Balancing Financial Inclusion and Stability

Regulators have traditionally focused their efforts on ensuring stable and sound financial systems, and this role has been amplified in developed countries since the global financial crisis of 2007 to 2009. During this period, most practitioners have rightly argued that to forestall financial crises and ensure financial stability we need better regulation, not more regulation, of the financial sector.

In developing countries, regulators previously grappled with financial instability in the 80’s and 90’s that was underpinned by weak institutional and governance structures of financial institutions. In those decades, regulators advocated more control. Significant progress has since been made in strengthening institutional, legal and regulatory frameworks in developing countries, evidenced by the relative stability of their financial systems during the global financial crisis. This stability was due in part to active and risk-averse oversight and in part to the fact that these financial markets were not closely integrated with the financial systems of developed markets.

Developing countries however continue to struggle with fighting poverty and raising the economic welfare of their citizens. The poor are among the unbanked in these countries, and often have no have no access to financial services. Whereas we see stable financial systems in most of Sub-Saharan Africa, their reach remains limited.

Poverty in Africa is exacerbated by lack of access to markets and the financial markets play a critical role. For example, in Kenya, the formal banking system served only 23% of the bankable population in 2009. This financial exclusion can be a source of financial instability through contagion effects. For instance in Kenya, pyramid schemes were prevalent in 2006 and 2007 leading to substantial financial losses. Indirectly, such schemes, which thrive in non-inclusive financial markets, can also jolt confidence in formal financial institutions and jeopardize financial stability. Such schemes thrive because of exclusion and the presence of a large informal economy, including informal financial services.

The growth of Kenya’s financial sector was previously hampered by missing markets and institutions that increased costs related to (i) financial services and products, (ii) time and distance spent to access financial services touch points and (iii) lost market efficiencies due to an informal market on one hand and a segmented formal market on the other. To overcome these issues, the Central Bank of Kenya (CBK) took a pragmatic regulatory approach that included lowering barriers to entry, allowing space for innovation, strengthening regulatory capabilities and supporting the development of a complete financial infrastructure. Together, this approach has led to the growing prominence of financial inclusion as an important complement to financial stability.

The CBK also took a proactive approach in addressing these bottlenecks in partnership with the Kenyan Government, market players and development partners. Accordingly, the CBK followed a pragmatic approach towards the much acclaimed mobile money transfer services pioneered by Safaricom through M-PESA. Mobile financial services present a significant opportunity to address two key constraints to financial inclusion: (i) the cost of services and (ii) the lack of proximity of financial service points of access. This potential informed the CBK’s plan and enabled the Bank to identify related risks, ensuring such risks were mitigated before the service was launched.

The CBK’s approach allowed it to bring more participants into the formal financial sector (deposit accounts have grown), and to develop a supporting financial infrastructure (such as credit reference institutions and agents). To promote competition and diversity, the CBK has also licensed six deposit taking microfinance institutions targeting the low income, unbanked and under-banked segments of the Kenyan population. The CBK has supported the roll out of these initiatives again by identifying the inherent risks and incorporation of appropriate safeguards to mitigate those risks, ensuring not just financial access but also soundness of the financial system.

The outcome of this regulatory philosophy has been the extension of financial inclusion frontiers in Kenya. Well over 18 million Kenyans now access mobile money transfer services through more than 40,000 agents transacting USD 41 million per day. The number of bank account holders has exponentially grown from 2.55 million in 2005 to over 15 million at the end of 2011. Of these deposit accounts, 94% are below 100,000 Kenyan Shillings (USD 1,150) and therefore fully covered by the Deposit Protection Fund. The agent banking model, which was rolled out in 2010, has expanded to include more than 9,000 bank agents and has been another major contributor to the growth in Kenyan bank accounts. At year end 2011 agent transactions were valued at more than USD 400 million and agents mobilized USD 264 million in deposits, nearly 2% of the total deposit base.

With enhanced financial inclusion comes the need to step up existing frameworks on consumer protection and deposit protection, while exploring emerging issues on competition and interoperability. But even as we address these emerging issues, we are still seeking to get an in-depth understanding of the risks and identify appropriate safeguards that will not stifle innovation. At the same time, we remain cognisant of the pivotal role of safety and soundness in the uptake of financial services.

The CBK’s experience yields five key lessons for regulators:

1. Adopt the “test and learn” approach enshrined in the G20 Principles for Innovative Financial Inclusion. In this approach, regulation follows innovation but simultaneously ensures sufficient safeguards.
    
2. Provide space for innovators to showcase their success and thereby protect their credibility.
    
3. Protect the unbanked as they enter the market via the Deposit Protection Fund and risk-based supervision while strengthening banks and deposit-taking microfinance institutions. This requires the regulator to partner with other actors to develop institutions and initiatives to complete the financial infrastructure of the country. Raising core capital requirements for banks has been quite important for Kenyan banks.
    
4. Better regulation will build strong institutions and thus encourage prudent behaviour in the financial market.
    
5. Regulators need to evolve as financial institutions develop and spread their footprint from national to supranational regional arenas. This requires the creation of regional supervisory networks.

The CBK’s regulatory approach continues to evolve as it engages market players and learns from the experiences of other regulators in the domestic, regional and international arenas. But balancing financial inclusion and stability remains the fundamental tenet of CBK’s vision.