NB Financial Health
Can Digital Credit Outperform Microcredit in the Developing World?
For decades, microfinance was hailed as the solution to the financial constraints faced by poor households and entrepreneurs in developing countries. Optimism was perhaps at its greatest when Grameen Bank and its founder Muhammad Yunus jointly won the Nobel Peace Prize in 2006.
Yet recent evidence – including seven randomized evaluations – suggests that providing small loans through microfinance institutions (MFIs) has not been the silver bullet it was once hailed to be. Despite its resounding success bringing large numbers of individuals into the formal financial sector, traditional microcredit has failed at delivering credit to poor people in a way that is convenient, affordable and sustainable.
Can Digital Credit Do Better?
While 2 billion adults still lack access to formal banking institutions, mobile phones have become ubiquitous in most developing countries. In this context, digital credit – typically in the form of short-term, mobile phone-based loans – has the ability to scale far beyond traditional credit channels.
According to CGAP, digital credit products are distinct in that they are instant, automated and remote. Now, at the click of a button on her mobile phone, a small business owner in rural Malawi can receive funds with no paperwork to fill out, no in-person interview with an MFI agent, no formal borrowing history and virtually zero processing or wait time.
Progress is happening quickly. Within two years of its launch in November 2012, M-Shwari (the Kenyan savings and loan product linked to a user’s M-PESA mobile money account) made over 20 million loans, totaling over $277 million. A wave of digital credit products in Kenya and other countries now caters to the market of financially underserved individuals.
One notable innovation is the ability of providers to assess credit risk without conducting extensive, in-person interviews with borrowers. Currently, there is a race among digital credit providers (and credit scoring agencies) to develop algorithms that assess a borrower’s ability to repay using nontraditional data sources. For example, loans are now being made based on behavioral clues found in call detail records, airtime credit records, phone usage data (including battery use), social media data, web browsing data, GPS coordinates and personal contact lists, among other sources.
While digital credit holds the promise to transform lives by helping underbanked individuals access the capital they need to deal with financial emergencies or grow their incomes without having to travel long distances, pay exorbitant fees, or have a formal borrowing history, it would be foolish to overlook the risks.
Our Malawian entrepreneur, while she may be able to make the payment on her upcoming inventory delivery, may not be fully aware of the interest rate (or “facilitation fee”) she now has to pay. That interest rate is likely unregulated (or under-regulated). While the algorithm used to assess her ability to repay may have gotten her a loan that she couldn’t get from a bank or MFI, it’s possible that it overestimated her ability to repay, or that she managed to “game the system” and borrowed more money than she should have, causing her to spiral into deeper debt. If she defaults, she could be placed on a blacklist that would prevent her from obtaining any type of digital loan in the future, effectively excluding her from the formal financial market.
So, What Can We Do?
The Digital Credit Observatory (DCO) was set up with the express purpose of putting this new (and little-understood) digital credit phenomenon under the microscope. Managed by the Center for Effective Global Action (CEGA) and funded by the Bill & Melinda Gates Foundation, the DCO will generate a coordinated portfolio of randomized evaluations, along with a handful of pilot studies, that will shed light on the important questions of whether and how digital credit is alleviating – or entrenching – poverty in emerging markets. It will further examine the extent to which digital credit algorithms and other consumer protection measures can minimize risk to consumers and providers.
In May 2017, the DCO hosted a matchmaking workshop in San Francisco that brought together researchers, digital credit providers and thought partners from around the globe to discuss existing knowledge gaps and open research questions. The event provided a rare opportunity for researchers and private sector partners to learn from one another and consider issues of consumer protection and product design from both an academic and private sector perspective. Over the coming years, the DCO will harmonize the key lessons and conclusions from funded research to help guide decision-making about digital credit.
While academic research can be expensive and take time, there is a clear need for answers about which types of digital credit products and consumer protection mechanisms work for poor people, and which do not.
The international development community stands to learn a lot from the experience of microfinance, as it stands to learn from these early experiences with digital credit. We should utilize cautious optimism and rigorously investigate the impacts of digital credit on welfare and consumer protection before it’s too late.