Digital credit’s impact potential
Can digital credit be a tool to reduce poverty
Digital credit remains out of reach for many people in developing nations, preventing them from realizing their full potential. Even with low overhead costs and the ability to reach the unbanked, there is still much to be done for digital credit to live up to expectations. In this final blog of our digital credit series, we explore the people behind the money; who finances credit? Our research uncovered five distinct groups of funders, as outlined below.
Somewhat ironically, we can attribute some of the less than ideal end-user loan experiences to the nature of the debt burden placed upon some last mile distributors by their capital providers. Rational investors will always want to maximize their profits, which can become rather problematic when short-term thinking is involved. This is especially true when it comes to debt investments. Pressure and cost to repay time-bound debt instruments are passed on to consumers through high interest rates, and harsh debt collection practices in case of default. In the absence of prohibitive regulations, distributors will rarely choose borrower welfare over their repayment obligations as they pursue market growth and, in some cases, survival.
This is in contrast to providers that attract capital from impact investors. While these investors all expect the company to remain profitable, their strategies more often consider impact on end-users. This orientation is often made permanent by board representation, ensuring oversight of operations to avoid harsh debt collection practices and protect consumers against blacklisting among other consumer protection priorities. They also choose to invest in better know-your-customer (KYC) protocols and better scoring, which is in contrast to other providers who accept higher default rates and rely on pricing to protect their bottom line.
While microfinance institutions (MFIs) have largely retained impact prioritization, we learned that the funding dynamic has been gradually changing. The space has been moving towards self-sustainability and away from donor reliance. MFIs are increasingly leveraging their speciality in extending loans to lower income rural populations, which banks are unwilling to do as their business models limits extending financial services to the lowest income demographic.
This has created greater demand for shorter term and more digital loans that MFIs such as the Kenya Women Finance Trust (KWFT) are now forced to adapt to. This will have implications for impact as MFIs begin to respond to trends in market demand for short-term loans, rather than strategically supplying loans that benefit the poor.
The repayment process
Due to the small size of many digital loans, most products in the industry only require a lump sum payment. However, there are some digital loan products that require fixed periodical repayments. These are more often products emerging from institutions that previously preferred this structure during brick and mortar operations. Preference for this structure is also rooted in the fact that they often extend larger loans, and as a result require more elaborate enforcement mechanisms to guide the borrower towards full repayment. Repayment schedules often come prescribed by the provider with limited flexibility.
The concept of a borrower being able to determine their own preferred repayment schedule is still nascent in the industry, but there is reason to believe that it could be a way to improve the borrower’s experience and impact. Many financial service providers that embrace inclusive finance are moving towards designing transactions, savings and borrowing products that are better aligned to people’s incomes and expenditures. Progress could be made through having the borrower involved to some degree in the design of the repayment process for loans that they procure.
Reluctant to get left behind by the wave of advancement of digital finance, banks have also invested in developing their own digital credit products through telco partnerships, or by offering their own new services. NCBA bank in East Africa, for example, partners with Vodacom - a multinational telco - but also offers enterprise credit via a product called NCBA loop. Their funding stream is entirely reliant on internal strategy, making them both the capital provider and the distributor unlike other digital credit varieties. Also, by virtue of being banks, they have larger amounts of capital at their disposal, allowing them to quickly extend loans en masse via telcos. For at least one supplier of telco facilitated bank loans, we learned that this dynamic brings with it a degree of openness to risk as far as pricing, credit scoring and lenience in the borrowing process.
Measures to prevent default are a priority for providers and those concerned with borrower welfare, explaining why this approach endures for digital credit and/or microfinance for low-income populations. However, there is emerging evidence that flexible terms do have benefits for the borrower and provider. An experiment on microfinance borrowers in India emerged with the following conclusions:
- The rigid and frequent repayment schedules that borrowers tend to be bound to often incentivize low-risk, low-return business activities.
- Flexible repayment schedules lead to higher repayment rates, compared to fixed schedules.
- Flexible repayment schedules led to higher overall business performance, among those that owned businesses.
Digital credit still has a long way to go before it can become the vehicle for credit that it has the potential to be. By plugging existing gaps, digital lending platforms can be further developed to increase access to credit, and empower more people to lift themselves out of poverty.
What role do philanthropists play in the digital credit space, and how can they influence it for the better? Watch this video on our YouTube channel to find out our recommendations for philanthropists, private sector and intermediaries.