibit certain collection practices Sharing of borrower information with Require borrower's signature before sharing information another entity with another entity 2 rates (APRs) by publishing them in loan con- Lender Practice Prohibitions and tracts and posting them on the premises. A Requirements clear and precise formula for APR calculation Norms, rules, and laws related to lending practice is determined by the Central Bank governor, prohibit and restrict certain types of undesirable by decree. Bank supervisors have already behavior. They may apply to any stage of the bor- fined several MFIs for breaching this truth- rowing cycle, but tend to focus on origination and in-lending provision.2 collection of overdue loans. These tend to be the In 2000, Panama's superintendency of banks stages where consumers are most vulnerable. Rules issued a resolution that requires banks to may seek to limit the pressure that lending agents provide customers with the effective interest can apply on potential borrowers to take a loan. rate and the nature of the product, along with For collections, protective measures may define other information.3 which techniques are considered inappropriate The European Commission has proposed a or coercive. These measures may go even farther 2005 draft directive for consumer credit in EU and declare these techniques illegal and give con- countries that will affect microfinance in the sumers the right to redress if they are victims of new member countries of Eastern Europe. The such techniques. directive includes substantial disclosure In developed countries, regulator concerns requirements (e.g., all credit agreements must about predatory lending practices have grown in include the total cost of the loan expressed as recent years. Predatory lending includes a broad range of lending behavior, e.g., unnecessarily an APR, and all creditors must use the same consolidating debts at a higher rate or charging formula for calculating APR).4 inappropriate fees. The effect is to leave the con- In the United States, lenders are required to sumer with an unsustainable or unnecessary debt display a "Schumer Box" (named after the US burden. To counter this practice, rules may define senator who shepherded the related bill maximum acceptable debt burdens relative to bor- through Congress), in all credit agreements rower's income, and charge lenders that breach which presents all required disclosures (e.g., such rules with predation. For these rules to terms and rates) in table format. Including this be enforceable, a central credit registry is re- box is a statutory requirement in the United quired, where all lenders register new loans so States under the Truth in Lending Act.5 Disclosure offers a level of consumer protection because comparable and widely available informa- 2Interview with Henry Madrenes, technical assistant to the Central Bank tion on true loan costs allows borrowers to com- of the Central African States (BEAC), April 2004. 3Superintendencia de Bancos, Republica de Panama, General Resolu- parison shop for loans. It might also have the tion No. 3-2000, www.superbancos.gob.pa. effect of stimulating pricing competition that 4Julie Robie, "EU Consumer Protection Laws Requiring MFI Compli- could bring their costs and interest rates down, ance" (internal memorandum, April 1, 2004). Also, see the original "Consumer Credit Directive" [official title: "Council Directive benefiting consumers over time. Also, in countries 87/102/EEC of 22 December 1986 for the Approximation of the that have credit bureaus, certain disclosure Laws, Regulations, and Administrative Provisions of the Member States Concerning Consumer Credit"] (Brussels, Belgium: European Com- requirements might allow customers access to mission, December 22, 1986), europa.eu.int/comm/consumers/ their credit records at any time and/or restrict cons_int/fina_serv/cons_directive/index_en.htm. lenders' ability to disclose information about bor- 5For more information, see Comptroller of the Currency, Administra- tor of National Banks, Truth in Lending Act: Comptrollers Handbook rower performance to other entities. (Washington, DC: US Department of the Treasury, December 1996), www.occ.treas.gov/handbook/til.pdf. 3 that prospective lenders could determine a and market conditions change. Countries with consumer's exposure. liberalized interest rates rely on the combination of Simpler approaches include giving borrowers interest rate disclosure and lender competition to the right to cancel loan agreements without promote fair rates over time. penalty during a defined period immediately after signing a contract (known as a "cooling-off" Mechanisms for Handling Complaints and period) and allowing early repayment of loans with Disputes limited or no penalty. Yet another strategy will Individual lenders may employ staff that specializes soon be employed in South Africa. The draft in handling customer complaints, and industry Consumer Credit Bill in South Africa, due to bodies may establish ombuds offices or other become law in 2005, requires that lenders take agents to resolve issues that consumers cannot "reasonable steps" to establish a borrower's ability solve directly with member institutions. This kind to repay before granting a loan.6 It also empowers of complaint-driven enforcement is a rather inex- the credit regulator to publish guidelines for pensive way to enforce rules, but many cases and assessing potential borrowers' capacity for debt. patterns of abuse go unreported or unnoticed. In An especially controversial aspect of lender South Africa, the Micro Finance Regulatory practices has to do with pricing. An important goal Council (MFRC) has set up a toll-free call center of consumer protection is to protect consumers to connect consumers with complaints officers from exorbitant fees and interest rates. Some gov- who investigate complaints and alleged abuses.9 ernments try to control this risk though usury laws For lenders found to be in violation of MFRC that set interest rate ceilings.7 However, defining rules, disciplinary action ranges from sanctions to what constitutes usury is often difficult. expulsion from the Council (which is tantamount The ACCIÓN International­Micro Finance to shutting down a microlending business). The Network (MFN) Pro-Consumer Pledge (box 2) South African credit law also provides consumers takes a voluntary, rather than imposed, approach with relatively quick, low-cost access to the legal to protecting consumers from exorbitant interest system through special consumer courts.10 rates. It includes a clear commitment to "fair rates ... [that] will not provide excessive profits, but will Consumer Education ensure that the business can survive and grow to Promoting consumer education is usually consid- reach more people." By comparison, ered a vital strategy of consumer protection. MicroFinance South Africa (the commercial Consumer vulnerability is most often characterized microfinance lenders' association in South Africa) by an inability to make informed choices and exer- addresses the issue in broader terms in its Code of cise contractual or statutory rights. To be effective, Conduct for members: "The Association sub- consumer protection measures, such as disclosure scribes to the view that free-market forces should requirements, lender practice rules, and complaint determine interest rates. Members should there- fore charge interest rates which are market related. Where called upon to do so, the Association may 6"Consumer Credit Bill," Government Gazette 26678 (August 17, 2004), www.dti.gov.za/ccrdlawreview/consumercredit/gaz26678.pdf. at its sole discretion issue an opinion as to what 7See Helms and Reille, Interest Rate Ceilings and Microfinance, for a constitutes an interest rate that is excessive in full description of this issue. terms of market forces."8 8MicroFinance South Africa, Code of Conduct (Lynnwoodrif, South Africa: MFSA, 2004), www.mla.org.za/code_of_conduct.php. Determining what is fair and what is excessive 9The Micro Finance Regulatory Council web site is www.mfrc.co.za. is difficult, particularly as local conditions differ 10For example, South Africa's draft Consumer Credit Bill. 4 mechanisms, require consumers to be educated tinents, which focused on the broad themes of about products and rights. Educated consumers money management, debt management, savings are not only less susceptible to lender abuse in the management, financial negotiations, and use of first place, but they are also better able to seek bank services. The examples in developing coun- solutions and compensation if they have been mis- tries are few; the Financial Literacy Project work- treated. Consumer education teaches borrowers ing paper highlights only three programs: the Self how to acquire the right information at different Employed Women's Association (SEWA) Bank in stages of the lending cycle so they can make wise India, World Education in Nepal, and the Food borrowing choices. and Agriculture Organization of the United Consumer education should be distinguished Nations (FAO) in Zambia. from the pre-marketing stage in the sale of a prod- uct or service. For example, with housing finance, Enforcement Issues consumer education would not start with the dif- ferent types of home loans on offer. The starting Whereas many people would agree on pro- point should be the tenure options--from rental consumer or consumer-protection measures in to ownership--and then the range of financial principle, they may disagree strongly on the pre- instruments (including savings) available to ferred enforcement method. In general, there are support each option. two distinct approaches: Consumer education on lending (including Industry self-regulation--Institutions within microcredit) aims to promote financial literacy as an industry form an association that subscribes "the ability to make informed decisions and take to a voluntary code of conduct, agree on mech- appropriate actions on matters affecting one's anisms of surveillance and monitoring for financial health and well-being."11 It includes basic adherence to the code, and decide on conse- financial management skills, such as household quences of violating the code, e.g., expulsion budgeting, as well as specific concepts, such as from the association. understanding interest rates and inflation. These Government agency enforcement--A state reg- topics are successfully taught in high schools in ulatory body, such as a consumer protection some countries and also can be taught in adult agency, is authorized to enforce the relevant law. education programs. Most consumer education Self-regulation is often more flexible and prag- programs are offered in specific localities by matic than government agency enforcement non-governmental organizations (NGOs) and because it more closely reflects industry views. In financed by philanthropic foundations. For exam- the case of microfinance, it is less likely to result in ple, the Citigroup Foundation is stepping up its excessive measures that reduce access to financial activity in this area by funding NGOs around the services and more likely to promote expanded world with close to US $10 million annually.12 access over time. However, one major drawback is Consumer education has not received much attention in the microfinance community to date. 11See ECIAfrica, "Financial Literacy Scoping Study and Strategy Pro- A recent working paper from the Financial ject Report" (paper commissioned by FinMark Trust, Vorna Valley, South Africa, 2004), i and section 7. Literacy Project concluded that "there are very 12For more information, visit the Citigroup Foundation web site, few examples of efforts to build financial literacy www.citigroup.com/citigroup/corporate/foundation. skills among microfinance clients or other groups 13Jennefer Sebstad, and Monique Cohen, "Financial Education for the Poor," Financial Literacy Project, Working Paper No. 1 (Washington, of clients targeted by these programs."13 These DC: Microfinance Opportunities, April 2003), 11. www.micro- conclusions stemmed from research on three con- financeopportunities.org/publications/. 5 that once an institution is expelled from the asso- abuse. Even self-regulation may require and bene- ciation for non-adherence, the association has no fit from cooperation with government agencies further authority over it. That institution may con- (see the "Regulation and Enforcement" section of tinue its abusive practices without risk of retribu- the Pro-Consumer Pledge in box 2). Indeed, self- tion. Bad practice by nonmember institutions may regulation and government enforcement often go undermine the reputation of the industry, despite hand-in-hand. But when state enforcement is seen good practice by members. This risk is particularly as an outright replacement for self-regulation, the high if a substantial number of non-subscribing or balance tends to tip towards over-enforcement. expelled institutions operate freely, without incur- The result may be to discourage competition and ring the costs of compliance. Only when voluntary ultimately limit access to services for poor people. industry associations develop a visible, trusted, and recognized public brand name are the incen- Conclusions tives strong enough to influence nonmembers and The issue of consumer protection in microfinance encourage institutions to remain members. is a challenge that is here to stay. Few lenders or Box 2 is an example of self-regulation: the Pro- policy makers would disagree with the principles Consumer Pledge, adopted in late 2004 by supporting consumer protection. However, there ACCIÓN International and MFN member insti- tutions. MFN's active working group on pro-con- exists no clear consensus about the scope and sumer policies developed the pledge and now intensity of appropriate measures or the mecha- seeks to document best practice as members nisms to enforce them, especially in developing implement it.14 The pledge principles address countries. As a result, developing countries may all the main categories of consumer protection inappropriately apply mechanisms and approaches highlighted in this note. from developed countries without a proper evalua- State enforcement of consumer protection laws tion of their costs and benefits, and often with can become cumbersome and bureaucratic. unintended consequences. Substantial human and financial resources are In countries where political pressure to imple- required to monitor compliance and run effective ment new protection measures is strong, regulators complaint investigation operations. Because of and policy makers should carefully consider the full their mandate, regulators may pursue consumer impact such measures may have, both immediately protection goals single-mindedly, possibly at and over time. Excessive protection could well lead the expense of expanding access to those to results that directly contradict what is intended. who presently lack services. However, the Rather than promoting the formalization and inte- advantage of state regulation over voluntary self- gration of microfinance into the mainstream of the regulation is that it applies to all institutions-- financial sector, MFIs could be forced outside of regardless of whether they are members of an any legal framework. Such cases would likely result industry association. in no protection at all for borrowers. Each of these two approaches offers its own Even in countries where consumer abuse is not advantages and disadvantages, and neither is a yet a problem, promoting consumer education and one-size-fits-all solution. The appropriate enforce- industry good practice holds considerable merit and ment approach for a particular country depends could reduce, if not completely eliminate, future on the maturity and size of microfinance lending 14For more information,visit the MFN home page,www.bellanet.org/ and the (perceived and actual) extent of lending partners/mfn. 6 pressure to over-regulate. Microfinance lenders organizational commitment at all levels. Regardless should consider adhering to voluntary pledges or of the regulatory environment for consumer protec- codes that promote effective consumer protection tion, a truly consumer-friendly approach may indeed and a consumer-oriented culture. Proper adherence be the only long-term survival strategy for microfi- to codes of principles and good practice will demand nance providers in competitive markets. Box 2 ACCIÓN International-MicroFinance Network (MFN) Pro-Consumer Pledge By adopting this pledge, the members of the MicroFinance Network agree to do the following: · To apply these principles in their own organizations. · To promote the widespread application of these principles among microfinance institutions in their countries. · To engage with regulatory authorities in their countries where needed to promote effective yet non-burdensome policies or rules. · To raise awareness in the global microfinance industry about the importance of pro-consumer principles. Principles 1. Quality of Service. MFN members will treat every customer with dignity and respect. Members will provide services in as convenient and timely a manner as possible. 2. Transparent Pricing. MFN members will give clients complete and understandable information about the true costs they are paying for loans and transaction services and how much they are receiving for savings. 3. Fair Pricing. MFN members will price their services at a fair rates. Their rates will not provide excessive profits, but will be sufficient to ensure that the business can survive and grow to reach more people. 4. Avoiding Overindebtedness. In order to avoid customer over-indebtedness, MFN members will not lend any customer more than the customer can afford to repay. 5. Appropriate Debt Collection Practices. While debt collection practices must include energetic pursuit of defaulters, MFN members will treat customers with dignity and will not deprive customers of their basic survival capacity as a result of loan repayment. 6. Privacy of Customer Information. MFN members will protect the private information of customers from reaching others who are not legally authorized to see it. 7. Ethical Behavior of Staff. MFN members will hold their employees to a high standard with respect to conflicts of interest and unethical behavior, especially behavior that harms customers (such as taking kickbacks). Employees who breach these standards will be sanctioned. 8. Feedback Mechanisms. MFN members will provide formal channels of communication with customers through which customers can give feedback on service quality. These channels will include mechanisms for responding to specific customers regarding their personal complaints. 9. Integrating Pro-Consumer Policies into Operations. MFN members will make pro-consumer orientation a hallmark of the way they conduct business, through efforts such as staff training and incentives, financial education for customers, customer satisfaction programs and the like. Regulation and Enforcement The Network acknowledges that although in an ideal world, all microfinance institutions would adhere to these principles voluntarily, reality often differs. Microfinance institutions should not be put at a competitive disadvantage by adhering to these principles when less conscientious organizations ignore them. In such cases, collective action, either by the industry or by regulatory authorities, may be required to enforce application of these principles. Source: www.bellanet.org/partners/mfn. 7 Focus Note Bibliography No. 27 ECIAfrica. "Financial Literacy Scoping Study and Strategy Project: Report." Paper commissioned by FinMark Trust, Vorna Valley, South Africa, 2004. Helms, Brigit, and Xavier Reille. Interest Rate Ceilings and Microfinance: The Story So Far. CGAP Occasional Paper, No. 9. Washington, DC: Consultative Group to Assist the Poor, September 2004. Available from www.cgap.org/publications/occasional_papers.html. Microfinance Gateway. "Q&A with Elisabeth Rhyne: ACCIÓN and MicroFinance Network's Pro-Consumer Pledge." Washington, DC. www.microfinancegateway.org/content/article/detail/21416 Please feel free to share this Rhyne, Elisabeth. "Taking Stock: Consumer Protection in Microfinance--A Non-Regulatory Approach." Focus Note with your Washington, DC: Microfinance Gateway, October 2003. Available from www.microfinancegateway. colleagues or request extra org/content/article/detail/21419. copies of this paper or others Robie, Julie. "EU Consumer Protection Laws Requiring MFI Compliance." Internal memorandum, April 1, in this series. 2004. Sebstad, Jennefer, and Monique Cohen. "Financial Education for the Poor." Financial Literacy Project, CGAP welcomes Working Paper No. 1. Washington, DC: Microfinance Opportunities, April 2003, 11. Available from your comments on this paper. www.microfinanceopportunities.org/publications/. CGAP 1818 H Street, NW MSN Q4-400 Washington,DC 20433 USA Tel: 202-473-9594 Fax: 202-522-3744 Email: cgap@worldbank.org Web: www.cgap.org