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Is Digital Banking Better Banking for the Bottom of the Pyramid?

Speculation over the future of retail banking reached fever pitch in 2018, with regulators, consultancies and standard-setting bodies all trying to predict what the next few years may hold. This comes as little surprise. Over the past decade, financial services providers have taken advantage of disruptive technologies and regulatory changes to create an array of new banking business models that could potentially make it easier to deliver financial services to the unbanked. Despite these developments, most traditional banks have continued to ignore the needs of excluded and underserved customers in low-income countries. Many still assume that these customers are not profitable, despite evidence to the contrary. For instance, a recent EY report showed that excluded segments could generate incremental annual revenue of $200 billion.

Mobile banking in rural India
Photo: Sujan Sarkar, 2015 CGAP Photo Contest

As competition between new banks and incumbents grows, the fundamental question for us in the financial inclusion community is: What will digital banking mean for the bottom of the pyramid in emerging markets and developing economies (EMDEs)? At CGAP, we hypothesize that the digitization of banking leads to operational improvements and efficiency gains that can enable providers to advance financial inclusion, both by reaching more unbanked consumers and by offering a higher-quality service. To test this hypothesis, we’re exploring whether the fundamentals of the retail banking business model are changing and how these changes are likely to impact financial inclusion in EMDEs. In particular, we are looking into whether digital banking is leading to cost savings that enable providers to reach more of the world’s 1.7 billion unbanked adults.

Early evidence that digital banking might be better banking

There is some intriguing evidence to support this hypothesis. Regarding operational improvements and cost savings, KPMG’s analysis of the UK market — one of the most mature when it comes to digital banking — found that new banking models, such as those adopted by the likes of Monzo or Starling, offer a cost-to-income advantage (48.5 vs. 63.5 percent) and return-on-income advantage (13.25 vs. 4.6 percent) versus incumbent models. These advantages could be even bigger in places like Africa. As McKinsey has noted, Africa’s banking industry is highly profitable but also highly inefficient in terms of operating costs and outreach to the mass market.

Importantly, the evidence doesn’t point just to a commercial reward for digital banking providers. Individual success stories seem to have a financial inclusion-oriented outcome, too. Monese, a European prepaid checking account provider that launched in 2015, provides services that explicitly target unbanked refugees and asylum seekers, primarily from low-income countries. Many of Monese’s customers have never used formal financial services before due to incumbent banks’ outdated assessment practices, which for many years required a fixed income, fixed address and credit history. Traditional banks started to offer basic bank accounts, with a more pragmatic assessment policy, only when they were forced to do so under the EU’s Payment Accounts Directive.

But digital banking providers are not just reaching the unbanked in Europe. They might also provide a better quality of financial services to the financially excluded in EMDEs. This includes firms, such as WiloBank in Argentina, that are looking to deploy algorithms that use alternative data to run credit scores for consumers who do not have a traditional credit record. When combined with reduced operating costs due to digital automation, this innovation is giving consumers access to digital credit for the first time. Technology, such as artificial intelligence that enables credit scoring on the basis of geolocation, call-history patterns and text messages containing payments data, seems to have helped digital banks to build profiles of customers' financial situations and to make more informed lending decisions. It is yet to be seen whether such a model can sustainably allay the concerns raised in CGAP’s October 2018 working paper on digital credit.

Going beyond early evidence

Testing our hypothesis is no easy task. There is a striking diversity of providers, whose numbers are growing almost daily, and many of their business models cut across traditional banking frontiers. The challenge will be to identify for which type of provider and business model, and under which circumstances, the hypothesis holds. As noted in an earlier blog post, analysis of digital banking must not be confined to licensed banks, as nonlicensed providers can play just as important a role in disrupting the banking value chain. That is why for the purposes of this work, CGAP defines banking broadly as a financial business that is defined by three key features: activities (taking deposits and extending credit), functions (financial intermediation, money creation and transmission of monetary policy) and regulation (license, safety and soundness rules).To test our hypothesis, CGAP will work to identify the specific operational improvements and efficiencies gained through digitization. We will then examine how, and under what circumstances, these may enable digital banking providers to better serve excluded and underserved customers.

Given that Africa and Latin America are the two most profitable regions globally, yet also the two most inefficient, the conditions are set for digital banking to dramatically shake up the banking sector in EMDEs. Whether this will happen through a fintech revolution or incumbent evolution remains to be seen.

Comments

08 February 2019 Submitted by Dr.V.Rengarajan (not verified)

Bitter banking for the bottom pyramid. Why ? The demographic profile of bottom pyramid IN Asia and Africa regions , embedded in basic innumeracy and digital financial illiteracy does not provide a conducive platform for DFS from demand side perspectives. While many of them could not remember their date of birth , how can they recollect password and OTP for mobile device operation? It seems DFS through mobile helps more to the criminals than the bottom layer EVIENTLY It seems there is a slow down of process of digitization African countries

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