Alternative lending options have grown rapidly in developed markets over the last 10 years. Fintech companies have raised significant funding, especially in the last two or three years, and developing markets are quickly catching up.
Currently, the digital credit landscape in emerging markets includes 22 live deployments offering instant, fully automated and remote loans on a short-term and collateral-free basis (and there are many more deployments that partially meet these criteria). The majority can be found in Africa, particularly in Kenya. At least six deployments have scaled to more than 1 million users, and successful deployments can scale fast. M-Shwari in Kenya, for example, reached 12 million customers in just three years.
The growth of digital credit is likely to continue in emerging markets. In this blog, we share three things we think are key to understanding this increasingly important market.
Smartphones could change the digital credit market structure significantly
Many partnership structures have emerged for offering digital credit and are differentiated by who owns what part of the digital credit value chain. In developed markets, we often see a variety of players, from banks to fintechs, in different parts of the value chain. By contrast, mobile network operators (MNOs) have a dominant role in developing countries because they own key assets of the value chain, such as access points, payment accounts and data pools. They can acquire balance sheets as a commodity through partnerships or lending licenses.
The emergence of smartphones provides a new access point to customers through the internet or an app. This may shift the current supply-side structure towards more fintech-led models because it provides a low-cost channel to the customer and their data. App-based solutions like Branch in Kenya can score, underwrite and lend while leveraging MNOs’ mobile wallets for loan disbursements and repayments using a simple bill-pay function. In this model, it is the MNO’s services that become a commodity. For the customer, more tech-led models could translate into greater flexibility and choice. Technology, with smartphones as a key component, can help lower the barriers to entry and increase competition.
The opportunity could also emerge for banks to take a more prominent position (they are natural candidates given their historical leadership in the mainstream credit market) if they are able to innovate around their traditional operating model and scoring practices.
Digital credit is not replacing other formal lending
Digital credit is not competing with formal lending: it is complementing it. The microfinance industry may well be evolving into a more digital operating model, but existing digital credit services address a different need. The primary purpose of digital credit is to provide short-term liquidity to cash-strapped vulnerable households, while microfinance and bank loans typically provide longer-term investment capital for business or other long-term assets.
Research shows that this is how these services are being used. According to FinAccess 2016 household survey data in Kenya, mobile banks are the primary source of credit used for both day-to-day needs and for emergencies, followed closely by informal providers like shopkeepers, chamas and moneylenders. Banks and microfinance institutions, who typically offer longer-term loans, combined provide less than 10 percent for both of these types of needs.
What digital credit does compete with is informal lending. To understand why, imagine you are a smallholder farmer in Kenya. The Kenya financial diaries show that poor households’ median income fluctuates 54 percent from month to month, with the average household using 14 different financing tools. With an income of $2 a day, on a month when you are 50 percent below your average, you are $30 short and might not be able to cover your family’s essential needs. In this context, digital credit can be obtained instantly and offer a good value proposition, potentially being lower cost than a moneylender or more reliable than friends and family who may also be having a rough month themselves.
Comparing APRs can be misleading when it comes to digital credit
Pricing on traditional credit offers is evaluated by comparing APRs, with the loan carrying the lowest APR generally considered the best value. Because digital credit typically collects interest for such a short time only, however, the comparison between short-term digital credit and traditional longer-term loans through APRs is flawed and does not reflect the actual cost to the customer.
For a poor customer who needs to supplement a lower than average income this month, borrowing for a year could be a bad option. If he pays 10 percent to borrow $30 for a month (more than 200 percent APR), covering his liquidity need will cost him $3 dollars. If he instead borrows the $30 dollars for a year, at an APR of 20 percent, it would cost him $6. Even at an APR that is 10 times less, he would still be spending twice as much, so borrowing for the additional 11 months would not make sense for him; he would be better off with the short-term loan.
Of course, this will not always be the case. A shorter product could very well be more expensive when needs are recurring, but it will be the case sometimes. Having access to a broader set of financial tools empowers customers to choose the best option for each of their needs. Better matching the length of a loan with the length of the actual financial need can help customers spend less on interest, and the fact is that the planning horizon is often very short for low-income customers. Looking exclusively at APRs misses this point.
Now, you might be tempted to ask: Why can’t the customer borrow at 20 percent APR just for that month? With an annual loan, the provider risks losing $30 in the event of a default, but otherwise collects interest on the $30 dollars 12 times. With a monthly loan, the provider is still risking to lose $30 dollars, but collects interest only once. The annualized interest rate required to break even will be very different in both cases unless the probability of default is negligible. Total cost of capital will be lower for the monthly loan, but risk and operational costs will significantly outweigh this. Operational costs per loan need to be minimal for a short-term small loan to be viable, meaning that requests for collateral or in-person credit assessments are not available as risk management tools.
Digital credit continues to grow and presents both new opportunities and challenges that will need to be addressed. Doing so effectively requires a shared understanding of the key elements of digital credit. We hope this blog contributes to a better understanding of this new market, which can be the starting point of an informed debate.
Agreed that we need a broader set of financial tools for the empowerment of low income families as the financial behavior exhibited by them is often complex. However, the argument against comparison of APRs is debatable. The assumption that the low income family would have to borrow for 1 year using conventional sources in the absence of digital credit does not take into account prepayment options which are widely available these days specially when you borrow from MFIs and cooperatives in mature microfinance markets like India and Kenya. If a borrower exercises prepayment option then he/she would not necessarily have to pay 6$ towards the interest component. In addition, just because a provider is offering a short term credit using alternative mechanisms of credit scoring to high risk families does not give them a free hand to charge exorbitant rates. We also have to understand that these are the same families which have been borrowing from other sources at much cheaper rate. Digital credit providers will have to exercise caution and responsible finance practices here and look these families as long term partners instead of treating them as one off customers.
Thank you for your comment. The case is definitely oversimplified just to illustrate the point. There are many other factors and pre-payment can be an option to lower the cost of longer term credit (tough it would impact MFI profitability if it happened at a large scale). There are other challenges too, for example, borrowing only $30 might not be an option as not all MFIs offer small loans. It is also unlikely that the loan would be available instantly or same day and there could be other requirements like being part of a group or having collateral or a business.
Thank you for sharing the presentation, very interesting research!