Good Customer Service versus Bad Regulation
The failings of microfinance institutions (MFIs) have been widely documented in the academic literature: there are failings in the treatment of customers, failings in the development of sustainable business models and failings to make lasting, measurable impacts on the lives of customers and their communities. One common response to these failings is to call for greater regulation of MFIs. For example, Lesley Sherratt writes that:
"The efforts towards self-regulation of the microfinance industry represented by the Smart Campaign go nowhere far enough to prevent deeply unethical practices in the industry or the recurrence of repayment crises. The ethical issues microfinance raises are too engrained in its model … for tinkering around the edges to succeed. The protection to clients offered by the Smart Campaign may emerge from the best of intentions. There is no need to question that. What is needed, however, is independent regulation" (Sherratt, 2016, p. 181).
And, Philip Mader writes that:
"One perfectly logical option for policy makers would be to discontinue their direct and indirect support … for microfinance systems, until the day their beneficence can be proven. Another logical possibility would be to regulate the sector in such a way as to ensure that the interests of investors and MFIs cannot supersede those of their clients. Yet the sector remains deeply averse to such regulation with teeth – such as interest rate caps or loan usage restrictions – and will likely strongly resist it by employing arguments that emphasize poor people's right to choose between different credit sources and modalities which would be curtailed by regulation" (Mader, 2015, p. 204).
We should be careful what we wish for: more regulation does not necessarily mean better regulation, nor does it guarantee better outcomes for customers. Regulation is not a free good. It comes with a price-tag and ultimately this price is paid by the customer.
Economists have described some of the generic effects of regulation on economic activity (Stigler, 1971). These include the raising of barriers to market entry, which embeds the power of existing market participants at the expense of potential new entrants to the market; this, in turn, reduces the pressure for innovation in product development and customer service within regulated market-places. Further, compliance with regulation increases producer costs, which are frequently passed on to customers, either in the form of higher prices, or in the form of reduced service quality. In addition, as James Broughel observes, "… regulations are unique in that – unlike taxes and spending – the vast majority of their effects are not captured in government budgets. In this sense, the effects of regulation are invisible to the public" (Broughel, 2017, p. 2).
The regulation of MFIs, and other sub-prime credit providers, has tended to focus on product features and product price. Many regulatory regimes for MFIs and sub-prime credit impose price caps on the amount that can be charged for credit. Since compliance with regulation tends to increase costs for the provider of services, where these additional costs cannot be passed on to customers through increased prices, they can only be mitigated by reductions in the resources available for service delivery. Credit providers are incentivised by the regulatory system to lower the costs, and therefore the quality, of their customer service.
The pressure to reduce the costs of delivering services to customers has been a major driving force in the move away from relationship banking to transactional finance. Just as supermarkets and airlines have sought to improve their margins by the provision of "no frills" services, so too financial institutions have redesigned their products and services to become simpler, standardised and automated. This trend towards low-cost, low-touch, low-margin products, has been supported by the increased use of information technology to deliver services. The growing use of data analysis to predict customer buying behaviour, has helped providers determine which products to promote to which customers without the need to consult the customer directly.
The automation of risk assessments and product delivery works well for customers who want standard products and who need only generic advice. However, low cost, transactional finance does not work well for customers who need non-standard products delivered with a high-touch customer service. To the extent that regulation pushes MFIs and sub-prime credit providers to become more like mainstream banks, with a greater reliance on automation and standardised transactional relationships, it also pushes them to reduce the richness of their customer relationships. This, in turn, will tend to worsen both repayment rates and customers' credit histories. Bad regulation tends to embed financial exclusion more deeply in the financial system.
There is a well-developed body of research that examines the role of relationships in the mainstream banking sector. The starting insight is that borrowers face a trade-off when they seek to raise funds for their business. Aside from the fact that borrowing directly from the capital markets -- through the issuance of bonds or commercial paper -- tends to possible primarily for larger firms, there is also an information asymmetry problem. New companies, without a track record of generating income and managing themselves well, are less attractive to "arms-length" lenders. Debt markets work best for larger firms and for firms with a track record of competence. Newer and smaller firms are therefore more dependent on direct lending, often from banks.
Arnoud Boot defines relationship banking as the provision of financial services by a financial intermediary, "which:
i. invests in obtaining customer-specific information, often proprietary in nature; and
ii. evaluates the profitability of these investments through multiple interactions with the same customer over time and/or across products" (Boot, 2000, p. 10).
According to Boot, the two principal benefits to the credit provider of building relationships in this way, are, first, the acquisition of re-usable information about the customer and, second, the ability to introduce special contractual features, specific to individual borrowers. Over time, these benefits lead to safer lending for the credit provider and, correspondingly, lower costs for the borrower.
Banks are willing to lend to new borrowers if they believe that they will be able to build up a store of private information about the business and/or person, that will allow them to exert some influence or control over the borrower, making it less likely that they will default on the loan and more likely that they will pay for additional banking services in the future (Rajan, 1992). Greater competition between banks, or a shift from a relationship to a transactional banking model, threatens to reduce the amount and quality of private information that is acquired by the bank, and to reduce the value of the relationship to the bank. This, in turn, makes it less likely that credit will be available to smaller and newly established businesses.
Empirical research on the US small business market supports these insights (Petersen & Rajan, 1994) and (Berger & Udell, 1995). Relationships between banks and businesses are valuable to both, and they tend to increase the total amount of credit available. The private information that is shared through a close relationship between lender and borrower creates greater assurance for the lender that resources are being well managed and appropriately allocated. Banks use this private information to adjust contractual terms for loan agreements, which would not be possible in a purely transactional relationship. Lenders pass on some of the lower costs to the borrower in the form of lower prices, or reduced demands for collateral. In addition, the value of private information is such that more credit is made available both at the early stage, and at subsequent stages of the relationship.
There is some evidence that the greater the market power of a lender (that is, the less constrained it is by competitive pressures) the more likely it is to lend to firms with lower credit quality, and at lower prices. From the borrowers' point of view, therefore, location in a highly concentrated credit market is an advantage in terms of access to credit. This is particularly true for new firms, which tend to borrow more when there are fewer lenders active in the market (Petersen & Rajan, 1995). The explanation for these findings appears to be that lenders smooth their interest rates over time, charging less than the risk profile of the borrower might imply at the start of the relationship, but charging more than the risk profile implies at later stages of the relationship. While the absolute cost of credit falls as firms become better established, the risk-adjusted margin secured by the borrower rises, to compensate for the higher risks taken at the outset of the relationship.
Some of these features of the small business lending markets have also been found in the personal credit markets. In a study that examined consumer credit card lending in the US, Argawal et al. found that there were "… substantial potential benefits from relationship lending, through lower default risk, lower attrition and increased utilisation" (Agarwal, Chomsisengphet, Liu, & Souleles, 2009, p. 5). The authors observed that information gathered through the wider banking relationship (for example, the use of savings products) helped the lender better to predict a borrower's changing demand for credit.
In mainstream finance, it is evident that the quality of the relationship between borrower and lender is crucial to the efficiency of the flow of credit to new businesses and to individuals. Where the quality of these relationships deteriorates, the ability of the lender and borrower to share the surpluses generated by business activity declines; consequently, the supply of credit reduces and the cost rises. Do these same factors apply to MFIs?
There have been a couple of recent attempts to measure the importance of relationship banking within microfinance, one using data from Ecuador and the other from Bangladesh. Using data from ProCredit Ecuador, Jan Schrader argues that competition between lenders leads to higher risk-taking, that is, banks providing loans to customers with a higher probability of repayment problems (Schrader, 2009). Banks that view lending as a purely transactional business tend to have lower interest rates, because their costs are lower, but correspondingly they have weaker relationships with their borrowers and less private information about the businesses to which they lend. As a result, where there is strong competition between transactional lenders, a higher number of risky loans are made and this tends to contribute to over-indebtedness among borrowers.
Schrader also noted that when borrowers are struggling to pay back multiple loans, they will give priority to loans from relationship lenders, at the expense of loan repayments to transactional lenders. In some cases, borrowers took out additional short-term loans from transactional lenders to ensure that they could repay their relationship loans. Borrowers appeared to place a higher value on relationship lending, despite it being a more expensive form of borrowing. The borrowers saw value in the relationship over and above the cost of credit.
In their study of lending in Bangladesh, Chakravarty and Shahriar found evidence that potential borrowers who had developed a relationship with a MFI, and who already used non-credit services such as savings accounts, were more likely to apply for, and were more likely to be approved for a loan. The lenders were more willing to extend credit to borrowers with whom they had established a credit history and with whom they had a wider (i.e. multi-product) financial relationship (Chakravary & Shahriar, 2010). Their study also suggested that, whereas in developed markets, such as the US, it is the larger lenders that are most likely to place reliance on formal financial records and objective customer data, in Bangladesh the larger MFIs were more likely to build relationships with their customers and to rely on relationship information in their lending policies. Small MFIs in Bangladesh, unlike small banks in the US, did not have the resources to build relationships with customers, nor to develop bespoke lending products.
In summary, there is some evidence that the valuable role of private information in building relationships between lenders and borrowers, operates in the MFI sector just as it does in mainstream banking. There is also evidence that intense competition among lenders can lead to looser lending policies, greater risk taking and, in due course, greater over-indebtedness. The value of relationship banking, both for the business seeking credit and for the lender providing credit, seems to be consistent across the mainstream and the MFI sectors.
Thus far I have considered the value of relationship banking from the point of view of the lender, who gathers private information to reduce the risk of loan delinquencies and to cover the initial cost of loans to new businesses; and from the point of view of the borrower, who benefits from greater access to credit and, initially, lower rates than might be expected from their relationship lender. There is an additional, very important aspect to relationship banking, which likewise appears consistent across the mainstream and the MFI sector. This is the benefit to the borrower of regular contact with and support from their lender. The personal aspect of relationship banking turns out to be highly beneficial to borrowers, especially for small businesses and for individuals who have experienced financial exclusion.
Antoinette Schoar conducted a study of the small business clients of ICICI (the Industrial Credit and Investment Corporation of India), the largest commercial bank in India, between July 2007 and April 2009 (Schoar, 2012). The evidence she gathered suggested that personal interactions between the borrower and the lender reduced the propensity of borrowers to default on their loans, which is of benefit to both borrowers and lenders.
Schoar divided her sample of around 1300 clients into four groups. All clients were provided with a 12-month overdraft facility with an average size of just over $20,000. The control group received a standard SMS text message from the bank when a payment was due; this was the bank's normal level of interaction with its customers for this overdraft product. Another quarter of the customers received a telephone call, from a randomly chosen bank employee, when a payment was due, but with no additional support or services; a third quarter received a telephone call twice a month, from one of three or four different employees, which addressed any service issues or customer questions, as well as reminding customers about forthcoming payments; the final quarter of customers received the high-touch fortnightly calls, but in this case always from the same employee.
There was a clear difference in the payment histories between the customers who received the high-touch, fortnightly calls and those that did not; and there was a modest, but not significant difference between those customers who received calls always from the same bank employee and those who received calls from one of a small group of bank employees. Schoar remarks that, "these results suggest that the interactions between the relationship manager and client not only prevented late payments overall, but in particular reduced the likelihood of repeated late payment spells" (Schoar, 2012, p. 14). Investment by the bank in building relationships with borrowers was rewarded by greater loyalty and reliability, which improved the risk prolife of the bank's loan book. While these improvements were clearly of benefit to the bank, they were also of significant benefit to the borrowers, who become eligible for improved access to credit and other banking products.
In a very different study, Lisa Servon went to work for a cheque casher – RiteCheck – in South Bronx, New York, and then for a payday lender – Check Centre – in Oakland, California. Working as a teller and a loan collector for sub-prime financial companies in the US, Servon observed first-hand the customers who make extensive use of products that are outside the mainstream and which are often regarded as exploitative by academics and policy makers. Her study is an ethnography rather than a randomised experiment, but for that reason it contains a wealth of information and insight into the motivations and behaviours of the customers of sub-prime credit providers (Servon, 2017).
Of the many lessons that Servon draws from her work experiences, two stand out. First, many of the customers of sub-prime lenders chose them in preference to mainstream financial service providers because they offered a more flexible and transparent service. It makes sense for some people to cash a cheque at only 98.5% of the face value and get the cash immediately, rather than wait three days for the cheque to clear through the banking system. Likewise, it makes sense for some people to pay a two-dollar flat charge to take ten dollars in cash from an electronic benefits card, if they have fifteen dollars in their account and the local ATM only dispenses twenty-dollar notes. Although these transaction costs appear to be high (by comparison with mainstream products), they allow easy and immediate access to cash which is what the financially excluded need most; and these costs are transparent, which allows customers better control over their limited financial resources.
Second, many sub-prime service providers offer a high-touch personal service. They build relationships with their customers and take time to understand their financial needs and habits. Most mainstream financial companies provided financial services this way fifty years ago, but today they prefer to automate as many of their services as possible, from ATMs, to online banking, to algorithmic reviews of credit profiles. The only "advice" that mainstream banks provide is when they try to cross-sell or up-sell a new product; or, if the customer is wealthy enough to be served by a private bank, when they provide helpful advice on tax management. Sub-prime providers, by contrast, tend to hire staff who look and sound like their customers, who understand the challenges faced by people who are financially excluded. When RiteCheck hires its staff, the key qualities it looks for are friendliness, patience and a customer orientation (Servon, p. 22).
These research studies by Schoar and Servon help to demonstrate that while relationship banking might be under threat in the mainstream sector, as automation drives a shift to transactional banking services, in many parts of the sub-prime sector relationships still matter a great deal. The private information gathered through relationships improves the quality of the services provided by the lender and improves the outcomes for the borrower. Relationship banking increases the chances that lending will be responsible, and that access to credit will be beneficial. For those who are concerned about the potential damage of irresponsible lending and the over-supply of credit, relationship banking appears to offer a valuable mechanism with which to mitigate these risks.
Let us now return to our starting point, the demand for greater regulation of MFIs. One of the general consequences of regulation is that barriers are raised to new market entrants, which tends to allow established market participants to build and maintain a dominant position in the market-place. While this might not be a spur to innovation and competition, it does help preserve some of the benefits of relationship banking. There is evidence that where competition pressures on lenders were not too great, it was more likely that borrowers were able to access credit and that the costs of credit were lower. In other words, a well-regulated market is likely to provide a more conducive environment for relationship banking to flourish and this is likely to increase the amount of credit available to new borrowers, especially in the small business sector. This outcome is also likely in the MFI sector, since a well-regulated environment will support relationship lending that reduces the likelihood of over-lending and the mispricing of lending risks. In this respect, then, regulation can be beneficial to both lenders and borrowers.
There are, however, good reasons to be alert to the potential of greater regulation to lead to maleficent outcomes for poorer customers. James Broughel describes the benefits of product innovation: when an innovation occurs, consumers pay the same price for a better product, and the innovative producer captures market share from competitors, increasing profits. However, the second effect is time limited, because other producers will eventually copy the innovative product to win back market share. As Broughel points out, this process has the consequence that the benefits of innovation are permanent for consumers but only temporary for producers (Broughel, 2017, p. 85). It is important to recognise that the converse is also true. When ill-conceived regulation inhibits the ability of producers to innovate, customers continue to pay the existing price for a product that is no longer optimal, and producers are unable to gather additional profits through increased market share, due to innovation. In this case the opportunity costs of regulation for businesses are temporary, but the higher prices and lower quality of products available to consumers are permanent regulatory costs.
When the specific form of the regulation involves price caps on lending products, which is common in the MFI and sub-prime sectors, then the impact of regulation is even less favourable for customers. By capping the prices of products, the regulator reduces the elasticity of the income of the service provider. Unable to increase income by raising prices, the service provider is forced instead to seek to reduce the costs of delivering products to the customer, resulting in more standardisation, more automation and fewer resources invested in customer service functions.
This often has the greatest negative impact on the poorest customers, who tend to be those who suffer most from financial exclusion (Zywicki, Manne, & Morris, 2014).They include smaller businesses with poor credit histories, who struggle to find banks willing to fund them, because the loan sizes they need are often considered sub-scale for the bank's profitability. Antoinette Schoar's evidence from India suggested that these customers would be more likely to repay on time, and to remain loyal customers of the bank, if they received regular calls from a customer service employee. However, this is not the standard service offered by that ICICI (or other banks, for that matter) because it is expensive. Automated SMS messages are the standard service, despite Schoar's evidence that they are ineffective for both lender and borrowers.
Likewise, Lisa Servon's account emphasizes the importance of the relationship between the teller, the loan collectors and the customers. She notes that while the headline costs of check cashing and payday loans might look high, they are costs that customers are willing to accept for the speed, transparency and quality of the service they receive. If service providers are not able to offer such a high-touch customer service, it is the customers who suffer. They are already, in many cases, already excluded from the mainstream; price caps further reduce their options by making it harder for sub-prime lenders to offer their customers much valued, highly personal customer service.
Good customer service that seeks to build a strong and transparent relationship between borrower and lender is likely to lead to more credit being available to borrowers; and is likely to lead to better repayment rates by borrowers. Good regulation should therefore seek to improve customer service, not to curtail it. When academics -- and others -- demand more regulation, they should therefore be very careful to specify what sort of regulation they want. If the aim is to encourage lenders to provide better services to customers, and to ensure that the needs of financially excluded people are met, then a regulatory regime that requires evidence of good service should be specified. That would almost certainly mean abandoning regulation by price, which would be a very good outcome for those who suffer financial exclusion.
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