The situation is dire. According to the Credit Bureau Monitor published by the NCR 1 32% of credit active South Africans are in arrears of 90 days or more on one or more of their accounts. This is not a mere technicality. It is not a mismatch between the date of the debit order run and the payment of salaries into an account. When borrowers reach 90 days chances are they are in real trouble, and they are not likely to be able to get out of that mess easily.

There are of course very different dynamics at play in the various segments of the market. Bureau data, admittedly drawn a year ago, indicates that of the 2.4 million borrowers who have a mortgage, a high but manageable 6% were in arrears on the product. Likewise of the 1.7 million who have vehicle finance 7% were in arrears. It is when you look at more widely accessible credit products such as clothing accounts or unsecured loans that a very different picture emerges. Of the  10.8 million unique individuals who have clothing accounts, 40% of them are 90 days or more in arrears on their worst performing account. For those who have accounts or loans at furniture stores, the proportion is a staggering 45% – a proportion matched by clients of micro lenders and second tier banks.

In May of this year African Bank reported that 32% of its book was NPL with another 12.5% in early stage arrears. The bank did not disclose what proportion of individual borrowers were not paying back. But assuming smaller loans were more likely to be in arrears than larger loans it is not inconceivable that upwards of 50% of its client base of around 2.6 million individuals were not paying them back. JD also recently reported that 50% of its book is 90 days or more in arrears. In fact their increase in provisions for bad debts in their latest financial statements of R2.5 billion is equivalent to the increase in their gross debtors book that they reported last year. In other words, the vast majority, if not all, of the business they wrote last year was bad. While we could see this as a massive redistribution of wealth from the shareholders of these lenders to the borrowers of South Africa, the truth is far from that. Borrowers will be handed over for collection. If they have not managed to disappear and if their loans are large enough to warrant it, they will eventually face the music.

It is interesting to explore how it happens that so many borrowers stop paying back, assuming of course they ever did. How does it come to be that a lender can no longer secure funds from borrowers? Did so many lose their jobs? How many were on the platinum belt and were adversely affected by the strikes? Perhaps they got tired of paying back month after month, and switched bank accounts, got a new sim card and moved away. We cannot asses what proportion of arrears are bad luck cases, compared to bad faith.

Economic theory of credit markets highlights market failures that arise from asymmetric information. The lender cannot assess risks known to the borrower and as a result rations credit. Deserving borrowers go without credit. The data in South Africa can hardly support that case. On the contrary, it would appear that market failure here has arisen from too little, as opposed to too much, credit rationing. Indeed, when you look at data on consumer credit the question you ask yourself is no longer why so many people are in default, but rather why anyone pays at all. Clearly the good payers subsidise the bad. That is how all credit markets work. But when there are so many lemons at some point the system tips. That is a dangerous position to be in.

For many individual borrowers who are in arrears things have already tipped. Focus group participants tell us the worst day of the month is payday because they have to decide who to pay, and who to hide from; you know when you get an unknown number on your cell phone that it is a lender, and you don’t take the call. Some describe what they call the ‘juggle effect’, a careful game carefully to keep lenders at bay. They tell us they prioritise payment to lenders who shout the loudest. Stress levels are high and in some cases lead people to do desperate things, like resigning to access pension savings, or to escape emolument attachment orders.

Tragic too is the impact that over-indebtedness has on the ability of borrowers to leverage credit to build assets in the long term. Mortgage lenders indicate that the primary reason applicants do not qualify for mortgages is they have no headroom – they are already paying back too much back already on clothing accounts or unsecured loans to be able to support a mortgage instalment. Histories of default are another important reason applicants are denied mortgages. It is sadly a case of too much access to some credit curtailing access to other credit, with tragic consequences for the borrower and significant consequences for the distribution of wealth in our society.

While credit potentially plays a critical role in enabling borrowers to improve their standard of living and to fund asset accumulation most would agree that in South Africa, the story has gone horribly wrong, particularly for lower income earners and those without assets.

It is hard to pin the blame on one party. Lenders and borrowers play this game together, refereed by the regulator.

We must surely regard borrowers as sovereign adults who are best placed to assess whether the yield generated by immediate ownership of a durable asset or branded clothing funded by expensive credit is worth its cost. No one is forced to take credit and every recklessly granted loan is one that is happily (sometimes desperately) applied for and taken up. While there are, in some cases, frictions in the decision-making process on the part of the borrower – including lack of knowledge, and of course cognitive biases that discount the distant future more  – borrowers need to take responsibility for the mess they have got themselves into.

But lenders are certainly not blameless. Credit is aggressively marketed above and below the line. It is standard practise on the part of credit retailers to offer generous inducements to borrowers for opening accounts. They tolerate, no, they expect, high levels of default. It is a feature of the business model characterised by high merchandise margin, high credit margin and high levels of default. Credit retailers bear high default rates because yields are supported by high merchandise margins and the sale of ancillary financial products, typically insurance, to credit customers.

Other lenders have amplified yields with opaque insurance products and appear to rely on their relative advantage in collections with emolument attachment orders often the safety mechanism that gives the lender comfort to grant the loan.

An analysis of credit granted in March 2013 showed that around 40% of credit granted in that month was granted to borrowers who had been two or more months in arrears during the preceding three months. How, we asked, do lenders grant credit to borrowers who visibly cannot maintain current credit obligations? Lenders told us it is immaterial whether borrowers can pay back loans to other lenders. What they care about is whether the borrower will pay them. And if they can get at the money faster than others or if they are higher in the order of priorities for the borrower they will grant the loan even if the borrower is already under visible financial distress. Under the current debt counselling process there is no penalty for late stage lenders. All are treated equally irrespective of the financial situation of the borrower at the time the loan was granted.

All in all, it would appear that between current processes designed to deal with delinquency and payment mechanisms that are wide open to abuse, lenders have ample financial incentive to over-lend.

The role of the regulator is unenviable. On the one hand the National Credit Regulator is tasked with protecting the borrower from both him /herself and predatory lenders. On the other hand the regulator must create an enabling environment for a smoothly functioning consumer credit environment that is critical for the functioning of an economy, and plays a vital role in enabling South African consumers to improve the quality of their lives. Too much protection sees lending, particularly to those who need it most, curtailed. Too little sees high indebtedness with disastrous consequences for the borrower and society as a whole. To date it seems the regulator has got the balance wrong and has for too long prioritised high profile interventions, such as the credit amnesty, rather than high impact interventions that curtail some of the perverse incentives that prevail.

What can be done? It is widely believed that the prohibition on reckless lending in the NCA was too vaguely worded to prevent the outcome we have today. The regulator has therefore proposed fairly prescriptive processes for lenders, many of which would have typically been followed by larger, more respectable lenders in any event. Borrowers need to produce evidence of income (payslips and bank statements). They also need to outline expenses in the more obvious categories such as food, transport and housing. Lenders need to take this information into account when assessing affordability.

The regulator is well aware that borrowers and lenders have an incentive to fudge expenditure numbers as much as possible and has provided a table with minimum levels of expenditure that lenders need to provide for when assessing affordability. There are however, two shortcomings. In the first instance the minimum expenditure levels are very low. Indeed when I commented on this to an industry participant, his response was “we lobbied hard”. By providing minimum expenditure levels the regulator effectively gives permission to lenders and borrowers to tend as close as dammit towards that low level in the disclosure process.

Secondly, and more fundamentally, the process does not change incentives – lenders who grant credit that borrowers cannot afford can, if they are worth their salt, recoup instalments by collecting better than their competitors, at worst seeking assistance from the courts in the form of an emolument attachment order. In addition, lenders who grant the final loan that tips the client do not have to take a bigger haircut. While the regulator has indicated that there will be provisions in this regard in the code of conduct for debt counsellors, that outcome is by no means certain, and is likely to be contested by lenders, all of whom can plausibly make the case that the credit they grant is more important than that of their competitor. Arguably this principle should have been incorporated in the legislation.

In light of this we should expect borrowers to continue to lie and lenders to continue to happily believe them. There will be no difference in outcome as a result of these amendments, with the exception of the lowest income earners whose prescribed minimum expenses are relatively high.

That is not to say the industry will remain unchanged. On the contrary. The very dramatic events at Abil and the JD Group are likely to result in a significant pull back in credit extension. Institutional investors are likely to be far more wary of consumer credit as an investment vehicle and wholesale funding might be more difficult to come by. Lenders may find it more difficult to fund their books and borrowers will find it more difficult to get credit.

The upshot over the medium term will be a significant contraction in unsecured and retail credit extension with knock on effects on aggregate consumption expenditure, particularly in those sectors that serve lower to middle income households. The recorded impact may be muted to the extent that this credit funded unrecorded activity in the past (such as the purchase of housing and cars through informal mechanisms). But quite possibly the recession that we so deftly avoided five years ago thanks to the availability of unsecured credit might finally make its appearance.

In the longer term this change might actually herald new opportunities to reshape patterns of borrowing and lending away from consumption towards asset building. As households de-leverage many may create the necessary headroom to take up mortgage credit – assuming of course they find affordable houses to buy. In addition, the reduction in credit availability may help wean the South African consumer off credit as a first resort and encourage them to defer consumption and save up rather than save down.

If we are to seize this opportunity it is critical that we agree on a vision for the credit industry and its role in our economy and society going forward. That vision should guide how we regulate and self-regulate. It should position credit primarily as a mechanism that facilitates asset creation and wealth building – a role it plays well for a minority of borrowers currently, albeit the majority of assets on the books of the financial sector- rather than as a safety valve for the desperate and struggling to last another month. It should be one where financial incentives, rather than regulations, govern the actions of lenders and limit excessive credit extension.

By Illana Melzer

[1] See Credit Bureau Monitor, First Quarter, March 2014