Has Fintech Closed the Credit Gap? Not by a Long Shot

With all the enthusiasm for fintech and the digital revolution, it's easy to forget the importance of traditional credit market infrastructure, including “old-fashioned” institutions such as credit bureaus, collateral and company registration systems and the legal systems that enable contract enforcement and debt collection. Despite all the ways in which digital technology has changed credit markets, weaknesses in traditional infrastructure still constrain lenders’ ability to provide business finance, undermining the critical role of private businesses in economic growth and wealth creation. In the realm of credit, the real value of fintech may well lie in its potential to strengthen traditional credit market infrastructure.  Unfortunately, the current focus is excessively on expanding consumer finance.

As Greta Bull points out in her blog post, “We Need to Talk About Credit,” FSD Africa’s research shows that development efforts neglect small to medium enterprise (SME) finance in many African markets. The statistics are staggering. According to the Bank of Zambia’s cutting-edge credit market monitoring reports, lenders issued only around 2,000 SME loans in 2017, compared to more than 80,000 microenterprise loans and more than 2 million consumer loans. Tanzania’s numbers look better, with cooperative lenders and microfinance institutions (MFIs) playing major roles, but the country faces many similar problems. Digital credit is a big growth market, but it is dominated by high-cost consumer finance, which makes a limited contribution to wealth creation or sustainable economic growth. Unfortunately, data that would illuminate this state of affairs are scarce. Domestic bank supervision reports generally do not provide sufficiently disaggregated data on the allocation of credit. The World Bank occasionally produces sector reports, but these are not regular or granular enough to create market awareness and build momentum for reform. The Zambian central bank’s credit market reports are setting an important new benchmark.

When looking at the global state of credit market infrastructure, it’s not hard to see why the well of SME finance is so shallow. Credit supply for SMEs across most of Africa and the developing world is seriously constrained by high levels of default and limitations on lenders’ ability to enforce contracts and collect debt. It is unrealistic to expect significant growth in business lending by banks, leasing companies or any other party if financiers are unable to take effective legal action when clients default. In Africa, it is not uncommon to see nonperforming loan levels of 15 percent or higher in business lending. It’s hardly surprising that lenders hesitate to increase business lending when every sixth loan may have to be written off. This is not sustainable lending, particularly for SME loans, given the size of the loans at stake.

Paradoxically, the success of digital credit and microfinance supports the notion that poor infrastructure is a binding constraint on traditional SME lending. Digital credit and microloans (including payroll-deducted loans) do not rely on credit bureaus or traditional debt collection through the legal system and courts. Instead, they employ technology or old-fashioned feet on the ground to overcome debt collection problems, providing various explicit and implicit incentives for good payment behavior and penalties for clients who do not repay on time. These incentives and penalties include group and social pressure, additional loans for clients who repay on time or reminders from persistent loan officers. High interest rates and fees on small loans compensate for high default rates. In short, these types of lending are effective precisely because they work around weaknesses in the legal and institutional environment. They respond to the critical demand for credit but do little in terms of the credit needs of formal businesses.

Undoubtedly, new technologies have the potential to improve SME finance, even in the context of weak credit market infrastructure. Fintech innovations like online lending, including platform lending and crowdfunding, stand to reach business clients that banks have been unable to serve. We should also not lose sight of technological applications in invoice discounting, merchant cash advances and a range of similar mechanisms, which are already having an impact in several countries. Although not all of these are truly new technologies, they fit easily into the fintech landscape and have potential to reduce risk and create efficiencies across different stages of the lending cycle, as discussed by Rashmi Pillai and Peter Zetterli in their blog post,"$4.9 Trillion Small Business Credit Gap: Digital Models to the Rescue." A next generation of technology may equally start addressing infrastructure constraints directly, such as by making court processes more transparent and efficient.

The fact that the financial inclusion community overlooks traditional infrastructure and SME finance is symptomatic of deeper issues in how we approach financial inclusion . It makes sense to take stock of the failings in financial sector development over the past few decades and reappraise priorities. A few thoughts:

• Beware of fads. A lot of faith has been placed in digital credit (and fintech, more broadly) to the extent that many development agencies are restructuring their priorities and moving away from anything that sounds too traditional. A realistic appraisal of both the strengths of past innovations and the limits of new technologies would help put the importance of traditional infrastructure into context.
   
• Be cautious about catch phrases and acronyms that over-simplify the real world. A term like “MSME” is a classic example. By conflating microenterprise and SME loans, it obscures the very different challenges facing each. Digital credit, online lending, payroll-deducted lending and platform lending each requires specific attention. Each could have a positive impact on financial inclusion but poses its own risks to consumers and the financial system and faces different institutional barriers to its development.
   
• Watch out for wolves in sheep’s clothing. Payroll-deducted loans stand out as a category that holds great danger both for consumers and the financial system, but these dangers receive far too little attention. The current debate is dominated by the apparent (and mostly mis-specified) risks of digital credit. Inappropriate interventions in response to misunderstood risks could negatively impact the expansion of online lending or the evolution of digital credit into new areas of finance, such as SME finance or agricultural lending.
   
• Don’t ignore old friends and trusted servants. It is interesting to note how far out of favor MFIs have fallen, with savings and credit cooperatives and community-based financial mechanisms like village banks receiving even less attention. Yet when conventional credit market infrastructure is weak, these mechanisms have been incredibly successful at reaching customers in a financially sustainable way.
   
• A little more patience and perseverance would be useful. The really important credit market segments, such as SME finance or housing finance, depend on traditional financial infrastructure, including mechanisms for personal and company registration, credit scoring, contract enforcement and debt collection, as well as the underlying legislation and regulations. Technology has an important role to play in transforming this critical market infrastructure, but it will require investment and attention. Reform in these areas is hard and time-consuming work, but it’s indispensable for progress over the long term.

Gabriel Davel is the CEO of the Centre for Credit Market Development and the previous CEO of the National Credit Regulator in South Africa.