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3 things needed for a healthy consumer credit system

A new wave of financial technology companies are trying to redefine/rethink/revolutionize/disrupt finance in developing countries including India, China, Brazil, Mexico etc.

A large set of these financial technology companies are focused on improving access to credit either through lending products or credit scoring. Due to less regulatory overview, startups are able to create innovative credit risk models that allow them to score/lend to previously underserved borrowers. These borrowers have a few common characteristics:

1. Zero or sparse traditional credit data
2. Mobile first or mobile heavy (mostly)
3. Limited or no access to traditional financial products like credit cards and loans

As startups jump onto the bandwagon of lending to these borrowers (and some successfully do), most of them run into problems such as loan stacking, online fraud, identity theft, etc.

Some of these companies will be successful in helping people with access to credit, but most importantly, they’ll help create 3 important requirements of a healthy credit ecosystem:

1. A standard score or some semblance of it — As there is FICO in the U.S. (which took decades to be close to a standard), there needs to be a standard score that most financial institutions can use. It is difficult to create and back test models with constantly changing sources of information that didn’t exist before. A standard score will allow multiple players to add some proprietary technology to this score to offer new products. Without a standard score investors won’t be able to benchmark returns and be confident of a platform’s loss rates.
2. Penalty for defaults — If someone defaults on one financial institution, every other player in the market should be able to know about it (as it shows up on a credit report in the U.S.). There are bureaus in every country, but reporting is either super expensive or lenders don’t want to report because of onerous reporting requirements. Most bureaus try to copy what they did in the U.S. and this is not how the developing countries will access financial services (I don’t think bureaus will be as useful in developing countries because new technologies like wallets have already better adoption than traditional products like credit cards). As borrowers go delinquent or default, they are not penalized correctly and still able to borrow from multiple local sources.
3. Cheap servicing and collection systems — As borrowers get into repayment cycle, there needs to be a cheap and easy way for lenders to debit money from a borrower’s account. In case of delayed payments, it shouldn’t be prohibitively expensive to collect money. Servicing and collections end up being a significant portion of operations in a lending business. For a scalable credit system, these costs (especially collections) need to be low enough to not significantly impact returns. In India, collection is super difficult and costs are so high that banks chose to write off loans. This also increases lending requirements and prevents them from making unsecured loans to consumers (or making it extremely expensive).

In my view, these are the 3 major factors that prevent adoption and scalability of companies that provide credit in the developing countries.

Regulations and newer technologies to build the infrastructure (where none exists) are positive for these countries, but that alone may not be enough for someone to build a credit business.

Hoping for a robust credit system.