Addressing Digital Credit Risks in Emerging Markets
In Part 2 of this blog series, Stephen Deng (DFS Lab) and Alex Rizzi (The Smart Campaign) share insights on consumer protection measures in emerging markets. This post was written by Alexandra Wall, a graduate student researcher with CEGA’s Digital Credit Observatory.
In Part 1 of this blog series we highlighted findings from two nationally representative phone surveys conducted by CGAP and FSD Kenya. The findings (published in this recent working paper) urge providers, policymakers, investors, and donors to improve transparency and consumer protection measures in order to ensure the responsible growth and expansion of digital credit markets. This post highlights conversations with two Digital Credit Observatory (DCO) Community of Practice members, Stephen Deng and Alex Rizzi, to learn how investors and consumer protection organizations are thinking about consumer risks in the digital credit space.
Digital Credit Concerns & Fintech Companies
Digital Financial Services Lab (DFS Lab), a seed stage accelerator for financial technology (fintech) startups in developing markets, has seen firsthand the consumer risks that exist in this evolving space. “One of our portfolio companies, which connects SMEs to peer-to-peer lending, discovered that loans were being used for sports betting,” shared Stephen Deng, Co-Founder and Investment Officer at DFS Lab. In other words, loans were being used for gambling instead of their intended purpose for productive business investments. “To mitigate this situation, the company started incorporating more financial education into their loan application process.”
While this company took the initiative to implement new measures to reduce consumers’ risky financial behavior, there is an ongoing debate within the consumer credit space about who bears the liability of ensuring responsible lending practices and adequate consumer protection measures. “There’s a fine line between educating potential borrowers and deterring potential borrowers by having too much extra education integrated into the application,” says Deng. “For example, if one or two more menu pages on financial education are added, will that turn some borrowers away?”
For-profit companies, especially as they are just starting out, rely heavily on product uptake to demonstrate demand to investors. As a result, many fintech companies walk the fine line of providing just enough product friction. This includes ensuring that consumers understand the terms and conditions of a financial product and how their data is being used. “It’s not that there’s an assumption that users (of digital financial products) do not care about how their data is being used, but it’s the assumption that there’s no real outside pressure — from users, investors, or regulators — to educate consumers on this topic,” explains Deng.
Whose responsibility is it to ensure products are designed responsibly and consumers are educated about privacy and protection concerns?
Some argue this falls on the shoulders of financial providers while others believe the push should come from regulatory and policy-making bodies. Accion’s Smart Campaign has established 7 Client Protection Principles “to help service providers practice good ethics and smart business.” While these principles are aimed at providers, the Smart Campaign also recognizes that regulators and supervisory bodies need to have strong market conduct tools and the capacity to reinforce.
Alex Rizzi, Senior Director at the Smart Campaign, says these principles came about in 2009 through the collective participation of microfinance institutions. “While commercializing microfinance enabled growth and scale, at the time there was also concern that this was happening at the cost of client’s well-being.”
While these principles were established at a time when microfinance was the primary financial product being offered to low-income populations, the Smart Campaign believes these principles can apply to other financial product models, such as digital credit. “The principles are a useful framework for thinking about risks. But the way to mitigate those risks is different in the digital space,” shares Rizzi. “We’re working with (digital credit) providers to understand what systems and policies need to be in place within an organization to meet certain consumer protection standards.”
What incentive do digital credit providers have to abide by client protection principles if little outside pressure is being put on them to do so?
The Smart Campaign has created a Certification Program in hopes of providing such an incentive. “For microfinance, the certification has recognized over 100 institutions that serve more than 40 million clients. What has incentivized them has been a mix of pressure from competitors — an institution wants to distinguish itself in the crowded market — as well as demand from investors and donors,” says Rizzi.
This certificate, which is awarded through validation by a third party rating agency, is in the process of being adapted for digital financial service providers. The Smart Campaign promotes certified organizations through media announcements, a repository on their website, letters to regulators, and announcements at relevant conferences. How valuable are such certificates to providers? Would it sway investors’ decision to provide capital for certain companies? “Many investors care about certification,” says Rizzi. “Regulators, through encouragement and not formal requirements, have helped incentivize the take-up of this certificate. We’ve pitched it to regulators that this certificate can serve as a good option in markets where capacity for supervision is limited.”
Certification from an Investor’s Perspective
From an investor’s perspective, seeing that a company has been certified would demonstrate that the business is taking consumer protection concerns into consideration with their product design and services. However, “we wouldn’t take the certification at face value and would still probe further by asking a lot of questions to understand how the company is embodying the principles,” explains Deng.
In addition to scrutinizing possible investees, DFS Lab does its due diligence to ensure digital financial service providers are minimizing risks faced by consumers. While DFS Lab does not have a strict set of standards that is applied across all companies when evaluating investment options, the seed stage accelerator does not fund unsecured consumer loans (that market is mature enough, according to Deng) and instead focuses on data the company has access to. “For example, for one of the main consumer risks of over-indebtedness we want to see a high level of financial ability to repay. And this requires access to data on the consumer.” Deng goes on to explain that “social media and telecommunications call detail record (CDR) data isn’t enough anymore. Mobile money data is considered a relatively good data layer, but it’s recognized that we need more information.”
Based on its experience with the company that dealt with sports betting, DFS Lab now also evaluates whether startups have a financial education component. “Financial education definitely has an important piece to play in this space,” acknowledges Deng.
CEGA’s Digital Credit Observatory (DCO) also plays an important role in generating evidence on the impacts of digital credit products on borrowers, which in turn helps the broader digital credit marketplace better design products and inform protection and privacy standards. “What (Joshua Blumenstock and Daniel Bjorkegren) are doing in their DCO study about the transparency of algorithms and lending decisions can have implications for how much we should ask providers to share about their decision making moving forward,” says Rizzi. “This is one of the reasons why when I heard about the DCO I was excited to be a part of the community of practice and to learn about the relevant and cutting edge research being produced.”
The Digital Credit Observatory, funded by the Bill & Melinda Gates Foundation, was established by CEGA in 2016 to fund a suite of coordinated studies answering questions related to the impacts of digital credit in emerging markets and the effectiveness of related consumer protection measures.