“Over the past 60 years, we have seen several episodes of economic growth in different parts of the world. One clear lesson of this experience is that growth is sustainable only if it is inclusive... Governments around the world are therefore anxious that even as they pursue economic growth, they must make their growth process inclusive.” Dr Subbarao, Former RBI Governor explained the need for financial inclusion in his 2012 speech.
The Reserve Bank of India uses two approaches to define the concept of financial inclusion-
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According to Dr. C. Rangarajan’s Committee on financial inclusion, it is defined as the process of ensuring access to financial services and timely and adequate credit where needed by vulnerable groups such as weaker sections and low-income groups at an affordable cost.
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A more recent update is from Dr. Raghuram Rajan’s committee on financial reforms that states that- financial Inclusion, broadly defined, refers to universal access to a wide range of financial services at a reasonable cost. These include not only banking products but also other financial services such as insurance and equity products.
This instinct of the central bank to proactively engage and include the marginalized and the poor is wise for the simple reason that it legitimizes the role of central banks in a democracy. With the tools of financial inclusion, the central banks help build modern citizenry. But the challenges to realizing such an ambition are many. For the sake of clarity these challenges can be subdivided into three categories: market-driven factors, regulatory factors, and infrastructure limitations.
Market-driven factors include aspects such as relatively high maintenance costs associated with small deposits or loans, high costs associated with providing financial services in small towns in rural areas, lack of credit data or usable collateral, and lack of convenient access points. The provision of financial services in rural areas can pose particular problems in archipelagic countries, such as Indonesia or the Philippines, which calls for a focus on innovative delivery technologies that can break down transport-related barriers. Further, the lack of credit data and reliable financial records worsens the problem of information asymmetry that discourages banks from lending to poorer households and SMEs.
Regulatory factors include capital adequacy and supervisory rules that may limit the attractiveness of small deposits, loans, or other financial products for financial institutions. Strict requirements regarding the opening of branches or ATMs may also restrict the attractiveness of doing so in remote areas. Identification and other documentation requirements are important both with respect to know-your-client requirements and monitoring of possible money laundering and terrorist-financing activities, but these can pose problems for poor households in countries that do not have universal individual identification systems. Regulatory requirements, such as restrictions on foreign ownership and inspection requirements, can also restrict the entry of MFIs. Regulatory requirements need to be calibrated to be commensurate with the systemic financial risks posed by various financial institutions and the trade-off of financial stability with greater financial inclusion.
Infrastructure-related barriers include lack of access to secure and reliable payments and settlement systems, the availability of either fixed or mobile telephone communications, and the availability of convenient transport to bank branches or ATMs. Again, these can pose particular problems in archipelagic countries. Numerous studies have identified lack of convenient transport as an important barrier to financial access.
Demand-side factors include a lack of funds, lack of knowledge of financial products (i.e., financial literacy), and lack of trust. Lack of trust can be a significant problem when countries do not have well-functioning supervision or regulation of financial institutions, or programs of consumer protection that require adequate disclosure, regulation of collection procedures, and systems of dispute resolution.
The outcome is that a major section of citizens is either completely cut off from formal banking services (Unbanked) or are aware but not committed to engaging with the institutions (Underbanked). The numbers are staggering. A recent World Bank report pegged the number of the unbanked at 1.7 billion worldwide. It is assumed that the underbanked stand at a similar number even though no research has been conducted at a similar scale. More than 70% of the adult population in South- East Asia is either “underbanked” or “unbanked,” with limited access to financial services. The region is currently considered one of the fastest emerging geographies of the world. In today’s post, we will look at the latter, their concerns and possible solutions. A comprehensive study was done in the US by the FDIC which placed the numbers in 2017 at 6.5% of U.S. households for the unbanked, and another 18.7% of U.S. households were underbanked. By all accounts, we are looking at numbers which are mind-blowingly large.
As mentioned above, trust and convenience are significant issues for the underbanked- customers who tend to utilize first-level services like a saving account, but due to psychological hesitancy or low credit scores are unable to optimally enjoy mainstream financial services. They largely tend to rely on alternative financial assistance that falls outside most regulatory purview- shadow banks. The existence of this large unorganised market has led to the emergence of shadow banks that invest in predatorial technological initiatives. The term coined by economist Paul McCulley in a 2007 speech at the annual financial symposium hosted by the Kansas City Federal Reserve Bank was initially used in the US context but has largely gained traction worldwide since then. These unconventional financial institutions are modern-day behemoths riding on the rising wave of new technologies and changing consumer expectations. China is home to the fastest growing shadow banks with a growth rate of over 30% for over 3 years, compared to the global growth rate of 10% and is pegged at US$12.9 trillion in 2020. The world’s biggest financial market- The US is home to the largest shadow Banking sector amounting to 15.2 trillion$ and represents 74.2% of its GDP as of the year 2018. Globally, the shadow banking sector has been the cause of disruption in the traditional banking sector and challenging regulatory standards. More and more people are been brought into the financial system by the shadow banks, something originally sought by central banks the world over but the concern is that this inclusion might come with a Faustian bargain.
The novelty and the speed of technological innovation have left compliance behind and this has been highlighted by global regulatory bodies as a pertinent red flag. Concerns raised by the global regulatory community are many.
- Gaps in regulatory perimeter: Consumers of fintech products may receive less protection than consumers of traditional financial products if there are gaps in the coverage of their country’s existing regulation and financial sector oversight.
- Fraud or other misconduct: Factors such as the novelty, opaqueness, or complexity of certain fintech business models and fintech entities’ responsibilities, as well as the lack of consumer familiarity, can lead to new or heightened risks of loss from fraud or misconduct by financial service Providers or third parties.
- Platform/technology unreliability or vulnerability: If a fintech platform or other systems underpinning a fintech offering are unreliable or vulnerable to external threats, they may expose consumers to heightened risks of loss and other harm.
- Business failure or insolvency: Consumers whose funds are held or administered by a fintech entity may risk losing those funds if the entity becomes insolvent or their business ceases to operate, and factors such as inexperienced entrants and riskier or novel business models can increase such risks.
- Consumers not being provided with adequate information: The standard risks arising from consumers not being provided with adequate product information can be heightened when new types of pricing, product features, and risks are introduced, or where digital channels for communication pose challenges to consumer comprehension.
- Product unsuitability: Fintech can increase access to riskier or complex financial products to consumers that may lack knowledge or experience to assess or use them properly, leading to greater risks of harm due to product unsuitability.
- Conflicts of interest and conflicted business models: Fintech business models may give rise to conflicts of interest under new circumstances not foreseen by regulators or expected by consumers.
- Algorithmic decision-making: The use of algorithms for consumer-related decisions is becoming particularly prevalent in highly automated fintech business models and some scoring decisions may lead to unfair, discriminatory, or biased outcomes.
- Data privacy: This is a particularly crucial consideration in relation to fintech offerings, given their highly data-driven nature.
For anyone searching for a solution to this rather dramatic and global phenomenon- the engagement starts with reinforcing existing regulatory bodies. Shadow bank’s digital offerings for the underbanked are largely in the form of four fintech products-digital microcredit, peer2peer lending, investment-based crowdfunding and e- money. Regulatory bodies and compliance enforcers can play an important role here in enforcing country specific and tailormade consumer protection protocols to shield them from harmful exposure. We have few suggestions.
The novelty and opaqueness of fintech business models and the consumer unfamiliarity with the offerings create fertile grounds for heightened risks of fraud or misconduct by fintech entities or third parties. In this context platform finance (P2PL and investment-based crowdfunding) poses risks to consumers who tend to be both lenders/investors and borrowers. In an unsupervised set-up loss due to fraudulent lending, misappropriation of funds, or facilitation of imprudent lending or investment to generate fee revenue for the operator to the detriment of consumers are dangers that investors and lenders need to be aware of. Similarly, borrowers can suffer harm from the resulting imprudent lending.
Regulatory approaches to address such risks include vetting of fintech entities during the authorization stage; risk management and governance obligations for platform operators; imposing clear responsibility and liability on providers for the conduct of persons acting on their behalf; placing obligations on platform operators to safeguard consumers’ interests regardless of the business model such as making it mandatory for P2PL platform operators to undertake creditworthiness assessments even if they are not themselves the lender; warnings and provision of other key disclosures to consumers regarding the risks associated with fintech products; and segregation of client funds.
Certain characteristics of fintech business models can lead to conflicts of interests between consumers and fintech entities. For example, lending models heavily dependent on fees generated by new business can give rise to perverse incentives for fintech entities to act in a manner inconsistent with the interests of their consumers, such as P2PL platforms or digital microcredit providers focusing on loan quantity over quality to maximize fee-related returns. Such risks can be exacerbated in markets where fintech entities are attempting to grow their revenues and size quickly. Potentially harmful conflicts can also arise where fintech entities are empowered to make key decisions affecting the risk of loss, but where that risk is borne by consumers—such as a P2PL or crowdfunding platform operator assisting with loan or investment selection and performing inadequate due diligence on these.
Corresponding regulatory approaches include placing positive obligations on fintech entities to manage and mitigate conflicts of interest, to act in accordance with the best interests of their consumers, to undertake adequate assessments regardless of business model, and to prohibit certain business arrangements that encourage conflicted behaviour.
Consumers may face a heightened risk of adverse impacts due to platform or technology unreliability or vulnerability. Consumers may be more vulnerable to cyber fraud when acquiring fintech products than when accessing financial products through more traditional channels because interaction with providers is largely or exclusively via digital and remote means. Platform or other technology malfunctions can have adverse impacts on consumers ranging from inconvenience and poor service to monetary loss and loss of data integrity, the risk of which may be increased due to heavier reliance on automated processing of transactions.
Regulatory approaches to address such risks include specific obligations on fintech entities to address technology and systems-related risks and risks associated with outsourcing.
Some fintech entities may be at greater risk of business failure or insolvency than established financial service providers (FSPs) due to inexperience, untested businesses, and market factors affecting long term viability. This can lead to consumers whose funds are held or administered by a fintech entity facing correspondingly greater risk of loss if the provider becomes insolvent or their business ceases to operate. Consumers may risk losing their committed loan principal or investment funds, or repayments or investment returns owed them, that are being held or administered by a P2PL or crowdfunding platform whose operator becomes insolvent or fails. Insolvency of e-money issuers or banks holding an e-money float similarly puts client funds at risk, especially where there is no deposit insurance.
Regulatory approaches to address such risks include requirements for client funds to be segregated from other funds held by a fintech entity and requiring that fintech entities have in place business continuity and resolution arrangements.
Consumers face potentially heightened risks when acquiring fintech products due to their lack of sophistication or inexperience. Due to the development of fintech, consumers increasingly have access to novel and complex financial products, but they may lack the knowledge or experience to assess or use these products properly. For example, platform finance enables more individuals to act as investors and lenders; this has positive implications for financial inclusion but can present enhanced risks for ordinary consumers new to assessing more complex opportunities.
Potential regulatory approaches include setting limits on individual investments, such as overall caps on how much an individual may borrow through a P2PL platform or how much money a company can raise on a crowdfunding platform, or limitations on specific types of investors or exposures; targeted warnings to potential investors; requiring consumers to confirm that they understand the risks they are undertaking; and cooling-off periods. Risks may also arise with respect to digital microcredit products being offered to consumers that are unsuitable and unaffordable for such consumers. Regulatory approaches include requiring effective creditworthiness assessments and applying product design and governance principles, particularly where automated credit scoring is utilized.
Use of algorithms for consumer-related decisions is becoming particularly prevalent in highly automated fintech business models. Consumers may face a range of risks as a result, such as discriminatory or biased outcomes.
Emerging approaches in this context include applying fair treatment and anti-discrimination obligations to algorithmic processes; putting in place governance frameworks that require procedures, controls, and safeguards on the development, testing, and deployment of algorithms to ensure fairness; auditing requirements; and providing consumers with rights regarding how they or their information may be subjected to algorithmic decision-making.
In the future, meaningful financial inclusion of the underbanked and fintech regulation will go hand in hand where the role of service providers will be to educate, engage and protect consumer interests. At Hashbrown Systems we comprehend the far-reaching impact of sustainable and well-regulated fintech solutions in strengthening financial inclusion. Our experience in building fintech products has provided us with a first-hand understanding of the process and its impact. Do reach out to us if you would like to know more about our fintech philosophy and our work.
https://www.bis.org/events/agm2019/agm2019_speech_seru.pdf
https://bcf.princeton.edu/events/amit-seru-on-the-rise-of-fintech-intermediaries/
https://documents1.worldbank.org/curated/en/515771621921739154/pdf/Consumer-Risks-in-Fintech-New-Manifestations-of-Consumer-Risks-and-Emerging-Regulatory-Approaches-Policy-Research-Paper.pdf
https://onlinelibrary.wiley.com/doi/10.1111/manc.12331
https://www.deepdyve.com/lp/sage/unbanked-in-india-a-qualitative-analysis-of-24-years-of-financial-dqVO5gqEvN?key=sage#bsSignUpModal
https://news.illinois.edu/view/6367/808477
