Implications of Improving Credit Rehabilitation for Low-Income Borrowers
In easing the debt burden of economically vulnerable groups, measures should be taken to prevent creditor resistance and moral hazard among borrowers.
In late 2018, the Korean government unveiled a series of plans to improve credit recovery service to encourage borrowers to repay their debts as scheduled. However, the revised schemes are likely to provoke creditor firms to disagree with the proposed debt restructuring plans more frequently to avoid losses. One way to address this would be to ask dissenting creditors to produce objective proof that borrowers can make repayments without restructuring their debts. Furthermore, customized small-sum financing support needs to be fortified for people who need money urgently so that they can successfully undergo credit recovery service or an individual rehabilitation program without resorting to private moneylenders. Lastly, borrowers’ asset condition needs to be more rigorously analyzed to avoid the problem of moral hazard and prevent risky behaviour.
In the Republic of Korea, the Credit Counseling & Recovery Service (CCRS), a non-profit organization, supports credit rehabilitation through either a pre-workout or an individual workout program. The pre-workout program applies to those with multiple debts with a period of delinquency of less than 3 months and allows cutting interest rates up to 50% for unsecured loans to be repaid in installments over a period of up to 10 years.
The individual workout program applies to multiple debt holders with a longer delinquency period and fully waives interests of unsecured loans and overdue interests. For bad debts that are written off, 30% to 60% of the principal may be reduced, depending on the borrowers’ repayment ability, and remaining debts may be repaid in installments for up to 8 years. (Note: Up to 90% of the principal may be reduced particularly for vulnerable borrowers, including recipients of basic livelihood aid and the severely handicapped. Also, the maximum repayment period may be extended to 10 years for the near-poor class.)
For secured loans, both schemes allow only exemption of overdue interests. The debt may be repaid in installments for a maximum of 20 years, including a grace period of less than 3 years.
In December 2018, the Korean government unveiled a plan to reform the overall financial support system for low-income borrowers. Two months later, it followed this with “measures to improve credit rehabilitation program for individual borrowers.” The CCRS debt rehabilitation service used to be unavailable to borrowers who are less than 30 days past due. This was revised to enable prompt support for borrowers that are at risk of delinquency by giving a grace period of 6 months maximum to those with multiple debts who can prove temporary income suspension or reduced income, and by suspending the count of delinquent days after an application for debt restructuring is made. Another change is up to 30% of the principal may be reduced depending on the borrowers’ level of indebtedness (the ratio of the principal of the loan to disposable income. Before, the principal was not reduced for loans that were overdue for 90 days or longer but not written off.
Furthermore, according to the previous individual workout program, 30% to 60% of the principal could be reduced for bad debts that were written off, depending on the borrowers’ level of indebtedness. Now, the borrowers’ asset equivalent amount is reevaluated, while the reduction of the principal is adjusted to 20% to 70%, with allowance for further reduction of up to 10% in consideration of the length of delinquent months and the borrowers’ income stability. (Note: In total, the amount of principal reduction may not exceed 70%).
Additionally, for particularly vulnerable borrowers including recipients of basic livelihood aid, pension for the handicapped, the elderly, or those with small long-time delinquent loans, the principal may be reduced by 70% to 90% for bad debts that were written off and 30% for loans not written off, regardless of level of indebtedness. And if the borrower successfully repays 50% or more of the outstanding debt as scheduled for 3 years, the remaining debt may be relieved.
These measures aim to expand the scope of debt restructuring to encourage borrowers to repay their debts more faithfully. For instance, the abovementioned prompt support for borrowers with a risk of delinquency can help them return to a normal life by deferring the burden of repayment for the time being. For those with reduced income, this helps avoid deterioration of credit rating during hard times. Meanwhile, the new inclusion of the asset equivalent amount in calculating the reduction in the principal is expected to assess the borrowers’ repayment ability more accurately. Given that most applicants to the CCRS programs are unlikely to be wealthy, the revised measures are expected to increase the rate of principal reduction, making repayment easier for borrowers.
However, it should be noted that creditors need to agree to the proposed debt restructuring plan, even after it passes the CCRS committee’s approval, for at least half of the total credit amount. Thus, with the new measures, the rate of rejection from creditors might increase, particularly among small financial firms that are less exposed to reputational risks. If these firms frequently object to the proposed restructuring plan, it becomes harder for borrowers to make repayment, and creditors that agree to the plan may have to bear a greater burden. One possible solution to avoid a holdout problem is to ask dissenting creditors to produce objective proof that the borrowers are capable of repaying their debts without restructuring them.
Additionally, customized small-sum financing support needs to be fortified for borrowers who need money urgently during a credit recovery program or individual rehabilitation procedure. Otherwise, they may be forced to resort to private moneylenders for expensive loans. Currently, the CCRS provides up to 15 million Korean won of small-sum financing at an interest rate of 4% or below for people who repaid their debts as scheduled for 6 months or longer according to the CCRS debt restructuring plan, or who did so for 2 years or longer according to the court-approved rehabilitation plan. Strengthening this support based on rigorous analysis of the borrowers’ specific needs and repayment ability would not only provide them with money they need but also facilitate successful credit recovery and individual rehabilitation.
Lastly, efforts are needed to avoid borrowers’ moral hazard by improving the procedure for analyzing their asset condition. As mentioned above, the equivalent amount of the borrowers’ assets is reevaluated in calculating the level of principal reduction. As it is, the government’s database is used to identify the borrowers’ ownership of the real estate, vehicle, and other properties; and more resources need to be tapped to accurately obtain information on financial assets as well. For instance, applicants for debt restructuring may be requested to submit information on their financial accounts based on the consolidated account management service.
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