Diversifying Digital Financial Services: A Way to Tackle Defaults and Over-Indebtedness

Consumer protection practices are needed to stave off cases of abuse and defaults in digital credit, but there’s another way to help: quickly spreading more valuable and diverse digital financial services (DFS).

Discussions about digital credit default rates have critiqued the “how” it gets delivered, but an alternative view is to blame “what” is being offered and conclude that more diverse and useful DFS are needed sooner. The digital credit so far in the form of the uniform, very small amount nanoloans aren’t delivering a strong enough value proposition in meeting specific needs to rank them high in a person’s order of expenses to cover and debts to repay.

How do we know that improving value propositions of DFS hold promise as a solution to defaults? Looking to two markets whose mobile money ecosystems have had more time to develop credit products can provide clues.

In this post, I’ll compare digital credit in Kenya and Tanzania. CGAP’s research reveals Tanzania’s default rate is 31 percent, almost 3 times higher than Kenya’s. Why do these neighbors have such drastically different default rates? Apart from other distinctions, two differences embedded in the research are:

  • Kenya has diversified the range and number of products on the market.
  • Tanzanians consistently preferred to use informal sources rather than digital credit.

Compare the data from the graphs below, from “A Digital Credit Revolution: Insights from Borrowers in Kenya and Tanzania,” a CGAP/FSD working paper published October 2018.

Those without steady income need to weave together a diversified portfolio of sources that they can tap when expenses exceed cash on hand. Much of these resources are garnered through informal means. People in poverty pay their expenses and debts based on what’s most crucial for survival at the time.

Evidence points to digital credit not being taken up by the most vulnerable nor being the most important within users’ financial portfolio, suggesting it “is not meeting their needs.” Survey respondents in Tanzania consistently ranked informal sources as more important for different purposes, and so repaying digital lenders becomes relatively less important. In contrast, for some purposes, Kenyans rank digital credit over informal sources.

That defaults and late payments are persistently high in both countries may just indicate that the small loans with limited features aren’t yet helpful enough to address users’ biggest pain points. Borrowers are not terribly worried if they lose access. FSD Kenya director, David Ferrand, called on similar logic to explain why widespread access to formal accounts doesn’t necessarily equate to financial health, according the FinAccess 2019 survey. “Financial services are just not very relevant to the needs of many – and especially poorer households. They simply don’t actually provide improvements on existing informal solutions,” Ferrand notes.

The inverse demonstrates the same principle as some attribute microfinance institutions (MFIs) high repayment rates to their reliability as a source of liquidity that is too valuable to jeopardize in a life of uncertain cash flows (beyond just due to the group guarantee screening or peer pressure).

A Solution: Greater Value Propositions Through a More Diverse Range of DFS

Customers will prioritize repayments to the degree providers create greater value propositions through a more diverse range of DFS that better meet complex needs. Here are the “what” DFS needs to become that many have proposed but have yet to be put into practice across markets.

  1. Focus DFS to better match the cash flow demands of distinct problems people face daily related to their nutrition, agribusiness, healthcare, school fees, etc.
  2. Shift the paradigm to creating comprehensive solutions that demonstrably fix practical problems instead of product-centric pushes.
  3. Embed DFS at points of service/purchase through partnerships with providers in different sectors/industries.
  4. Blend credit with savings and insurance to more flexibly address different cash flow needs (and for lower costs).
  5. Use digitized data to better segment customers and automate tailoring of DFS to meet individual needs.
  6. Tackle what Mas and Murthy aimed to simultaneously solve for in the triangle concerns of: “Where does my next dollar comes from?”, “How can I keep on…?”, and “What if…?” by managing tensions — like discipline vs. flexibility or surprise vs. certainty — through coping strategies likes like income shaping, liquidity farming and animating money.

Experimenting with Value Add that Integrates Informal Mechanisms

Defaults to formal institutions are only one side of the Rubik’s Cube of over-indebtedness and personal financial management. Far more of the financial flows of people at the base of the pyramid (BoP) are happening through informal mechanisms. It’s hard for any outsider to judge overall indebtedness without a way to see a balance sheet that accurately reflects assets and liabilities, including informal savings and lending, and the social capital and obligations upon which life runs.

Fintechs need to experiment with facilitating existing mental models and adding value to informal behaviors like local merchant’s shop credit, family P2P lending, community saving for weddings or funerals, ROSCAs, VSLAs, savings collectors/money guards, or agricultural middlemen. With these informal instruments combined with the income side from efforts to digitize payments through manufacturing supply chains or agribusiness value chains, there comes the possibility to see the comprehensive, complex financial trade offs that an impoverished individual juggles in her head every hour.

Diverse DFS could find novel, more valuable ways to intermediate informal cash flows. With more of these solutions digitizing daily transactions we gain financial diaries-type insights en masse, seeing indebtedness more clearly than credit bureaus. This information is based on immediate customer circumstances and can provide a more detailed reflection of current financial needs to customers, so they can optimize their own financial health. The same information can be used to create tailored solutions that meet individual needs or supportive behavioral nudges.

With this diversification of offerings providers present a greater value proposition and support previously invisible informal activities, and people will find resulting services too valuable to miss repayments.

Navigating a Market Learning Curve

Going through a process of market forces to design and price useful DFS solutions that the market will bear and business model experimentation will take iterations much like AI credit scoring algorithms. Reports on defaults don’t need to be seen merely as bad news, but also as feedback loops growing collective intelligence about what tools the bottom of the pyramid prioritize and which are yielding gains that outweigh their costs.

Because all this diversification to create greater value propositions and digitize informal transactions requires experimentation for everyone, credit bureaus should institute safety nets to prevent poor people from bearing the burden of a market’s collective learning curve.

One way to reduce the burden of adverse credit reporting is to make exempt from default reporting small-amount loans, first-time loans, or — as Ignacio Mas has suggested to me in a personal correspondence — high APR loans. Another option would be that after a country goes through the digital finance learning curve and the market has matured, the credit bureaus could hit a one-time reset that universally wipes the slate clean for defaulters. Such moves would not be about rewarding irresponsibility, as much as acknowledging we all collectively paid for the market data gathering process to figure out reasonable pricing for a diverse basket of DFS tools.

More than a decade after the launch of M-Pesa, most markets’ learning curves have barely begun. Only a handful of countries offer multiple mobile credit, savings, and insurance products. Not yet scratching the surface of addressing people’s daily dilemmas, slowing down threatens to prolong the disappointment of failing to discover what really tailors to BoP cash flow needs. Instead we need to push beyond cookie-cutter digital credit to more and faster iterations of DFS diversification that should also boost current mobile money 90-day active usage rates of only 34.5 percent.

While continuing to improve consumer protection practices promoted by efforts such as the Responsible Finance Forum, the Smart Campaign, GSMA’s Code of Conduct, or CGAP’s Consumer Protection in Digital Credit, let’s protect clients from the harms they’re enduring without financial intermediation by driving toward delivering greater value. This can help customers see repayment in formal finance as essential so that digital integration of informal transactions better avoids over-indebtedness.

How can your institution contribute to the experiments it will take for your market to learn how to deepen DFS value propositions to solve for BoP cash flow volatility and practical problems?

For more ideas, links to research, and other intertwined issues, read part two on LinkedIn.

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