Nadia is a former Africa Program Manager for the Smart Campaign
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Senior Research Manager, Financial Inclusion Insights, InterMedia

Nadia van de Walle

New data from InterMedia breaks down the impact of demonetization on financial inclusion across gender, locality, income levels, account types, and more. 

Blog Post

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Demonetization had a strongly positive effect on financial inclusion, leading to increases in account registration and active and advanced use of registered accounts, according to our data. Perhaps surprisingly, given some of the discussion in the financial inclusion community over the last year predicting demonetization increasing electronic payments, these account registration increases were mostly among bank accounts rather than mobile wallets.

InterMedia’s fourth annual Financial Inclusion Insights (FII) survey was underway on November 9, 2016 when approximately 85 percent of the banknotes in circulation in India were invalidated by the policy known as demonetization. The invalid notes had to be deposited in a bank or exchanged for new ones at banks and other financial institutions. The timing of demonetization in relation to InterMedia’s activities presented an opportunity for us to measure the impact on financial inclusion using a panel survey of 1,600 randomly selected individuals in the states of Gujarat, Madhya Pradesh, and Rajasthan. These respondents were first interviewed for the FII survey roughly one month prior to Nov. 9, and then re-interviewed seven months later.

<a href="https://centerforfinancialinclusionblog.files.wordpress.com/2017/12/figure-1.png"><img class="wp-image-24757 alignright" src="https://centerforfinancialinclusionblog.files.wordpress.com/2017/12/figure-1.png" alt="" width="617" height="391" /></a>Before demonetization, nearly half of the respondents were nonusers of financial institutions. After demonetization, only 19 percent remained nonusers (see Figure 1). These former nonusers advanced to the access and trial stage of the customer journey, which increased from 53 to 81 percent of the respondents. Nearly all of those who had accessed an account also held an account registered in their name, as the proportion of account holders rose from 51 percent to 78 percent of the panelists. Active users of financial accounts (used an account in the past 90 days) increased to 51 percent of respondents after demonetization, from 34 percent pre-demonetization. Active users who used advanced services (beyond deposit and withdrawal) grew substantially, but remained a small portion of the study group overall. Thus, after demonetization, more customers advanced to every stage of the customer journey − from access and trial of financial services, to account registration, to active use of registered accounts, to active use of advanced services − compared to pre-demonetization.

Demonetization had a strongly positive effect on increasing financial inclusion relative to previous policies. While the data collected for this study is not nationally representative and, therefore, not directly comparable to previous annual surveys of India implemented by InterMedia, the change in the proportion of study group members who became registered bank account holders after demonetization exceeds the changes observed previously. For example, the implementation of Pradhan Mantri Jan-Dhan Yojana (PMJDY) in 2014 coincided with only a <a href="http://finclusion.org/uploads/file/reports/India%20Wave%204%20Report_8-Jun-2017.pdf">34 percent increase</a> in the proportion of the population that held a registered financial account over 2013-2016, compared to a 53 percent increase after demonetization.

All demographic groups showed gains in financial inclusion after demonetization. A greater share of nearly all demographic groups advanced at all stages of the customer journey post-demonetization. The only exception to this overall finding was the lack of movement from active use to advanced active use among respondents living below the <a href="https://www.povertyindex.org/country/india">$2.50/day poverty line</a>.

Financial inclusion increased fastest among women and rural residents. A critical measure of social inclusion is whether or not achievement gaps exist between demographic groups. Prior to demonetization, gaps in advancement along the customer journey existed for women, rural dwellers, and those below the $2.50 per day poverty line. After demonetization, the demographic gaps shifted as follows:
<ul>
 	<li>Gender: Women advanced to later stages of the customer journey at rates that exceeded their male counterparts (see Figure 2). This movement reduced the gender gaps among the respondents at each stage of the journey. However, the increases were not large enough to eliminate the gap entirely at any stage; more men are still financially included than women.</li>
 	<li>Locality: Rural residents advanced to the access and registration stages of the customer journey faster than their urban counterparts, which eliminated the locality gaps at the access and registration stages. While rural respondents advanced on the journey to active use more frequently than urbanites, these gains were not sufficient to eliminate the urban vs. rural gaps at later stages of the customer journey.</li>
 	<li>Poverty status: Unlike the gaps for gender and locality, the gap between respondents living above and below the poverty line widened after demonetization at each stage of the customer journey, because the rate of advance was greater among respondents living above the poverty line than among those below the line.</li>
</ul>
[caption id="attachment_24764" align="aligncenter" width="614"]<a href="https://centerforfinancialinclusionblog.files.wordpress.com/2017/12/figure-2-asdf.png"><img class="wp-image-24764" src="https://centerforfinancialinclusionblog.files.wordpress.com/2017/12/figure-2-asdf.png" alt="" width="614" height="280" /></a> (click to enlarge)[/caption]

The requirement to exchange demonetized notes provided a strong impetus for financial engagement that overrode tendencies towards non-engagement. The forthcoming 2017 annual Financial Inclusion Insights (FII) tracking survey will provide new data to evaluate whether these phenomena also occurred at a national level and were sustained into the latter half of 2017.

Respondents most often registered new bank accounts and Post Office Bank accounts. Mobile money showed a much smaller increase in users. The increase in the number of Post Office and Bank users may or may not be a lasting change now that all demonetized notes have been exchanged. The InterMedia team plans to monitor 2018 data during its annual FII survey in order to examine whether or not accounts were closed or fell inactive to assess the resilience of this impact. The cash shortage did contribute to increased mobile money use, but not to the degree approaching the envisioned “cashless society.” More effort is required to spur mobile money adoption, particularly among less well-off consumer segments.

Consumers reported that demonetization was disruptive but necessary. In the immediate aftermath of the announcement of demonetization, the ensuing cash shortage spurred widespread reports of economic disruption, <a href="https://cfi-blog.org/2016/11/25/demonetization-in-india-is-causing-more-than-economic-harm/">political and social challenges</a>, and, for certain segments and industries (for example, trucking and logistics), <a href="http://www.dnaindia.com/india/report-demonetization-with-no-cash-on-hand-4-lakh-trucks-stranded-on-highways-2273414">complete, though temporary, paralysis</a>. The study found that while respondents confirmed that the cash shortage was indeed disruptive, it may not have been as disruptive as some news accounts suggested. Despite difficulties, a majority of respondents agreed with the government’s broadcast rationale, that demonetization was a necessary step to combat “black money.” Majorities also agreed that the effects of demonetization were more beneficial than disruptive, the demonetization policy was successfully implemented, and cash will be used less often in the future for routine purposes.

Overall, respondents perceived demonetization as a necessary and beneficial policy, despite the economic disruption it caused. These perceptions may be affected by high levels of support for Prime Minister Modi’s party, the Bharatiya Janata Party (BJP), in the three states where the panel survey was implemented. Nationally-representative statistics on demonetization will be gathered by the FII India 2017 Annual Survey.

Nearly all merchants remain cash-dependent. When asked about which groups benefited from demonetization, consumers perceived the least benefit for merchants. These perceptions were supported by data from the survey of merchants:
<ul>
 	<li>Over 90 percent of merchants only accepted cash during demonetization. Sixty-five percent of these merchants reported that their businesses suffered due to the shortage of cash.</li>
 	<li>Of the merchants who reported only accepting cash during demonetization, less than half reported that accepting cashless payments would have helped their businesses.</li>
 	<li>Merchants reported that a tiny proportion (less than 3 percent) of their customers use cashless payments, and a primary reason for not accepting cashless payments was a lack of perceived demand from customers.</li>
</ul>
Demonetization had little immediate effect on the prevalence of cashless payments. A small portion of the study group – 7 percent – adopted cashless payments to facilitate transactions during the cash shortage after demonetization. Merchants generally do not see a need to adopt electronic payment products in the face of low consumer demand. However, the few merchants who did adopt these products and services found them valuable, which indicates that barriers to uptake are not product-specific but related to limited utility in the current context of early adoption.

In conclusion, a little more than a year after the roll-out of the demonetization, the FII data shows immediate impacts from the policy on financial inclusion. We look forward to seeing what our annual 2018 demand-side survey has to say regarding the Indian population's engagement with financial services.

What do you observe and what do you think we may see in 2018?  We are eager to hear from you!

Have you read?

<a href="https://cfi-blog.org/2016/11/16/what-does-indias-demonetization-experiment-mean-for-financial-inclusion/">What Does India’s Demonetization Experiment Mean for Financial Inclusion?</a>

<a href="https://cfi-blog.org/2016/11/25/demonetization-in-india-is-causing-more-than-economic-harm/">Demonetization in India Is Causing More than Economic Harm</a>

<a href="https://cfi-blog.org/2017/01/18/what-does-effective-human-touch-look-like-in-indias-digital-age/">What Does Effective Human Touch Look Like in India’s Digital Age?</a>

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India’s Demonetization: One Year Later, What Was the Impact on Financial Inclusion?

A keynote speaker at a recent conference I attended described consumer protection as “incredibly important,” before adding that it was also “boring.”  Palpable excitement buzzes around new products or technologies, but consumer protection can be a real buzzkill. After all, it is often viewed as a dry, bureaucratic subject, costly for providers, and entailing barriers to pace of change and convenience.

As the Smart Campaign’s Africa team lead, I’m excited about client protection! And that’s not because it’s my purview. First, I think that client protection should not be seen as pumping the breaks on financial inclusion’s momentum. Rather, it guarantees a longer, more enjoyable ride. Secondly, client protection need not be a dull compliance exercise. It too can crowdsource, beta-test, gamify, and so forth to hack innovative, agile, disruptive approaches. But seriously, as an industry we can consider and engage in client protection practices that are data-driven, and that use behavioral economics, human-centered design, fintech, and other disciplines to not only ensure fair consumer treatment but strengthen financial bottom lines.

At the Smart Campaign, we see this need in <a href="https://cfi-blog.org/2016/10/25/building-trust-and-growing-digital-financial-services-a-look-at-jumo/">our work</a> concentrating on consumer protection for digital credit. Digital lending has unique characteristics that present both opportunities and risks. Digital credit can reach previously excluded borrowers, and it can make the borrowing process much quicker and easier. However, its new methods, such as loan underwriting based on proprietary algorithms, bring new risks. For example, digital financial products may pose the potential for premature client blacklisting, as high default rates on initial loans are often built into the customer acquisition process. Algorithms start by offering loans relatively indiscriminately and refining criteria as time helps identify better client profiles. If early defaulters are reported to credit bureaus, they may have a hard time qualifying for credit in the future. Or consider that digital credit has no waiting or “cooling off” periods which allow customers to re-consider their decisions to borrow, and this can be dangerous when combined with “push” marketing and unsolicited offers. We also see that proprietary algorithms have the potential to discriminate in ways that we might otherwise find unacceptable (e.g. gender, ethnicity, etc.). Finally, the expansion of digitization and data creates a plethora of risks surrounding data security and fraud. The list could go on.

With credit now literally in the palm of a customer’s hand, and immediately available, how will this change behavior? If providers are going to instill adequate client protection practices, they’re going to have to harness innovative thinking across areas like behavioral economics, human-centered design, user experience (UX), data science, and fintech. And yes, it’s the provider’s responsibility. No doubt consumer protection requires an ecosystem of actors, but it is those digital credit providers who must figure out the client protection measures that will be successful in the long run.

Using insights from behavioral economics and processes from human-centered design. Eldar Sharif, co-author of <a href="https://www.google.com/url?sa=t&amp;rct=j&amp;q=&amp;esrc=s&amp;source=web&amp;cd=1&amp;cad=rja&amp;uact=8&amp;ved=0ahUKEwifusyqz7rQAhVE7oMKHazuBckQFggeMAA&amp;url=http%3A%2F%2Fscholar.harvard.edu%2Fsendhil%2Fscarcity&amp;usg=AFQjCNGkQd3wKEm4BnzrZw4Dj9kDokWiiQ&amp;sig2=ZK-Mq0ISFOTVK3Rg1LiPyA&amp;bvm=bv.139250283,d.amc">Scarcity</a>, has become a common name in financial inclusion spheres through his applications of behavioral economics to look <a href="http://bit.ly/2dLzJRB">inside the mind of a client</a> and understand how the scarcity of mental bandwidth affects behaviors. Cognitive abilities can be weakened by stress and juggling priorities. Human-centered design is a tool that should inform the crafting of product disclosures and transparency in a digital landscape where customers are being inundated with information and credit offers.

Linking consumer protection to user experience (UX). Clients who believe their providers are enabling them to benefit from their services, and are not trying to dupe them, are more likely to be longstanding customers. For new digital credit users, especially those who were previously unbanked, comfort with digital models will depend on customer trust and confidence. <a href="https://cfi-blog.org/2016/10/18/what-is-lost-in-a-digital-financial-world-and-how-to-get-it-back/">Consumer trust</a> can be a stronger framing than client protection for practices that create customer lifetime value, build partnerships, expand new services and providers, and raise digital usage. Inadequate data security, for example, can compromise trust and buy-in from clients, not to mention partner organizations, and regulators as well.

In this increasingly competitive industry space, providers need to recognize the appeal of consumer protection. We who promote consumer protection need to leverage the language of and emphasis on innovation, incubation, and acceleration so popular in the world of investment and business development. And if helpful, these efforts should be reframed to place greater emphasis on tenets more often linked to financials, like client trust. After all, client protection in digital credit is innovative, and good business.

Have you read?

<a href="https://cfi-blog.org/2016/10/25/building-trust-and-growing-digital-financial-services-a-look-at-jumo/">Building Trust and Growing Digital Financial Services: A Look at JUMO</a>

<a href="https://cfi-blog.org/2016/11/01/the-smart-campaign-and-the-mastercard-foundation-team-up-to-tackle-the-next-wave-of-consumer-protection-challenges-in-financial-services/">The Smart Campaign and The MasterCard Foundation Foundation Team-Up to Tackle the New Wave of Consumer Protection Challenges in Financial Services</a>

<a href="https://cfi-blog.org/2016/10/06/changes-afoot-for-ugandas-tier-iv-financial-institutions/">Changes Afoot for Uganda’s Tier IV Financial Institutions</a>

How to Make Consumer Protection Sexier

Almost two years ago, the Smart Campaign surveyed financial service providers in Uganda as part of our study, <a href="http://www.smartcampaign.org/tools-a-resources/1030">What Happens to Microfinance Clients Who Default</a> (WHTCWD). In summarizing what they described, we did not mince words, reporting the environment as “Hobbesian” at the time. Providers in Uganda described default as a major issue of concern for them. Borrowers in arrears would skip town or change their name, behaviors enabled by the lack of government IDs and credit bureaus.

MFIs often adjusted for these thin credit envelopes and their high distrust of clients by meting out harsh, inflexible punishments on an immediate basis to those who missed a repayment. For instance, providers, suspecting customers of being at flight risk often seized collateral immediately after missed payments in ways that contrasted sharply with the <a href="http://smartcampaign.org/about/smart-microfinance-and-the-client-protection-principles/certification-standards">Client Protection Standards</a> and best practices <a href="http://smartcampaign.org/storage/documents/20110916_SC_Principles_Guidance_Draft_Final.pdf">guidance</a>. Some providers explained that they had to act quickly because borrowers have multiple loans and if they didn’t seize the collateral quickly, another lender would swoop in, leaving them with nothing. Unfortunately, all of this was occurring in an environment of weak due process and slow legal enforcement, and we heard about instances where lenders were paying off local law enforcement, turning to local councils to pressure defaulters, and even getting clients thrown in jail.

We observed major gaps in the consumer protection regulatory frameworks and supervisory enforcement. At the time of the WHTCWD study, the Bank of Uganda only regulated commercial banks and a few leading MFIs, and its 2011 <a href="https://www.bou.or.ug/bou/bou-downloads/Financial_Literacy/Guidelines/2011/Jun/Consumer_Protection_Guidelines_June_2011.pdf">consumer protection guidelines</a> pertained only to larger deposit-taking providers. The roughly 2,000 NGO MFIs and savings and credit cooperative organizations (<a href="http://www.ucscu.co.ug/">SACCOs</a>) were effectively unregulated and registered as Tier IV institutions, which fell under the purview of the Ministry of Trade, Industry, and Cooperatives. SACCOs, often the only option for the rural poor, particularly in the underserved north, offer loans, including emergency loans, with interest, and savings, and are often additionally capitalized by government ministries and international NGOs for purposes of channeling money to support local development such as agricultural business (e.g. <a href="http://allafrica.com/stories/200710150295.html">Prosperity for All</a> project). These types of organizations represented a large share of microfinance debt and were described in our WHTCWD interviews as among the most frequent client mistreatment offenders.

In the time since WHTCWD, the media have continued to raise sector issues, and SACCO’s <a href="http://ugandaradionetwork.com/story/saccos-fail-to-meet-requirments-to-access-government-funds?utm_content=buffer8d2a8&amp;utm_medium=social&amp;utm_source=twitter.com&amp;utm_campaign=buffer">big losses and financial management issues</a> are <a href="http://www.newvision.co.ug/new_vision/news/1434800/saccos-advised-prioritize-unity">increasingly in the news</a>. For instance, news stories over the last year drew attention to SACCOs <a href="http://allafrica.com/stories/201608220661.html">with high profile fraud</a> and major losses for members in the Rakai and Sembabule districts. State Minister for Microfinance Haruna Kasolo recently <a href="http://www.newvision.co.ug/new_vision/news/1434800/saccos-advised-prioritize-unity#sthash.HmJDZOjW.dpuf">emphasized</a> the importance of SACCOs taking responsibility and staff working together to expose fraud and hold one another accountable.

Yet, the winds of change might be blowing in Uganda. After more than a decade of work, in July 2013 new regulation was passed pertaining specifically to Tier IV non-banking and micro deposit taking institutions (MDIs) including SACCOs, NGOs, and community groups. These laws place them under the control of a new Uganda Microfinance Regulatory Authority (UMRA). UMRA will license and supervise them, but the institutions will not be permitted to collect savings (as deposit taking institutions are in Tier III). Further, we read <a href="http://www.newvision.co.ug/new_vision/news/1433560/govt-close-errant-saccos#sthash.3i2Iih7v.dpuf">statements</a> in New Vision last week indicating that the government would be taking a harder line against SACCO misbehavior. Haruna Kyeyune warned SACCOs that they would be closed down if caught cheating clients.

At the same time, the national ID card system, launched in Uganda in the spring of 2014, is now in its second year of registration and could help improve client records with positive implications for the sector.

These developments all suggest that the environment for consumer protection at the low end of the Ugandan market is improving, thanks to commendable work to put regulations and systems in place. The foundation for better consumer protection is becoming stronger. We are eager to hear from those on the ground in Uganda on the differences these developments will make over time. For instance, will national IDs and affordable credit bureau reference checks lead to reduction in the risk of client flight and better institution-client relationships? What will this mean for financial service providers and their operational costs? We have heard concerns about the challenge the government will face in regulating and supervising 2,000 or so new institutions. We’ve also heard complaints that reporting will be burdensome and that the new requirements may lead to some sector consolidation. Finally, some of our partners also expressed the sense that it would be crucial to educate clients directly as well regarding these new Tier IV regulations. After all, SACCOs’ reputation among many clients is poor and one of UMRA’s goals is to improve the sector’s credibility and trust between providers and customers. Even Kyeyune in his announcement said that it will be important to educate citizens about the new Tier IV regulation for positive impacts to be assured.

Have you read?

<a href="https://cfi-blog.org/2015/02/09/taking-it-from-the-top-how-market-infrastructure-sets-the-rhythm-of-default-management/">Taking It From the Top - How Market Infrastructure Sets the Rhythem of Default Management</a>

<a href="https://cfi-blog.org/2015/02/02/two-sides-of-a-default-coin/">Two Sides of a Default Coin</a>

<a href="https://cfi-blog.org/2014/04/11/giving-microfinance-clients-a-voice/">Giving Microfinance Clients a Voice</a>

Changes Afoot for Uganda’s Tier IV Financial Institutions

The following is part of the Smart Campaign’s #FintechProtects mini campaign. We’re raising awareness about responsible digital financial services, spotlighting work from the Smart Campaign and others, and engaging with industry actors on how fintech can move forward in a way that’s best for clients. For more information on #FintechProtects, and to get involved, <a href="https://cfi-blog.org/2016/09/14/fintechprotects-keeping-clients-first-in-digital-finance/">click here</a>.

Digital credit is growing fast in developing markets, particularly in Sub-Saharan Africa. Lenders such as <a href="http://www.safaricom.co.ke/personal/m-pesa/do-more-with-m-pesa/m-shwari">M-Shwari</a>, Jumo, M-Pawa, Eazzy Loan, Branch, EcoCashLoan, Timiza, KCG M-Pesa and others are attracting interest and investment. They are seen as having the potential to improve financial access and to make banking with poor clients more feasible and sustainable through technology that reduces underwriting and infrastructure costs. They offer small or nano loans starting as low as $5 or $10 dollars, make use of simple mobile user interfaces, and provide funds in real-time.

The Smart Campaign and others <a href="http://www.cgap.org/publications/doing-digital-finance-right">such as CGAP</a> have been carefully looking at client protection risks in the burgeoning digital credit space, particularly in relation to transparency and informed consent. Other potential consumer protection issues include the implications of data analytics rather than traditional repayment capacity analysis as a basis for underwriting, high interest rates, and lack of rigorous regulation in many markets. The Smart Campaign is conducting small research projects to identify consumer protection concerns and good practices for mitigating them. Ultimately, we would like to see standards of care developed for digital credit products.

Using the <a href="http://smartcampaign.org/about/smart-microfinance-and-the-client-protection-principles">Client Protection Principles</a> as a framework, we have identified several consumer risks where deeper research, industry discussions, and consensus-building are needed.
<ul>
 	<li>Appropriate Product Design and Delivery: “Pushy” Sales and Marketing: The sales and promotion strategies used by mobile lenders include “push” marketing methods such as bulk SMS messages. In more developed markets, our Client Voice research identified pushy unsolicited offers as a tactic that customers dislike, but more important (and especially for clients new to formal credit), unsolicited offers can lead clients to over-borrow. We wonder whether customers’ should have opt-out options to avoid such offers. The Smart Campaign is interested in working to better define “aggressive sales” and “deceptive marketing” in the context of digital credit.</li>
</ul>
<ul>
 	<li>Avoiding Over-Indebtedness: Damaging Credit Scores for Early Adopters: In the early stages of a digital credit roll-out, the lender is often still tweaking its underwriting algorithms. In the process, early adopter clients who are not good credit bets may be approved, and then punished through blacklisting with credit bureaus when they cannot repay. We see <a href="http://www.nation.co.ke/business/Pain-of-Kenyans-blacklisted-for-amounts-as-small-as-Sh100/996-3374952-k2dkdvz/">an example</a> of this in Kenya where hundreds of thousands of Kenyans have been blacklisted through the country’s credit reference bureaus for outstanding mobile loans of less than Sh200 (approximately $2). The credit bureaus charge about $20 for clients to clear their names. The Smart Campaign is interested in exploring guidelines to prevent adverse reporting to credit bureaus for clients that fail to repay due to inadequate appraisal.</li>
</ul>
<ul>
 	<li>Fair and Respectful Treatment: Big Data and Potential Discrimination: The use of big data and alternative data in credit underwriting may be <a href="http://www.nytimes.com/2015/01/19/technology/banking-start-ups-adopt-new-tools-for-lending.html">helpful</a> for increasing financial access to thin file customers, but there are also concerns about potential discrimination arising from these proprietary algorithms. Digital lenders use predictive models based on demographics, web presence, mobile activity, and other similar variables. These models often rely on automated software algorithms that are learning as they process more data. Discrimination may arise through this complex, rapidly evolving process. If a variable is predictive, the algorithm will incorporate it. This raises the possibility of discrimination based on ethnicity, religion, political affiliation, age, etc. The Smart Campaign is interested in learning more about how data analytics firms are building in protections against discrimination on such characteristics.</li>
</ul>
One broad concern cuts across all the Client Protection Principles: With digital, who is responsible for the client? The degree and direction of influence between digital lenders and their partners can create client protection gray areas. Should the digital lender be required to ensure that the mobile network operator (MNO) or other partner improves transparency, responsible pricing, or protection of client data? A particular focus area concerns who ensures fair dealing and appropriate behavior from banking agents? Who is ultimately responsible for securing and protecting against the unauthorized spread of client data? Do the service level agreements that guide roles and responsibilities in a partnership between a lender and an MNO, clarify responsibilities and requirements to ensure that end clients are treated fairly? The Smart Campaign is interested in exploring the levers that can be used in such relationships to influence adherence to consumer protection responsibilities.

Have you read?

<a href="https://cfi-blog.org/2015/02/04/keeping-score-the-client-protection-principles-vs-the-u-s-subprime-auto-loan-market/">Keeping Score: The Client Protection Principles vs. the U.S. Subprime Auto Loan Market</a>

<a href="https://cfi-blog.org/2016/05/31/smes-speak-out-on-online-lending-if-you-build-the-website-they-will-come-but-they-might-be-a-little-confused/">SMEs Speak Out on Online Lending</a>

<a href="https://cfi-blog.org/2016/09/14/fintechprotects-keeping-clients-first-in-digital-finance/">#FintechProtects: Keeping Clients First in Digital Finance</a>

Digital Credit in Africa: Are Nano Loans Safe for Consumers?

The following is part of the Smart Campaign’s #FintechProtects mini campaign. We’re raising awareness about responsible digital financial services, spotlighting work from the Smart Campaign and others, and engaging with industry actors on how fintech can move forward in a way that’s best for clients.  

Do you have a credit card you don’t know about? Last week, <a href="http://files.consumerfinance.gov/f/documents/092016_cfpb_WFBconsentorder.pdf">we learned</a> that over 5,000 employees across Wells Fargo, the United States’ biggest home lender and one of the nation’s largest banks, had opened at least two million unauthorized deposit and credit card accounts in clients’ names. In an effort to meet high sales targets and earn bonuses, bank employees transferred funds from customers’ existing authorized accounts to unapproved accounts in customers’ names. Clients had not consented and were mostly unaware of this, despite incurring late fees and other charges on these new unapproved accounts. The <a href="http://www.consumerfinance.gov/about-us/newsroom/consumer-financial-protection-bureau-fines-wells-fargo-100-million-widespread-illegal-practice-secretly-opening-unauthorized-accounts/">widespread practice</a> had somehow gone undetected for 5 years.

The U.S. Consumer Financial Protection Bureau (CFPB) and the Office of the Comptroller of the Currency announced that Wells Fargo would be <a href="http://www.usatoday.com/story/money/2016/09/08/wells-fargo-fined-185m-over-unauthorized-accounts/90003212/">fined $185 million</a> and will have to pay $5 million directly to customers who incurred costs. The bank also faces a related <a href="http://freepdfhosting.com/c7384fa6fc.pdf">Los Angeles County Superior Court lawsuit</a>. The bank has agreed to resolve the CPFB allegations but refused to admit wrong-doing. Regardless, the bank’s reputation has taken a hit. Wells Fargo will have to respond to difficult questions during next week’s September 20th Senate Banking Committee session.

How could such extensive fraud happen at a major bank with a solid reputation for customer service in a well-regulated market? We at <a href="http://www.smartcampaign.org">the Smart Campaign</a> have long cautioned about the very thing that caused this widespread breach of customer trust: inappropriate staff incentives.

The bank has historically mandated and incentivized staff to “cross-sell” existing customers for additional products and services. While many peer institutions do this today, cross-selling was a big part of Wells Fargo’s success story in becoming an industry leader. Its former CEO is <a href="https://www.google.com/webhp?sourceid=chrome-instant&amp;ion=1&amp;espv=2&amp;ie=UTF-8#q=richard%20kovacevich%20and%20cross%20selling">widely seen</a> as having invented the cross-selling strategy. Banks often see cross-selling as a way to increase profit.  After all, a client simply in need of a checking account is less appealing than that same client who also has a credit card and other products, especially products that generate regular fees.

Wells Fargo’s pursuit of cross sales led it to organize its staff incentives around targets that motivated bank employees to open new accounts in order to meet sales goals and earn bonuses. Employees who cannot make the number of expected deals were tempted to engage in aggressive sales, or even, as happened in this case, turn to fraudulent practices. At the Smart Campaign, we emphasize the importance of pay and commission structures in ensuring positive client treatment and limiting risky practices. After all, staff with adequate base pay are less likely to push bad loans on customers than those desperate for better commissions. We have focused mainly on the risk that poorly designed incentives will provoke loan officers to approve risky loans. The Wells Fargo example demonstrates that the same problem can occur in any aspect of bank operations. We recently drafted a <a href="http://www.smartcampaign.org/tools-a-resources/1096-balanced-incentive-for-frontline-staff-a-tool-for-financial-institutions">tool</a> for the providers we work with describing non-financial incentives to improve performance. It targets outcomes that relate to both portfolio growth and strong customer service. Such incentives can for instance be a <a href="http://www.smartcampaign.org/tools-a-resources/905-use-of-nonfinancial-incentives-to-manage-performance-at-bandhan">powerful long term motivator</a> for sustainable accomplishments, teamwork, and portfolio quality.

This incident spotlights the importance of effective disclosure and client engagement. While it appears that most clients were completely unaware that their names were used in unauthorized accounts, and that Wells Fargo employees effectively “leapfrogged” disclosure, there were instances after the initial account opening where clients became aware that they had a “surprise” account. Some received debit cards they did not request or paid overdraft charges and insufficient fund fees for these accounts. Would financial education, clearer explanations of fees, or knowledge of their right to efficient recourse have made a difference? Not likely. The focus here would be on how to ensure disclosure at the relevant time (i.e. upon account opening) and in ways that capture client attention.

The Wells Fargo case raises governance questions. Could the board have implemented any internal controls to detect such widespread fraud? Was the board aware of the employee culture and incentives? Has the focus on e-commerce meant a greater disconnect from end-clients? This was, after all, not an isolated incident with one ringleader but rather widespread, blatant, and pervasive, at a scale that suggests a very problematic corporate culture. Bart Naylor, a financial policy advocate for Public Citizen, <a href="https://www.washingtonpost.com/news/wonk/wp/2016/09/13/wells-fargo-fired-5300-workers-for-illegal-sales-push-executive-in-charge-retiring-with-125-million/">said</a> “There are two possibilities: Customer abuse was part of the business model, in which lots of high ranking people need to go to prison. Or the bank is too big to manage, and folks high up don’t even know that laws are being broken a few levels down." Given that thousands of employees were involved, risk management monitoring, staff training whistle blower policies, and auditing measures were clearly missing or ineffective. It is especially troubling that Wells Fargo is only now <a href="http://www.usatoday.com/story/money/business/2016/09/13/wells-fargo-eliminate-bank-sales-goals/90295538/">considering limiting bank sale goals</a> and <a href="http://www.bloomberg.com/news/articles/2016-09-13/wells-fargo-eliminates-product-sales-goals-for-retail-bankers">doing away with cross-selling</a> to rebuild consumer confidence - because these issues are not new in the industry. In fact, The Los Angeles Times first reported such fraud at Wells Fargo in 2013 and The Wall Street Journal began uncovering related trouble in 2011, <a href="http://www.newyorker.com/business/currency/the-record-fine-against-wells-fargo-points-to-the-failure-of-regulation">according to New Yorker</a> journalist Adam Davidson, and this was the same period that Wells Fargo CEO John Stumpf made $20 million and won two prestigious banking CEO of the Year awards. Comparisons to the stonewalling behavior of Volkswagen about its massive diesel engine fraud are apt here.

Ultimately, responsibility for this fiasco lies at the top, with CEOs and investors. We’d like to know to what extent Berkshire Hathaway Inc., Wells Fargo’s largest shareholder, emphasized consumer protection to the bank’s leadership. <a href="http://www.nytimes.com/2014/05/04/magazine/only-one-top-banker-jail-financial-crisis.html?_r=0">To date CEOs have not had to worry</a> about personal criminal prosecution or job-jeopardizing fines.

The fine levied in this case and the CFPB’s decision are historic. But compare the $185 million fine CFPB levied with the compensation that will follow the executive who headed the unit into retirement: <a href="http://fortune.com/2016/09/12/wells-fargo-cfpb-carrie-tolstedt/">$124 million according to Forbes</a>. The fines themselves are a small price to pay for a very large, profitable bank. The hit to the bank’s reputation will be more important. We hope consumers take action in response. At the end of the day, Wells Fargo fired 5,300 lower-level employees. Meanwhile, as Davidson <a href="http://www.newyorker.com/business/currency/the-record-fine-against-wells-fargo-points-to-the-failure-of-regulation">points out</a>, Stumpf was recently reappointed to the Federal Reserve Board’s Advisory Council, mandated to provide guidance to our nation’s leading bank regulator.

It may unfortunately come as no surprise that it is not just in the United States, a country with <a href="http://siteresources.worldbank.org/EXTFINANCIALSECTOR/Resources/Good_Practices_for_Financial_CP.pdf">relatively strong laws and regulatory practices</a>, that such bank fraud occurs. In fact, <a href="http://indianexpress.com/article/business/banking-and-finance/how-banks-cut-their-zero-balance-jan-dhan-accounts-one-rupee-trick-3028190/">as highlighted by a recent case</a> in India where bank officials, under pressure to improve zero balance account numbers, were dressing data by themselves making one rupee deposits to client accounts, low-income clients are particularly vulnerable in developing markets with weaker regulatory environments. In an effort to protect all customers, the Smart Campaign continues to advocate for standards of consumer care, provide tools and incentives to financial service providers, and give low income clients a voice. Our goal is to integrate client protection practices into the institutional culture and operations of financial institutions all over the world.

Have you read?

<a href="https://cfi-blog.org/2015/02/04/keeping-score-the-client-protection-principles-vs-the-u-s-subprime-auto-loan-market/">Keeping Score: The Client Protection Principles vs. the U.S. Subprime Auto Loan Market</a>

<a href="https://cfi-blog.org/2016/05/31/smes-speak-out-on-online-lending-if-you-build-the-website-they-will-come-but-they-might-be-a-little-confused/">SMEs Speak Out on Online Lending</a>

<a href="https://cfi-blog.org/2016/05/12/the-lending-club-scandal-and-what-it-means-for-marketplace-lending/">The Lending Club Scandal and What It Means for Marketplace Lending</a>

Why the Fraud at Wells Fargo Is a Big Deal

<h4>"If you build the website, they will come – but they might be a little confused"</h4>
As my Accion <a href="http://blogs.accion.org/features/small-business-week-economic-growth/">colleague Lauren reminds us</a>, and as many politicians (whether New York hotel magnates or northeastern socialists) often emphasize, small and medium-sized businesses (SMEs) help ensure economic growth and spur job creation.  The <a href="http://www.forbes.com/forbes/welcome/#185355cd2c0b">challenges they face accessing credit</a> are an element of the U.S.’s financial inclusion story and important to anyone who cares about innovation, economic growth, equality, and employment.  When given the chance to express preferences and discuss their perceptions of the lending landscape, small businesses say that online lending improves their access to credit, as in <a href="https://www.newyorkfed.org/medialibrary/media/smallbusiness/2015/Report-SBCS-2015.pdf">this recent study by the Federal Reserve</a>.  But they also say that in order to enable small business owners to continue to grow their businesses and operate sustainably, these evolving online models must pay better attention to user preferences and actively embrace consumer protection standards such as transparency.  As one car dealership owner <a href="https://www.clevelandfed.org/newsroom and events/publications/special reports/sr 20150825 alternative lending through the eyes of mom and pop small business owners.aspx">noted in the Fed’s focus groups</a>, online lenders present their loans “in the most confusing way possible.” The websites are full of bright colors and testimonials from nice people, the owner added, but they don’t give applicants all the information they need.

There is no doubt that the rapid growth of online lending reflects its ability to address the huge credit gap for small and medium-sized enterprises.  Recent <a href="http://www.newyorkfed.org/smallbusiness/joint-small-business-credit-survey-2014.html">Federal Reserve data shows</a> that even as the economy continues to grow, small businesses in the United States struggle to find lenders. In fact, just over half of small businesses are denied a loan when they apply to banks, and microbusinesses and startups struggle the most.  As Ty Kiisel of Forbes notes, “In an absolute sense small business loans on the balance sheets of banks are down about 20 percent since the financial crisis, while loans to larger businesses have risen by about 4 percent over the same period.”  Even the companies that did receive funding noted that they received less than half of their requested.

SMEs struggle because they are viewed as riskier and less predictable that mainstream businesses.  They have higher failure rates, less cash flow, a hard time finding and retaining qualified staff, fewer assets for collateral, are sensitive to economic and personal swings, and are not required to report as much information.  Limited public information can make it difficult to assess their credit worthiness and check for red flags. Even growth stage firms reported that the main reason for not receiving a loan was insufficient credit history or collateral.  SME heterogeneity also makes it difficult for lenders to develop standards for evaluating repayment capacity and harder to standardize or bundle products.  After all, how easy is it to compare a dog walker and a phone app or a nail salon and a microbrewery?

The struggle to raise capital can cause clients to take risks with their personal finances in order to meet operating expenses or expand the business. In the recent Federal Reserve study, 63 percent of respondents reported holding debt in small amounts secured with personal assets and one in five growing firms used personal finances to finance their business.

Interestingly, as confirmed in the Federal Reserve’s research, a small but growing number of small businesses unable to obtain adequate traditional bank financing are turning to online lenders.  New entrants such as peer-to-peer platforms, cultivators of non-traditional data for loan decision making, or lender-agnostic marketplaces (e.g. Biz2Credit) are shaking up markets, and larger banks and their clients are paying attention. These new firms use advances in technology to achieve a competitive edge in terms of access (it is quick and easy to apply online wherever you are and whenever you want), fast turnaround (timing improves when your application goes through an algorithm), and data proxies to improve credit scoring for thin envelop clients (no more finding all your old tax returns).  While the majority of larger businesses still seek traditional loans or lines of credit from banks, it is telling that, given the short period of time that they’ve existed, almost a third of microbusinesses and small firms now apply to online lenders.

However this migration to online lenders doesn’t necessarily reflect satisfaction. The Federal Reserve’s study found that while small businesses like the simplicity of the online application process, they struggle with these providers. Seventy-five percent of businesses approved for a traditional bank loan report satisfaction, but only 15 percent of those using an online lending platform do.  Complaints include lack of transparency, unfavorable repayment terms, and high interest rates.  In <a href="https://www.clevelandfed.org/newsroom%20and%20events/publications/special%20reports/sr%2020150825%20alternative%20lending%20through%20the%20eyes%20of%20mom%20and%20pop%20small%20business%20owners.aspx">recent focus groups</a> convened by the Federal Reserve Bank of Cleveland and the Federal Reserve Board small business owners commented on how modern, visually pleasing websites containing what initially appeared to be clear terms actually hid the real, often high, cost of doing business, with hidden late fees and repayment penalties, poor communication on features and costs, and lenders demanding a cut of daily sales until repayment. They also voiced data privacy concerns and confusion over the actual loan amount. Meanwhile, regulators and others have noted that while in theory, expanding credit access is a good thing, it should not mean lowering underwriting criteria or accepting proxy data points.  After all, not all small businesses SHOULD get loans, and these critics are not convinced that these lenders harnessing fintech are effectively improving the imperfect science of defining which businesses are credit worthy.

Of course, traditional banks are still absolutely seen as important for SMEs.  The same Federal Reserve study found that, along with being a potential source of financing, small businesses go to bankers or lenders for advice (almost 75 percent of them) and the majority of those that borrow from banks report high satisfaction.  While banks can reassure themselves that they have satisfied clients, it is likely that the new players will challenge traditional banks to make changes and seek to build out their own similar services in the space.

How should regulators respond? Regulations have to balance quality of services with access to services and accommodation for innovation. For instance, <a href="http://www.hbs.edu/faculty/Publication%20Files/15-004_09b1bf8b-eb2a-4e63-9c4e-0374f770856f.pdf">some reports</a> note that regulation related to the capital levels banks are required to maintain has deterred banks from underwriting SME loans.  Similarly, community banks, often the likely option for a local small business, say they are burdened by staff time focused on compliance and oversight enforcement, which has hurt their return on assets.

At the same time, small business loans are not covered under consumer protection legislation or the Consumer Financial Protection Bureau. In that circumstance, as the Smart Campaign often asks, what about self-regulation and consumer advocacy?  A number of socially-motivated alternative lenders – including the Accion U.S. Network – have joined together to promote the <a href="http://us.accion.org/borrowers-rights">Borrowers Bill of Rights</a>, a set of principles for responsible small business lending that closely mirror the <a href="http://www.smartcampaign.org/about/smart-microfinance-and-the-client-protection-principles">Client Protection Principles</a> promoted by the Smart Campaign.  As the Borrowers Bill of Rights gains traction, perhaps it will begin to influence online lenders.

We look forward to hearing your thoughts.  Over all, as we saw in our own <a href="http://smartcampaign.org/tools-a-resources/1075">Client Voice study</a>, efforts like those from the Federal Reserve and others that allow small businesses to voice their views in their own words can reveal the full picture of the impact of financial services.  Perhaps, in our upcoming presidential debates, we will be surprised to see server discussions turn from Benghazi to online lending risks?  Ok, that’s unlikely….

&nbsp;

Have you read?

<a href="https://cfi-blog.org/2016/03/30/interest-rate-caps-in-nigeria-may-not-be-good-for-clients/">Interest Rate Caps in Nigeria May Not Be Good for Clients</a>

<a href="https://cfi-blog.org/2016/03/17/do-lenders-make-clear-the-risks-of-microfinance-loans/">Do Lenders Make Clear the Risks of Microfinance Loans?</a>

<a href="https://cfi-blog.org/2016/05/09/what-will-become-of-bank-branches-and-other-unexpected-fallout-from-digital-finance/">What Will Become of Bank Branches? And Other Unexpected Fallout from Digital Finance</a>

Nadia van de Walle

Latest by Nadia van de Walle

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