Wednesday, May 20, 2015

Financial Inclusion – Selling cars on an island without roads

Financial inclusion is the delivery of financial services to all the people in a fair, transparent, and equitable manner at affordable cost.”
Indian Banks’ Association

Let me try another definition: Financial inclusion is like selling cars and accessories to poor people in cities without roads. The strategy seems compelling to carmakers looking for new customers. But will the idea fly? Can your new customers pay for your cars? Will they like your cars without the possibility to drive them?

My definition shows why financial inclusion is interesting for banks today: Not only is the financial sector shrinking and desperately needing new markets. Banks also need a new image too and this is where helping the poor can be of utmost importance. To revert to my example: People will like you if you provide them with cars.

But my definition also shows where the impediments to financial inclusion lie. You need the infrastructure for people to use your car; otherwise, it will be useless for your client.

Technology – A prerequisite for financial inclusion

Without a payment system, one cannot use money. Traditionally, building a payment system was expensive – too expensive to serve poor customers who cannot pay for such an infrastructure. This is where new technology comes into play. A typical set up could look like that:

  • You hold an account with a bank or a mobile phone / internet provider that you can credit by depositing cash with retail agents. E-money in such account is outside the official banking system. Therefore, it is usually not considered as a deposit, covered by any deposit insurance.
  • Through a POT (= point of transactions) device or your mobile phone (sms, application, etc.) you advise the bank or provider to transfer some money to another person, also holding an account with that firm.

Such system might not necessarily be constantly connected to the core banking system. In other words, transactions could be registered only in specific intervals (for example on a daily basis).

However, financial inclusion technology should go beyond just enabling transactions. As the Indian Banks’ Association suggests, it should “capture more insightful and rich customer information”. Big data is the buzzword here.

Technology should also be interoperable. Basically, you must be able to reach the person you want to pay through the system. Otherwise, this will not work out.

Technology – A guarantee for profitability

A common concern of any “bottom of the pyramid” business strategy is that the poor can’t pay enough to make your business viable. Again, technology is the answer here, making banks more efficient and financial inclusion cheaper.

Technology actually creates value by transforming business processes and industry structures.”
Indian Banks’ Association

Financial inclusion – Finance at its best

With financial inclusion, banks can ameliorate our society and heal the wounds of the 2008/09 financial crisis:

  • Access to financial services such as micro credit allows individuals and small companies to innovate and create jobs.
  • Mobile banking increases the financial security for people living in unsafe regions where it is difficult to hold cash.
  • Financial inclusion allows the poor to develop a credit history, thus making it easier for banks to make credit decisions.
  • Electronic banking saves the cost of printing and safely transporting cash.
  • Financial inclusion techniques increase the efficiency of banks, lower transaction costs, and reduce the number of bank branches. This is not only true for developing, but also for developed markets.

There are clear benefits of financial inclusion at the individual and macro level – even though the macro effects are difficult to quantify.”
Institute of International Finance

Regulating financial inclusion – New business, same topics

Imagine you want to try a new recipe when cooking for your family. Here, you will always find lots of people explaining you why your recipe cannot taste good or might even be dangerous for your kids. In finance, it’s the same: Any time something new comes up, regulators are never far away. In case of financial inclusion, the regulator is usually a central bank, a banking supervisory agency, or a finance ministry.

Here is what we have to pay attention to when it comes to financial inclusion:

  • We need uniformed KYC rules.
  • We need to combat cybercrime and money laundering.
  • We need standards for secure data storage and transmission.
  • We need to protect financially illiterate people.
  • We need to protect the financial system, as financially illiterate customers (or financial institutions lending them money) can create credit bubbles and bad loans.

Interestingly, the degree of regulation seems to depend on the institution that carries it out and not only on the underlying activity:

This is especially true for regulatory power for corrective and remedial action and standards for internal risk management policies.

Financial inclusion risks – The difficulty of paying, getting repaid, and operating the business

Financial inclusion involves the same risk as any other lending activity. However, three specific types of risk stand out:

  • Operational risk is an important factor because microcredit institutions act, time and again, in environments with poor or unreliable infrastructure.
  • Even though a typical micro-finance instrument is short-term and small in size, credit risk is still a major risk. The first reason is that clients assume follow-on loans and virtually link repayment to such follow-on loans. Secondly, micro-finance loans are usually unsecured.
  • Clients’ expectations of follow-on loans effectively transform short-term assets into long-term assets. This triggers substantial liquidity risk in the micro-finance space. In addition, microfinance institutions often refinance through local banks which are, in turn, exposed to potential liquidity shortfalls.

Is financial inclusion just another temporary hot topic dedicated to disappear over time? One thing seems clear: It’s more than just a philanthropic action taken by banks to ameliorate public relations. When combined with new technology, it might effectively force even developed markets to transform from traditional retail banking with physical client contact to more efficient digital ways of communicating with clients.