Building credit history for the unbanked can help 1.7 billion people get the financial services they need
In a previous post, I discussed how lack of identity was blocking financial inclusion for 1.7 billion adults globally. Today, I’m going to talk about the other fundamental key to financial inclusion that is lacking for most of the world’s unbanked: credit history.
As a quick refresher, World Bank defines financial inclusion as [1]:
…access to useful and affordable financial products and services that meet their needs…”
Let’s zoom in on “useful” and “affordable” for a minute:
Useful. Try to imagine your life without a checking account, a credit card, or a mobile payment option. You’d be forced to use cash for every transaction. You wouldn’t be able to order anything online. Think about how many times every day you rely on some form of financial product or service — and not just cash — to enable your life. This isn’t to say that cash is bad, it just severely limits where and how you can transact, creating a systemic ceiling for access to products and services.
Affordable. What’s your cost of capital? You might buy a home with a 4.5% interest loan. What if that interest rate was 25% — would you still be able to afford your home? If you pay your credit card in full each cycle, there’s usually zero finance charge. What if it was 15% even when you paid in full — would you still use your credit card? Every transaction that involves some form of credit is predicated on the quantity and especially the cost of capital available to you. Having access to credit is better than not having access, but affordability will drive how much you’re able to use it.
So, how does credit become useful and affordable?
They tend to go hand in hand. When consumers use credit, a credit history is generated. Even modest amounts, like the $200 limit on your first credit card after high school, start to generate credit history. The next time you need to access credit — for a new credit card, a home loan, or otherwise — the potential lender can use existing credit history to better predict your credit risk. Knowing that you’ve paid $200 a month for 2 years without missing a payment makes it much easier to give you a $400 line of credit, especially compared tongiving that credit to someone with zero history. The core cycle is:
1. More data enables better risk pricing.
2. Better risk pricing means more credit (when appropriate).
3. More credit means more data.
Credit history is what drives the entire cycle of more, cheaper credit. Take away the data, and lenders are unable to leverage your past creditworthiness to provide more and cheaper credit in the future.
In the developed world, we almost take this for granted. Our credit cards, auto loans, home loans, and a variety of other credit products automatically report data to established credit bureaus. Let’s forget about the challenges with central credit bureaus and hacking for a minute, and focus on the utility of a lender being able to go to one source, get a borrower’s complete credit history, and use that information to provide appropriately-priced credit. This system enables you to be instantly approved for a new credit card, and to get a relatively low-interest rate on a home or auto loan. It’s all because there is a system that accurately reports your credit history to a new lender, who can then determine repayment risk and underwrite a new credit facility.
In much of the developing world — and for all of the 1.7 billion unbanked globally — this system of credit history is broken. As an example, Kiva has provided over $1.2 billion USD in micro-loans in 85 countries over the past 13 years. But most of the credit data from these micro-loans never made it to a credit bureau. This means that borrowers who have consistently repaid their loans to microfinance institutions for the past 5 years get no benefit for all of their historical repayments. When they come to apply for their first credit card or line of credit, the bank will start them with a much smaller limit than they might deserve — entirely because the bank cannot see their credit history.
This is a systemic problem for financial inclusion. The path to useful and affordable credit relies on generating a credit history that can enable future lenders to better predict underwriting risk. These credit histories for the unbanked exist, but are invisible to future lenders — they are distributed across MFIs, NGOs, and other ground-floor financial organizations that operate in the unbanked world.
A regional bank may want to give a loan to a local shopkeeper in a rural village, but the apparent lack of credit history will make the cost of capital prohibitively high. This excludes the shopkeeper from all the financial products and services that this regional bank offers, and provides no path to ever access them. Without access to larger, cheaper sources of capital, the shopkeeper cannot afford to lower prices on the shelf, or to provide additional community credit to long-standing customers.
We need to fix this systemic issue. We need to provide a way for all credit data — regardless of how high or low on the economic ladder it originates — to be included in someone’s credit history. We need a way for MFIs to merge their thin credit files into a single, robust, federated credit history for each borrower. This will not only allow larger financial institutions to flow capital to the unbanked, but will also enable MFIs to better price risk and allocate their existing loan portfolios. And this system must be sustainable, creating a one-way path to financial inclusion for 1.7 billion people.
How can we solve systemic financial inclusion? I’ve spent a lot of time researching this at the ground floor with Kiva. The “right” solution needs to address 4 main principles:
1. We need open-source technology, so that access is universal.
2. We need a standard data format, so that all data can be included.
3. We need an offline mode, since many of the unbanked lack reliable internet access.
4. We need to give control to the end user, as they are the only constant and they should control who can access their information.
The fourth point is incredibly important. A single user might interact with multiple MFIs, NGOs, and (someday) banks. But these organizations do not necessarily interact with each other. The only constant source of interaction is the borrower— in fact, the borrower is involved in every transaction relevant to their credit history. So, the credit system of the future is not a global credit bureau controlled by a central authority — that would require the central authority to establish a relationship with each organization. Instead, the future is a framework that enables each individual to report credit data when it is generated, have it validated by an independent network, and to reveal that data to any bureau or platform at their discretion. A truly decentralized system that puts the user at the center of their financial lives, empowering them with self-sovereign financial inclusion.
We must build tools for the challenges the unbanked face today, and provide a pathway to long-term, sustainable financial inclusion. Kiva has spent the past 13 years generating its own credit files for unbanked customers in 85 countries. If we could federate these with the thousands of other MFIs that work in the developing world, we could create robust credit profiles that enable our borrowers to achieve true financial inclusion. With this, 1.7 billion people will be given a first step towards escaping poverty, and achieving the United Nations’ Sustainable Development Goals [3].
Subscribe to ‘Tech for social impact’ or visit Kiva to learn more.
Sources:
[1] World Bank: Financial Inclusion Overview
[2] World Bank Global Findex, 2017
[3] CGAP, 2016
