A Practitioner and a Regulator Talk Digital Credit

A scan of recent blogs and public discussions suggests an emerging sense of unease among responsible practitioners, regulators and industry experts surrounding the proliferation of digital credit. While continuing to generate widespread interest, this new digital finance offering has sparked an array of debates, ranging from the appropriateness of loan terms and conditions to projections about the future of consumer lending. In the spirit of bridging divisions and fostering informed discussions, this post brings differing viewpoints on three questions head-to-head, channeled through the voices of one practitioner and one regulator. The practitioner, Byoung-Hwa Hwang, is a digital finance consultant at CGAP, primarily focusing on research and engagement efforts related to digital credit. The regulator, Stanislaw Zmitrowicz, works with the Conduct Supervision Department of the Central Bank of Brazil.

As more non-bank financial institutions enter the digital credit space, adequately regulating the industry poses a new challenge. For consumers, do the benefits of having access to more credit options outweigh the new risks?

Byoung: Unlike conventional credit offered by a commercial bank or a microfinance institution, digital credit relies on partnerships between different providers with access to capital, distribution channels and customer intelligence. In fact, we note a horizontalization of the value chain, with banks finding themselves in the unfamiliar position of having to compete with non-bank financial institutions (NBFIs), FinTechs, mobile network operators (MNOs) and mobile payment providers to partake in the lending business. Such interchangeability of providers fuels competition and creates a breeding ground for innovation. To date, there are at least 22 live digital credit deployments worldwide, and only about half of them involve a commercial bank as the lender.

Stan: That may be true, but this new horizontal business model also blurs policy makers’ mandates and providers’ liabilities. Who in the value chain is responsible for customers’ losses? Partnerships between institutions under different regulatory frameworks require greater coordination efforts to monitor and supervise.

Also, I’m not sure that horizontalization necessarily leads to innovation. Under current business models, much of the customer data is available only to MNOs and their partners. Uneven access hinders competition and monetizes data, increasing costs for providers who are charged to use it and challenging data protection principles.

Finally, responsible financial practices, monitoring and supervision must apply to all players in the value chain, including FinTech start-ups. Deregulation cannot be the answer. After all, the reason why banking and lending are highly regulated is that they can have damaging effects on the economy, especially on low-income people. Take the microcredit bubble in Andhra Pradesh in 2010, for example. There, defaults on small ticket size loans had wide-ranging consequences for bottom-of-the-pyramid customers and the country’s economy as a whole.

Digital credit offers a unique opportunity for unbanked, low-income customers to receive a formal loan. But does the short-term nature of the loans and the consequences of default outweigh the benefits of financial inclusion?

Byoung: To me, the fact that digital credit is targeting the bottom of the pyramid is among the most promising aspects of this new form of lending. When was the last time you saw commercial banks cater to the financial needs of the poor — a customer segment that was once considered irrelevant, if not undesirable? In the absence of a formal financial history, digital credit providers creatively — and boldly, I admit — leverage alternative data sources to assess customers’ credit risk. For the unbanked, this forms a gateway to formal financial services that did not exist before.  

Stan: But bottom-of-the-pyramid customers’ financial needs go beyond 30-day loans. The need for longer-term financing may result in customers juggling between different providers, and digital credit may become a permanent high-cost debt trap. In Kenya, for example, some consumers interviewed by CGAP used KCB M-Pesa to roll over their M-Shwari loans and vice versa. See the similarity to payday lending?

As a matter of fact, 2.7 million Kenyans — about 10 percent of the country’s adult population — are blacklisted in the main credit bureau for defaulting on digital credit. These people not only lose eligibility for other loans, but their income can be impacted when employers use credit reports to screen job applicants.

Byoung: But to that point, we must remind ourselves that digital credit is never meant to be a long-term financing tool, and most providers are very clear and upfront about its intended purpose and use: namely, to offer short-term liquidity. And without an all-encompassing credit reporting system in place in a market, there is no way of a lender knowing how many outstanding balances a borrower may have at other institutions. None of the deployments I am aware of extend credit to borrowers with an outstanding loan. Providers are merely complying with credit reporting requirements in their countries.

The interest rate charged on digital credit deployments is high. Can interest rate caps work to the benefit of the borrower?

Stan: To answer that, let’s briefly go back to the payday lending comparison. Many digital credit products charge interest rates that are comparable to those charged by informal lenders. In the United Kingdom, the FCA imposed interest caps for the payday lending industry. The same could apply to digital credit. Moreover, digital credit providers should structure sales incentives and product designs to prevent reckless lending.

Byoung: Frankly, I don’t think interest rate caps help anyone in the context of digital credit. Even if providers benefit from the automation and digitization of lending processes, there are still significant costs and risks in offering unsecured loans to a new customer segment. Caps make it difficult — if not impossible — for formal providers to operate sustainably. You may even create an opening for unregulated players to enter the market, resulting in even greater risks for the customer.  

Byoung and Stan: We find reasons to be both excited and wary about the proliferation of digital credit. The fact that providers are working hard to innovate and reach the unbanked is encouraging; however, digital credit introduces new consumer protection risks that call for close scrutiny.