Despite the rise in mobile money in Africa, and globally, the gap between supply and demand for credit in the region remains. Surprisingly, in this milieu, start-ups are at risk of accelerating the pace of over-indebtedness in Africa. The number of start-ups reaching last mile clients is rising. The driver of this is fintechs taking advantage of a business opportunity, and the prospect that if you offer clients much-needed credit at a lower cost than the alternative, they will be better off.
But is this necessarily true? Are these start-ups offering solutions to the credit needs that many small and medium African businesses have, and are clients better off with these solutions? Or is the fintech digital credit hype attracting lenders that offer credit in the wrong places – and for the wrong reasons? What is needed to ensure that digital credit is provided responsibly, for the benefit of clients?
Start-ups are at risk of accelerating over-indebtedness by supplying credit to clients without conducting appropriate repayment capacity analysis.
Some estimate that digital technologies have cut the cost of providing financial services by 80-90 percent (McKinsey Global Institute, 2016, PDF). Africa is taking the lead in the rise of mobile technology, and the opportunities are promising. Start-ups in this space are making big strides. Those involved in digital credit either deliver digital credit directly or enable its delivery through downstream product servicing. The number of fintechs – startups offering these services – in Africa is growing daily (Mesropyan, 2016).
Technology well used offers opportunities not previously available. However, two key issues need to be recognized and addressed in order to generate long-term benefits for both clients and providers.
- Provider and client interests must be aligned. If providers profit while clients are experiencing stress in repaying, defaults will catch up with the client or the institution, and the client will no longer be able to borrow. Aligning interests requires providers to think of client benefits as well as their own, from the start.
- A well-designed loan should match the ability to repay. Well-designed loans are a blessing, for example, helping a small business; yet loans that do not consider clients’ capacity to repay sets them up for failure. Even if they repay in the short term – which is often why default rates stay low – it can be at the cost of extreme hardship, making it a poor predictor of over-indebtedness. It may take some time before the debt stress of clients affects providers.
“Instant”: an Opportunity and a Risk for Consumers
A key attribute digital lenders advertise is speed of access. Where traditional loans could take weeks for approval, with many requirements, this is a plus from the perspective of clients. But the automation and speed raises concerns: are decisions made too quickly, and are risks adequately measured and mitigated, especially from the clients’ perspective?
Other aspects of digital credit lead to new risks compared with analog lending: start-to-finish digitization; the move from high to low touch processes; small credit amounts that grow; short-term loans; reliance on alternative data analytics; and decentralized support workforces.
What Could Go Wrong?
With analog credit, prevention of over-indebtedness centered on adequate repayment capacity, and on growth not taking place at the expense of quality.
In the digital context, the following major categories of risk have been identified (Center for Financial Inclusion, 2017/2018. See References):
- Limited – if any – debt capacity analysis
- Products that do not match client needs
- Lack of credit reporting
- Automatic renewals
- Aggressive sales and marketing
- Disproportionate consequences of late payments that lead to a cycle of debt.
Algorithms are institution centric, not client centric. Over-indebtedness is not only reflected in default, it is first reflected by the extent of the sacrifices that the client endures to avoid defaulting.
Alternative credit scoring methods – often using elaborate algorithms that predict the probability of repayment – help to include people who have thin credit files and who would otherwise have been excluded. However, these models are a poor replacement for the repayment capacity analysis previously conducted by lenders serving vulnerable excluded populations. While the algorithm may predict whether or not an institution will be repaid, it does not consider clients’ situations and needs, and therefore, the sacrifices that clients might have to make in order to repay. Over-indebtedness is not only reflected in default, it is first reflected by the extent of the sacrifices that the client endures to avoid defaulting. Algorithms are institution centric, not client centric. They are meant to learn over time, becoming refined and better predictors; yet they do so at the expense of early clients who enabled the algorithm to become better fine-tuned, as they have a higher probability of defaulting and suffer dire consequences (Ngigi, 2016).
The promise of well-tuned algorithms saving costs and managing institutional risk is unfortunately skewing attention away from client risks. Over-indebtedness needs to be reframed from a client perspective: can clients afford the loan? Even if they can repay, what sacrifices are they making? Are they at risk of not being a client ever again in the future (which would hurt both the client and the provider)?
Mitigating Over-Indebtedness in a Digital World
Over-indebtedness is a multi-stakeholder issue, and is linked to the client protection issues summarized in the Client Protection Principles. Prevention of over-indebtedness is a particularly tricky one, in that it requires the concerted effort of a wide range of stakeholders.
Providers have a responsibility to ensure that their practices do not lead to an oversupply of credit to clients who are unable to meet their payment obligations, and digital lenders will need to adopt a more client-centric approach to understand the risks of over-indebtedness from a client perspective. Algorithms need to evolve to take this into account.
Digital lenders need to understand the risks of over-indebtedness from a client perspective, and algorithms need to evolve to take this into account. Regulation also must guide good practice for fintech digital lenders.
Because only one irresponsible lender is needed in terms of over-indebtedness to negatively affect clients, it is necessary that financial consumer protection regulation evolves to guide the practices of otherwise unscrupulous digital lenders.
Investors can, and should, use their leverage to encourage good practices by digital lenders, as they have for analog lenders. They can reward digital lenders who design and deliver appropriate products, are transparent about terms and conditions, explain to clients the risks of over-indebtedness, adopt fair and responsible practices during repayments, and help clients who cannot, but want to, repay.
Importantly, digital providers can leverage the same technology used to deliver products to educate and empower clients. Clients have rights and responsibilities. Informed consumers are better able to protect themselves and avoid becoming victims of predatory lenders.
Over-Indebtedness Is Multidimensional and Dynamic
In the interest of long-term mutual benefits for both providers and clients, providers need to move away from a uni-dimensional definition of over-indebtedness that overly emphasizes repayment as the proxy for whether or not a client is indebted, towards client-focused definitions of over-indebtedness.
Digital credit providers need to complement credit bureau data with disbursement and repayment data on digital loans so that a fuller financial picture can emerge for digital borrowers.
Over-indebtedness is not a steady state. As the lives of vulnerable clients evolve, so do their needs and challenges. A client who may have received a loan from a responsible lender in the past may suddenly not be in a position to repay. We need to develop ways to monitor whether clients are showing signs of financial stress. Responsible institutions should be able to identify this, and work with clients until it is resolved.
The role of responsible providers goes beyond providing loans to ensuring that clients are supported, if needed. Microfinance Opportunities, in collaboration with Social Performance Solutions, has been developing a stress assessment tool that enables providers to monitor whether borrowers are incurring stress after having received a loan. Such tools are extremely important to have a full picture of over-indebtedness, and a broader suite of tools needs to be available to responsible providers.
Fintech Protects Against Over-Indebtedness
Fintech digital credit providers need to unite and agree to collective measures to tackle the problem of over-indebtedness. This will entail defining responsible digital underwriting, leveraging technology, while learning from the past, expanding credit bureau reporting, and agreeing on common practices for the benefit of clients. Some fintechs are already taking the lead, and through the Smart Campaign’s Fintech Protects Community of Practice, they are working together to define and implement responsible practice. The body of evidence around risks is growing. Now is the time to define the guidelines of good practice for fintech digital lenders and identify solutions that work for clients.
McKinsey Global Institute, “Digital Finance for All: Powering Inclusive Growth in Emerging Economies,” September 2016.
Elena Mesropyan, “63 Companies Shaping Africa’s FinTech Ecosystem,” Fintech Ranking, December 2016.
Alexandra Rizzi, Isabelle Barrès, Elisabeth Rhyne, “Tiny Loans, Big Questions,” Center for Financial Inclusion at Accion.
John Owens, “Responsible Digital Credit,” Center for Financial Inclusion at Accion. Forthcoming, 2018.
George Ngigi, “Pain of Kenyans Blacklisted for Amounts as Small Sh100,” Business Daily Africa, September 2016.