A decade ago, digital credit models that catered to low-income consumers were relatively unknown and untested. A lot has changed since then. Data from the Cambridge Center for Alternative Finance shows that between 2011 and 2021, the number of digital lenders — including those catering to low-income consumers — has grown nearly ten-fold globally. Economies in Africa and Asia have significantly driven this growth within the emerging market context. This rapid growth has been accompanied by a rise in consumer protection challenges, which have been studied and reported extensively in the East African context.
Catalytic capital — debt, equity, guarantee, or other instruments that assume disproportionate risk to return — is often seen as an important signaling device to attract further, timely investment in the target. As such, it can facilitate innovation and help organizations and companies build a track record in underserved markets.
Catalytic capital has spurred rapid growth in digital credit, but at the same time, digital credit has created significant concerns over consumer protection.
However, the role of catalytic capital in influencing market-level incentives for digital credit has been less studied. In multiple markets, catalytic capital has spurred rapid growth in digital credit, resulting in an influx of investment. At the same time, digital credit has created significant concerns over consumer protection, and the supervisory capacity of local regulators has failed to keep pace with the risks emerging from the rapid growth of digital credit.
In our research, we focus on the role of catalytic capital in shaping market incentives as they attract capital to digital credit models. We conclude that the role played by catalytic capital differs depending on the stage of market development. At an early stage, catalytic capital investments can help prove business models, expand services to newer consumer segments, and/or attract capital to underserved geographies. As the supply of capital increases, markets shift to a growth stage. Catalytic capital investors, who are more impact-oriented, need to shift their roles as markets grow to one that addresses consumer risks that accompany an increased supply of capital.
A helpful case study: Kenya — the birthplace of digital credit
Our research traces the role played by catalytic capital investments, mapping consumer risks that evolved to missed signals that catalytic capital investors could have used to build guardrails. We hope other markets on a similar growth path as Kenya can use this guidance.
Consumer risks rising from digital credit can be influenced through investor incentives, and they fall into three broad categories:
High interest rates, indebtedness, and default risks
Financial service providers often cite the high cost of funds in emerging markets as the underlying driver for high interest rates. Catalytic capital investors can play a crucial role in reducing the cost of funds by deepening domestic capital markets. As one positive example, Lendable and other funders, including FSD Africa, set up a fund offering a first-loss default guarantee. This structure mobilizes domestic debt investors, increases transparency, and reduces the cost of funds for end borrowers as the supply of on-lending funds in emerging markets becomes less constrained.
Aggressive sales practices, exploitative terms and conditions, and deceptive fees
As investments in digital credit models rise, there is a need to establish responsible market practices. Catalytic capital providers can play a role in working with industry associations and regulators to establish responsible market practices, and advocacy is one of the most powerful tools they can use. For example, community Investment Management (CIM) is an institutional impact manager that began operations in mature markets and is now expanding to emerging markets. CIM co-founded the Small Business Borrowers’ Bill of Rights, identifying six fundamental financing rights of all businesses. The Small Business Borrowers’ Bill of Rights has now been adopted by the Responsible Business Lending Coalition, a network of for-profit and non-profit lenders, brokers, and small business advocates.
Data privacy issues
With the emergence of technology-driven business models, using data to innovate is a crucial part of the DNA of digital financial services. Catalytic capital providers have a role in ensuring that companies respect data privacy without constraining innovation.
Complementing catalytic capital investments for responsible market development
While catalytic capital is crucial for innovations and expanding access, not everything is attributable to catalytic capital investors. While catalytic capital may enable market development, as the case of digital credit demonstrates, responsible market development does not automatically follow. Several other factors must be supported to complement investor incentives for responsible market development. Responsible market development needs investments beyond the firm level to enable market information, consumer awareness and capability, regulatory and supervisory capacity, and various other measures that can serve as checks and balances on firm behavior.
While investors can conduct firm-level due diligence to ensure client protection principles are respected, two of the three legs of the consumer protection stool require grant funding: regulation/supervision and building consumer awareness. Market actors need access to timely information and market research that informs them about potential market risks and which consumer segments might be particularly vulnerable. In addition, market conduct supervision that facilitates consumer protection needs investment that allows actors to test and invest in new tools that can capture consumer risks as they evolve. Therefore, traditional grant funding is needed to support responsible market development along with catalytic capital investments.
As a complement to catalytic capital investments, our research highlights six key lessons that can help support responsible market development:
1. Recognize market growth indicators.
This requires infrastructure investments that can contribute to responsible market development. Catalytic capital investors face four strategic decisions that will shift their role as the market develops: when to exit an investment, who would replace them, how will the investee company continue responsible behavior post-exit, and how to balance financial and social returns at the time of exit. Answers to these questions require agreement on a common set of indicators for market growth.
2. Support initiatives that can help source market-level data.
Surveys that provide information on trends in funding and areas of concentration are crucial to support funding decisions for underserved areas. We need investments in sector-level evidence gap maps and systematic data on the volume of investments made in digital credit by funders and instruments.
3. Design Digital Public Infrastructure (DPI) that respects users’ privacy and security.
This will have a cascading effect on newer business models because those using digital rails tend to build on existing infrastructure. Responsible market development can result from investing in the inclusive design of public infrastructure, respecting users’ privacy and security, and supporting regulations that ensure accountability.
4. Invest in industry associations and networks to complement regulatory capacity.
Industry associations and networks can play the role of effective shadow regulators, often with the ability to monitor and identify emerging risks with market development. However, building this ecosystem requires investments beyond catalytic capital.
5. Build regulatory/supervisory capacity.
Expanding new models requires testing tools that can detect new risks and initiatives that can bring together regulators to learn from “sister” networks in other markets. These initiatives can help augment the capabilities of market conduct supervisors but require traditional grant funding.
6. Invest in mechanisms enabling consumer awareness.
Consumer awareness is crucial to reinforce consumer protection, but extant investment instruments may lack the incentives to support such initiatives.