UNITED NATIONS CAPITAL DEVELOPMENT FUND    Microfinance

Issue 12 / May 2005

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By Robin Young, Senior Development Specialist, Development Alternatives Inc.

Credit bureaus are being established in more and more markets, selling more information on more people to more firms. For those in the business of providing financial services to low-income populations, these institutions are critical-the information they collect on loan histories, bankruptcies, foreclosures, and criminal records enables banks, other financial intermediaries, and commercial enterprises to make informed decisions about individuals and businesses that may otherwise be considered bad risks.

Private credit bureaus, which operated in only a few Latin American countries a decade ago, are now more numerous and more profitable throughout the region. Local, regional, and international credit bureau companies are taking advantage of expansion and competition in financial markets, spurred by economic stabilization, financial sector liberalization, and the growth of consumer and microenterprise lending. They also are capitalizing on privatizations in recent years that have expanded telephone and cellular phone markets (and thus client payment histories) and on department store credit and other consumer services in the region. In Latin American countries, where 20 to 80 percent of the population can be poor, this growth among credit bureaus has only been achieved by addressing the base of the economic pyramid.

Latin America's credit bureau expansion into base of the pyramid (BoP) markets generates three sets of winners. Credit bureaus are winning new clients, increasing transactions, and generating growing profits. Financial institutions and other firms that use credit bureaus are reaching new markets that in many cases are more profitable than traditional client segments. Perhaps most important, poor people gain access to financial services at better terms and conditions than previously were available. This article explores the business case for credit bureaus and their relationship to poverty reduction, with a focus on Latin America.

Translating Reputation into Capital

Small businesses, low-income microentrepreneurs, and salaried employees are the primary BoP market segments that can benefit from the establishment and expansion of credit bureaus in developing countries. In much of Latin America, anywhere from 20 to 50 percent of the economically active population is employed in the microenterprise sector. Credit reference services allow people and firms to turn their reputations (credit and social history) into collateral for loans to finance businesses, home improvements, and consumer purchases and to respond to other opportunities and needs that require financial services. Borrowers can use their credit reports as substitutes for formal financial statements and traditional collateral to access loans usually unavailable from the formal financial sector.

Credit bureaus can help increase access to client information, thereby lowering costs on loan appraisal, collections, and losses. They can increase competition for smaller borrowers, which expands access to credit and lowers costs on financial services for these traditionally underserved segments. When credit bureaus expand their databases and services to include sectors beyond banking-into utilities, telephone companies, and department stores, for example-they can facilitate expanded access to these service markets as well.

In her comprehensive literature review for Credit Reporting Systems and the International Economy, Margaret Miller notes that "information sharing is associated with higher levels of lending in relation to GNP [gross national product] as well as lower default rates."1 Inessa Love and Nataliya Mylenko of the World Bank, in their empirical study of credit bureaus' impact on credit markets, found that the presence of private credit registries "is associated with lower financing constraints and higher share of bank financing…Small and medium firms tend to have higher share of bank financing in countries where private registries exist and stronger rule of law is associated with more effective private credit registries." They found that 49 percent of small firms report credit constraints in countries without a credit bureau, compared with only 27 percent in countries with one, and the probability of obtaining a loan improves from 27 percent in countries without a credit bureau to 40 percent in countries with one.2 The increasing numbers of bankers and other lenders buying private credit bureau reports as part of their credit appraisal process indicate that they are relevant for decision making among lenders.

What Innovations Have Been Necessary To Serve the BoP Viably?

The credit bureau is itself an innovation, a form of cooperation among firms that improves their business environment by sharing information on client indebtedness and credit history. Innovations in loan underwriting, data acquisition, technology, business strategy, and public policy have all been critical in developing credit bureaus that include BoP market segments.

Loan underwriting moves toward character- and cash flow-based lending. Because of various external and internal factors (insider lending restrictions, competition, excess liquidity, and so on), banks throughout Latin America have moved from a focus on corporate banking toward retail lending to public and private sector salaried employees and, increasingly, micro and small businesses. This type of retail lending is information-intensive and is based more on character and cash flow than on formal financial statements and traditional collateral. A review of an applicant's payment history, combined with a review of personal and business credit histories and other relevant behaviors, is essential to an individual loan assessment. As more banks enter the consumer, micro, and small enterprise markets, they look for tools such as credit bureaus and credit scoring to reduce costs, increase efficiencies, and control risks.

Data acquisition is expanding in its quantity, diversity, and source. Credit bureaus help overcome two challenges to assessing a microenterprise client's creditworthiness: lack of reliable information and mixing of personal and business finances. A credit report that includes data on the personal and business finances of an applicant can facilitate and simplify the loan appraisal. A credit bureau report is not a perfect substitute for reference checks and other elements of credit analysis, but it can serve as a filter to reject unqualified clients, such as those with a high level of arrears. Such screening mechanisms for bad loans free lenders to focus on other potential clients rather than wasting time searching for references and other information on applicants who clearly do not qualify.

More sophisticated credit bureau operations also offer data on the timeliness of loan repayments and outstanding loans from a variety of regulated and unregulated lenders and other service providers. This helps in both preparing credit appraisals and motivating repayment: once clients realize good repayment patterns help them access loans, possibly at better terms and conditions, they have an incentive to repay on time. Lenders reduce arrears and hence collection and provisioning costs. In a competitive marketplace, these benefits translate into lower interest rates and better terms and conditions for clients. In their empirical analysis using data from a private credit reporting firm in Chile, Kevin Cowan and Jose De Gregorio found that "both the positive and negative information available in credit reports in Chile significantly contributes to explaining defaults…Their results suggest that information sharing increases the volume of lending, and that the longer the historical record or the more data in the credit record, the greater is this effect."3 Credit bureaus also can help provide a client risk profile, which helps lenders better tailor their products and services to clients. The benefits of credit bureaus are similar for other services sold in advance of payment, such as phones.

When credit bureaus are subscribed to by a wide variety of lenders-such as banks, department stores, credit unions, telephone companies, and unregulated microlenders-poor people can move from less formal to more formal institutions, from small consumer loans at a local store to larger business and housing loans with banks. A credit bureau helps low-income people who have developed a credit relationship with one institution signal their credit-worthiness to the market, allowing them to access diverse sources of financing at competitive rates and terms. This relationship is well established in the United States, where college loans and credit cards set the stage for future car loans and mortgages.

Increasingly, credit bureaus in Latin America are incorporating the commercial and microfinance sectors, including stores, telephone and utility companies, and consumer and microenterprise lenders. In Peru, where private commercial credit bureaus have incorporated a wide variety of data, the largest and most profitable banks are rapidly expanding into the microfinance market with loans as small as $100. Although credit bureaus are not the only driver of this financial market deepening, they are certainly a critical tool for market expansion and risk management.

Other factors underlying the growth of credit bureaus include the following:

Information communications and technology enables more frequent and timely data sharing and analysis. Improving and expanding telecommunications, including phone lines and high-speed Internet connections, have drastically improved data transfer in much of Latin America. Banks and other financiers can provide more data, more quickly, and more reliably to the bureaus. The financial institutions also can use information communications and technology to improve their analysis of the data generated by the credit bureaus. This leads to improved credit reports and to the introduction of new decision-making tools, such as credit scoring. Expanded communications via extended telephone lines and the Internet provide quick and direct access to credit bureaus even in remote regions.

Business strategies have begun to target BoP data sources and tailor credit bureau services to BoP lenders. Some private credit bureaus have begun to see BoP lenders as attractive clients and have developed a business strategy and service offering for this segment. In some cases, microfinance lenders themselves have set up specialized credit bureaus, such as InfoRed in El Salvador. In other cases, donor projects have encouraged large commercial credit bureaus, such as Equifax in Peru and El Salvador, to consider microfinance institutions (MFIs) as viable clients and to tailor their services for this sector. Other local and regional credit bureaus-such as Datacredito in the Dominican Republic and Caltec in Ecuador-have catered to the traditional banking, commercial, and microfinance market segments from the start. The growth of commercial credit through department stores and supermarkets, combined with the growing trend of commercial banks moving into microfinance, should encourage more credit bureaus to expand their registries into BoP market segments.

Policy and regulatory frameworks that promote information collection and sharing. In some countries, such as Ecuador, public entities have developed public credit registries and provided credit bureaus with client data to kick-start the development of private credit bureaus. Establishing universal, unique, and easy-to-obtain citizen identification numbers facilitates data compilation and sharing. Many credit bureaus operate using tax identification numbers, but these are relatively costly to obtain and most microentrepreneurs do not have them. In El Salvador, where credit bureaus were using a mix of tax identification numbers and locally issued identification cards known as cedulas, the situation was improved with the creation and dissemination of a unique identity document.

By contrast, bank secrecy laws that prevent private credit bureaus from integrating nonbank or nonregulated institutions' data into the credit bureaus, or that prevent nonregulated institutions from gaining full access to credit bureau reports, are policy obstacles to credit bureau development. This has been the case, for example, in El Salvador. In some countries, banks can work around existing bank secrecy legislation-for example, by incorporating client notification clauses in loan applications.

How Does Serving the BoP Market Help Alleviate Poverty?

Financial services are a key element of economic development. With relatively small loans, the poor can leverage their ideas and hard work to develop viable businesses, generating incomes for their families and, in some cases, generating employment and income for others. Credit bureaus help the poor build credit histories that they can then use to shop around for the best and most appropriate financial services available, turning their reputation-defined in a formal credit history-into collateral to access financial services. As credit histories and credit bureaus develop, they facilitate other types of business transactions; for example, poor entrepreneurs can use their credit history as references for business relationships with suppliers and other business connections.

Credit bureaus can help the poor use their good reputation to gain access to other services, such as telephones, that can improve their quality of life and, in some cases, their business opportunities. Depending on the data included and used in credit bureaus, they also facilitate business-to-business transactions and commerce, in theory at least, for micro and small enterprises as well as larger firms.

How Profitable Is Serving this Market?

Once established with traditional lenders and markets, BoP niches such as consumer and micro-enterprise lending-with their high-volume transactions-present significant potential for credit bureau expansion. These are the highest-margin and fastest-growing sectors in many financial systems in Latin America. This is a volume business requiring upfront investments in information and communication systems, data processing, marketing, and client management. With relatively high fixed costs, capacity and quantity are critical in terms of the number of clients and transactions per client. Using their large databases, credit bureaus are able to develop additional revenue-generating services such as credit scoring and other decision-making models that these lenders value.

The recent expansion into emerging markets of established credit bureaus such as Transunion and Equifax, and the establishment of new local and regional credit bureaus throughout Latin America over the past decade, indicate the perceived profitability of these ventures to multinational credit information firms. Private credit bureaus of some type operate today in Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, the Dominican Republic, Ecuador, El Salvador, Guatemala, Honduras, Mexico, and Peru. Their owners and operators include local business associations and chambers, local and regional private credit bureaus, and international (U.S.-based) credit bureaus.

DAI's Experience in Latin America

Development Alternatives Inc. (DAI) includes credit bureaus as part of its financial sector development and microfinance work. Specifically, in projects throughout Latin America, and increasingly in other parts of the world, DAI is working to develop industry infrastructure to promote financial sector deepening, particularly for microenterprises, while supporting the sustainability of financial intermediaries. Credit bureaus are a key part of this support infrastructure.

In El Salvador, DAI has supported the increased use of credit bureaus among microenterprise lenders and supported dialogue between lenders and the credit bureaus to improve services. As part of a USAID-sponsored rural microfinance project in El Salvador, DAI subsidized credit bureau participation on a trial basis for nine of the program's participating MFIs. DAI offered the participants-two banks, three credit unions, and four NGOs-the services of two very different credit bureaus, DICOM/Equifax and InfoRed, encouraging participants to enroll in both for points of comparison. As a large, generalist credit bureau, DICOM/Equifax dominates the Salvadoran market for credit information, but it only recently began to target MFIs with the introduction of a new, MFI-focused credit-reference product, Credimypes. InfoRed, on the other hand, serves almost exclusively MFIs; it was established with USAID assistance for that purpose and maintains an inherently small, niche clientele.

Although both programs returned an impressive percentage of requested credit reports-InfoRed with 35 percent and DICOM/Equifax with 33 percent-the distinction in client focus between the two bureaus, as well as the higher costs of DICOM/Equifax's services, may have led to the final decision of many participants to continue using only InfoRed services after the conclusion of DAI's four-month subsidy program. All nine institutions using InfoRed actually decided to continue using that service at their own expense. As a direct result, InfoRed achieved profitability for the first time, and DICOM/Equifax redesigned its product and pricing to retarget the MFI market. Use of the credit bureaus allowed participating MFIs to dramatically change their loan approval process. One participant reported that resulting changes had compelled it to decline 180 applications during the trial period as a result of exceptionally poor credit history or overindebtedness.

In Ecuador, where the largest banks in the country have launched microfinance programs in recent years, DAI developed a proposal for the legal and normative framework to allow credit bureaus to operate for the first time in the country. In addition, DAI prepared a market study that demonstrated the business potential of this market; currently, six private credit bureaus have operating licenses. USAID's DAI-managed Strengthening Access to Microfinance and Economic Liberalization (SALTO) project in Ecuador continues to promote public-private sector dialogue and public policy conducive to maintaining an enabling framework for credit bureau development and assists financial institutions in incorporating the new information gained from the credit bureau reports into their microcredit loan appraisal policies and procedures.

In Bolivia, one of the more highly developed microfinance markets in Latin America, private credit bureaus are in their infancy. Here, USAID's Policy and Regulatory Enhancement for Microfinance Innovation and Expanded Outreach (PREMIER) project is taking a two-pronged approach: (1) technical assistance to strengthen existing credit bureaus by upgrading their technology and financial capacity as well as developing stronger, commercially oriented business strategies, including facilitating relationships with international credit bureaus; and (2) evaluating the legal and regulatory framework, facilitating public-private sector dialogue, and making proposals for improving public policy.

In Haiti, USAID's Financial Service Network for Entrepreneurial Empowerment (FINNET) project helped establish a "bad debtors" list among diverse institutions-including banks and bank affiliates, credit unions, and NGOs-to share regional lists of clients in arrears. This monthly list was recently expanded with a technological upgrade, and a more robust Internet-based credit liability system is being tested between two of the lenders. Although hopes for a more highly developed credit bureau remain, the political and economic landscape in Haiti is not encouraging. But this rudimentary system developed in the microfinance industry is the basis of a credit reference program in the country.

DAI's experience shows that the development of credit bureaus is much more than a technical issue. A successful credit bureau requires business acumen, financial resources, and strategic vision and management. Moreover, good public policy is essential to strike the right balance between consumer protection (privacy, data accuracy, and use) and credit bureau development. And there is no single, static, definitive framework to serve as a model-even in the United States, which has one of the most mature credit information systems in the world, laws and operations are continually being updated in response to concerns such as identify theft, for example. Developing and transition countries therefore have a lot of work to do to foster successful credit bureaus, but it seems clear that the benefits-in terms of bureau profits, financial sector development, and public goods-are justifying the effort.

*This article also appeared in the Winter 2005 edition of Developing Alternatives.