While the citizens of Norway, Finland, and Denmark all have at least one bank account, there are developing countries like the Central African Republic, Niger, and Madagascar, where the percentage of the unbanked population rises well above 85%. The poverty rates in such places are quite high, and is part of a vicious circle, since the inability to get a loan or to make deposits keeps people living day to day. The only available financial resource is social borrowing from friends and family. Yet, rapid technological advancements could turn this situation around.
The world of micro-loans
The regions with unbanked population have attracted a different type of financial services. Micro-financial institutions (MFIs) have developed a particular product, the microcredit, as a way to grant individuals the necessary money to expand a small business or to cover some surging costs, like healthcare.
Yet, the current model for these products is far from efficient, with high operational fees which translate to interest rates around 35-40%. It has even been said that micro-loans promote poverty. From the lender’s perspective, the product carries a high risk since until now, there were no tools to assess the creditworthiness of the borrower. Is there a better solution for this problem?
Challenges and solutions
To improve the micro-loan and make it a competitive financial product, one should first be aware of and address the key issues that include: substantial costs with HR and offices, high default risks due to poverty, geographical barriers, and low educational levels of borrowers.
Since most of these companies operated in rural communities, they relied on a personal banking model, where an agent would sell the service after carefully explaining the benefits and evaluating the borrower’s ability to repay the loan. The process required a substantial workforce to present the offer and then to process the applications. Just the agents’ commissions alone made up a significant part of the interest, becoming a real burden for the borrower.
The smartphone revolution can transform this system entirely. It is all about replacing the sales agents with carefully crafted advertising through social media channels and replacing the application process with a user-friendly app. Such an approach not only streamlines the process but makes the costs drop significantly, creating more competitive products for a fraction of the original fee.
Risk measurement and hedging
Some of the reasons traditional banking institutions avoided areas that have low banking adoption rates were related to risks. These included both default risks and systemic risk due to terrorism, lack of infrastructure and the inability to accurately measure the borrower’s ability to meet their end of the agreement.
In the USA, the FICO score is a way to assess any person’s creditworthiness and associate a risk score. The formula used to compute this is a weighted average of the on-time payments, length of credit history, debt ratio, credit mix, and the number of credit applications. In developing countries such records are not available, so a proxy of risk needs to be constructed in another way.
Big Data can offer a very accurate and satisfactory answer by tracking the activity of the applicant. Looking at the records and logs generated by their smartphones you can have a good representation of their interests, purchases, plans and even risky behaviors that could create a default risk, like alcohol abuse.
The target client of a micro-loan usually lives in a remote rural area. This aspect poses specific challenges to the sales funnel of such a product. Since reaching the client is difficult and expensive the deal needs to be closed in the same session, making the accelerated sales process difficult.
The smartphone can become a trustworthy partner of the micro-financing institution for this aspect. Through online communication the company can get closer to their prospects in progressive steps, giving them enough time to get familiar with the offer. By implementing SMS and social media marketing campaigns and monitoring the responses, the lender can create very personalized offers which work on specific triggers. For example, if they identify the lead as someone with college-aged children or a small business, they could market particular offers and conditions that are appealing to the borrower’s situation.
Lack of financial education
The low educational standards of the people who are most likely to become the clients for micro-loans could be exploited by predatory lenders. However, this is only a short-term win, since either they just take a loan once, struggle to pay it off and never repeat the action, or they fail at repaying even this first loan, incurring a loss for the lender.
The best approach is to educate potential borrowers and transform them into knowledgeable business partners. This is best done by using simple and straightforward language. They should understand the terms and conditions, how much they will repay every month and in total and agree to potential late penalties.
Fintech solutions can inform the lender about the borrower’s situation and help them decide on the best course of action. Starting with an analysis of the borrower’s previous exposure to financial knowledge, the lender can create informational materials. Also, it is worth considering if the borrower has enough economic power to repay the loan without getting into additional debt.
Asian countries have excellent development potential, with China hosting 12% of the world’s unbanked population and India 21%. Other worthwhile nations for this revolution are the Philippines, Indonesia, and Vietnam. An automated system that eliminates most middlemen and processing costs and relies on Big Data for risk assessment could be the future for the millions who don’t own a bank account but have a smartphone.
Companies offering such services have enough growth potential to attract investors, they just have to pay attention to their business plans. It is all about highlighting how they will use existing information about potential borrowers to assess their creditworthiness. Previously excluded segments will become active contributors to the financial market by using technology and alternative scoring methods.