Father and son, Vietnam. Photo by Minh Quoc Le, 2014 CGAP Photo Contest.
In the early 2000s, the microfinance sector was on a roll. It was accessing capital markets for growth, securing regulatory legitimacy, developing savings and insurance products in addition to credit, demonstrating social performance, and working on institutional transformation.
Then, in 2007, M-Pesa was born, and things started to change. The attention and support of the international financial inclusion sector shifted abruptly from credit for the poor to payment and delivery channel innovation. And the low operating costs of the new models attracted new players with enormous resources, from telcos to tech platforms and beyond.
Away from the spotlight, microfinance institutions (MFIs) continued to grow, thrive and serve hundreds of millions of people, using their familiar methods and feeling little need to adjust. But as 2020 approaches, the digital juggernaut has changed the world around them in ways they cannot ignore. At the recent Microfinance Network’s 25th anniversary meeting, the CEOs of leading MFIs urgently discussed how to respond.
Looking at the next 10 years, and reflecting on conversations at the meeting, I offer my own take on seven questions MFIs face.
1. Are fintechs going to take over the microfinance market?
In the 1990s, if you wanted to be a social entrepreneur, you founded an MFI. Today, you start a fintech. Accion has become one of the world’s leading investors in “fintech for financial inclusion”, with investments in nearly 50 companies offering such products as payment networks, remittances, small and medium enterprise (SME) credit, consumer credit, PayGo applications, customer advice, insurance, and data analytics.
At first, many fintechs were out to disrupt traditional financial institutions, like MFIs, but they continue to confront two fundamental problems: customer acquisition and raising capital. This requires many fintechs to pivot towards partnering with traditional institutions, and that offers a path to the future for many MFIs: fintech partnerships can help MFIs make the leap from traditional to digital.
In the 1990s, if you wanted to be a social entrepreneur, you founded an MFI. Today, you start a fintech.
However, MFIs need to prepare to work with fintechs. They need IT departments that can connect seamlessly to the technology fintechs bring. They need to develop a culture of experimentation, in contrast to an organizational identity wedded to traditional methods. And they need to recognize that fintechs, with limited financial resources, need to get to market quickly, or they need financial support from prospective partners. To take advantage of what fintechs have to offer, MFIs must not only ask what they need from fintechs, but also be prepared to offer what fintechs need from them.
2. Will MFIs join the shift to digital lending?
MFIs swear by their traditional underwriting methodologies, whether they involve group guarantees or individual repayment capacity assessment. These high-touch methods often yield repayment rates that other lenders only dream of. A key to success is that the methodology not only predicts the ability of a customer to repay, it actually increases motivation to repay, through peer pressure personal contact and the promise of continued access to credit.
In contrast, the algorithms generated through big data and machine learning lack most of the motivational aspects and are designed primarily to predict repayment. As a result, much of the algorithm-based lending we see today features high default rates, which in turn requires high interest rates.
That said, once the initial set-up is in place, algorithm-based credit is so cheap to operate that its rise is inexorable. Just look at Kenya, where digital lending got an early start. There are over 6 million digital borrowers, and according to a draft study by MSC, nearly 9 out of every 10 loans in the entire system are digital. Algorithm-based lending is made possible by access to customer behavioral data, data analytic capacity and ability to reach customers digitally, all of which may be difficult for MFIs (another reason for partnering with fintechs).
As they develop the capabilities that enable algorithm-based lending, MFIs may wish to explore hybrid models that combine tech and touch. They may find it possible to focus on market segments that are hard for digital lenders to reach. In all cases, they need to advocate for high standards of consumer protection to be enforced in their markets, to avoid being crowded out by predatory lending.
3. Can MFIs participate in the innovation happening in SME (small and medium enterprise) credit?
After decades of stagnation, SME credit is alight with innovation. This innovation is enabled by three economic structure changes that are moving previously informal businesses toward greater formality:
Electronic invoicing: Across Latin America and other regions, governments are requiring SMEs to invoice electronically, mainly for taxation. Lenders like Konfio in Mexico use the resulting data trail as the basis for digital lending.
Supply chain finance, led by the large companies that supply goods to local merchants or that purchase agricultural output, is emerging.
Ecommerce, perhaps the biggest force, is connecting millions of SMEs to technology platforms.
Many MFIs have a ready advantage in connecting with these market opportunities as they already serve SME clients and are skilled at underwriting for at least the lower end of this segment. Going forward, they can develop lending methods that use electronic data trails. They can also partner with big distributors, agricultural buyers or ecommerce firms taking advantage of the fact that these platforms do not see lending as core to their business and often welcome partners with lenders.
4. Will insurance ever matter for MFI customers?
Most MFI clients who have so far received insurance coverage probably didn’t even know they had it, because the most common insurance product is credit life, integrated into their loans without them having to make a decision to purchase it. But innovation is finally coming to insurance for low income people.
For example, Accion’s Venture Lab has invested in several creative start-ups: Pula offers weather insurance together with seed purchases, thanks to a chip embedded in the seed bag; Toffee offers bite-sized insurance cover for specific, often short-term activities; and Lumkani packages fire insurance with fire prevention.
These and other insurance products upend conventional insurance wisdom in order to reach low income customers, by doing three things:
They reduce costs of sign-up by doing away with exclusions.
They reduce costs of claims payments by making them automatic.
Instead of insuring infrequent events, they build a culture of insurance by covering common problems.
These offers are facilitated by electronic distribution. MFIs can participate in this innovation, recognizing how important insurance can be for the financial health of their customers. Mitigating customer risks should be a good business strategy for MFIs, and at the same time, insurers still need good distribution and customer data partners.
MFIs need to advocate for high standards of consumer protection to be enforced in their markets, to avoid being crowded out by predatory lending.
5. Will consumers be adequately protected in a digital world?
We have to keep asking this question, as digital financial services bring new risks to consumers. Digital loans can be very easy to get, but also very expensive. In Kenya, where tiny digital loans are available via the phone, we get a good picture of the risks involved: 20 percent of customers in default, many digital loans used for sports betting, prices much higher than microfinance loans, and an enormous number of people added to the credit bureau blacklist.
Data protection is another rising risk: customers want assurance that their private data remains private, both as a fundamental right and because they are concerned about their exposure to hacking, fraud, and mistakes. As MFIs go digital, their exposure to cybersecurity risk rises.
Regulators are struggling to keep up with emerging risks, and MFIs can play an important role in ensuring that they meet high consumer protection standards and shaping high market conduct standards for other players.
6. How will payments and credit connect in 2020?
MFIs began with credit as a stand-alone product, but increasingly, digital payments are the gateway to credit because of the data payments produce, and this gives an enormous potential advantage to major payments platforms. These platforms already have massive customer bases that generate floods of data, which, properly analyzed, yield the insights needed to offer credit. The combination of payments and credit has the potential to be highly powerful. Major tech platforms could very well end up dominating lending, while smaller providers, such as MFIs, either remain very small or become dependent on the platforms.
The evolution of financial inclusion in Kenya shows how the future may unfold, with the market-dominating combination of M-Pesa payments with M-Shwari credit. Of the global big tech firms such as Amazon and Google, only Alibaba has moved into finance in a big way, but all the big techs are making moves. Ant Financial has become the lifeline for Chinese SMEs for both sales and working capital, and the model is spreading worldwide as Ant Financial invests across Asia.
This platform-dominated scenario is not present in most MFI markets yet, and it may not come to pass. But what is clear is the power and efficiency of payments data to inform credit decisions, suggesting that MFIs should be looking for ways to connect to and harness such data.
7. Is digital transformation feasible for traditional MFIs?
For MFIs to turn the challenges described here into opportunities, they must be willing to undergo digital transformation. In many cases, such as the MFIs that are members of the Microfinance Network, they are already moving along the digital journey, but few have completed that transformation. Many organizations have created digital tools for their loan officers, some have incorporated credit scoring tools into their underwriting processes, and many have switched to digital loan disbursements and repayments.
More fundamental digital transformation requires rethinking business models, including the role of the cadre of loan officers who constitute the backbone of the staff of most MFIs. This transformation entails difficult choices about retraining and employment, which need to be discussed more openly in the sector. Investments in data analytic capabilities are needed, and at the board level, expertise needs to be brought on to guide the transformation.
MFIs have the chance to use digital tools to pursue their missions in an increasingly digital world. If they haven’t started already, it’s high time to begin.
The excitement around fintech in India is palpable. Many see it as a market-led solution to the policy objective of financial inclusion. Fintech regulation must therefore be designed carefully to prevent and mitigate risks while also preserving the potential for financial inclusion.