Introduction:
Somewhere remote in a low-income coastal area of Kerala, in the early hours of the morning, a woman street vendor uses her cell phone to borrow a very small amount of money digitally to buy a basket of fishes in the whole salefish market. During the day, she will sell those fishes in her small shop located in the outskirts of the town. Few customers will pay her using their mobile wallet, others with cash. She will transfer the cash onto her phone at the shop next door, where the merchant is also a business mobile money agent. At the end of the day, she will be able to pay back her loan taken by the bank/fintech agency and keep her profit in her mobile wallet. She can use this mobile money to pay for the gas she uses to cook dinner, as the utility company has recently connected its payment system to the mobile money infrastructure.
These above facts that preceded the COVID-19 pandemic illustrate the ways in which fintech has enhanced financial inclusion at different stages of development.
Digital finance is increasing financial inclusion, complementing or substituting traditional finance. While digital financial services are still small relative to traditional services, they are growing rapidly and at varying speed across regions and countries.
Globally more than 1.7 billion people have no access to a bank account and small- and medium-sized enterprises (SMEs) (95 percent of companies worldwide) provide employment to more than 60 percent of workers, yet struggle to access finance. In this environment, fintech (technological innovation in the financial sector) is creating significant opportunities, helped by the growing ownership of mobile phones and access to internet.
The COVID-19 health crisis has created new opportunities for digital financial services to accelerate financial inclusion. The health crisis led to the “Great Lockdown,” as country heads have opted for restrictive containment measures like lockdowns, quarantines, travel restrictions, and other social distancing measures to bring the contagion of the virus under control.
Fintech, including mobile money, can help people and firms to maintain and increase access to financial services during lockdowns and the reopening of businesses, given growing preference for cashless and contactless transactions to mitigate the spread. Many countries have encouraged its use by introducing measures to lower cost and increasing the limits on transactions for digital transactions.
These developments could help to accelerate the shift towards digital financial services from traditional financial services. For instance, the severe acute respiratory syndrome (SARS) epidemic in 2003 accelerated China’s launching of digital payments and e-commerce (World Economic Forum).
Many evidence depicts that fintech is already playing an important role in mitigating the economic impact of the COVID-19, by facilitating targeted fiscal measures to be deployed efficiently and quickly to their intended beneficiaries, even the unbanked. By reducing or eliminating the need for physical interactions and the need for cash, fintech is helping governments to reach people quickly and securely.
2. Impact and Implications of Digital financial inclusion :
a) Digital finance is increasing financial inclusion, even where traditional financial inclusion is declining :
Digital financial inclusion tends to fill a gap where the traditional delivery of financial services is less present. Many study reports says that in some countries fintech lenders participate in the government schemes to support credit extension to SMEs, whereas in other countries many fintech firms are scaling down new lending in response to weak demand and to focus on preserving liquidity and managing credit risks.
b) Digital financial inclusion is associated with higher GDP growth:
Adoption of digital payments is significantly and positively associated with growth, consistent with the notion that fintech might contribute to growth. Fintech could thus play an important role in mitigating the economic impact of the COVID-19 pandemic, and support the recovery, as countries with higher digital financial inclusion will find it relatively easier to:
- Ensure continued access to financial services, including by maintaining credit flows to households and businesses while keeping people safe.
- Deliver government support effectively and securely; and
- Support consumption, innovation, and hence productivity through digital economy developments.
c) Fintech is contributing toward closing gender gaps in financial inclusion :
This is something which many initiatives couldn’t do but fintech did its best as huge opportunities opened up to women in the form of work from home (WFH), online classes, flexible timings, online credits/ loans and online sales etc.
d) The safe development of digital financial inclusion rests on a combination of factors :
Rapid financial inclusion without proper regulation and financial literacy can lead to financial instability, as witnessed during the global financial crisis. Regulators warned that cybersecurity risks or inappropriate lending practices by under regulated institutions could jeopardize trust in this context, consumer protection, digital identification, and financial/digital literacy were high on their agenda. Fintech companies highlighted the supply of skilled labor for fintech companies and availability of digital financial infrastructure as major constraints.
e) Digital finance can create new risks to financial inclusion:
Those risks stem from unequal access to digital infrastructure, constraints to financial and digital literacy, and potential biases amplified by new data sources and data analytics. The current model of lightly regulated digital lending could, in turn, threaten financial stability. Indirect risks relate to the possible disruption of financial inclusion through microfinance institutions, and to the consequences of a demise in trust in digital technology. All of these risks are even more important in light of the rapid and abrupt shift toward digital financial services amidst the COVID-19 crisis.
- Are Fintech Companies Disrupting Traditional Providers?
The fintech companies that target the under and unserved populations have had a limited disruptive impact on traditional bank operations so far. The services that fintech companies are providing (for instance, small loans at short duration or aggregator of services of various companies on their digital platform) are typically not services that traditional banks provide to small clients. The 24/7 access to online lending platforms is allowing small SMEs to seek financing outside of business hours. In some sense, the fintech companies are complementing the services of traditional providers who focus on big clients and larger loans for longer duration. In advanced economies, for instance, where fintech lenders target the underserved borrowers, fintech. companies do not compete with the broad spectrum of services provided by banks, but rather provide “pointed technical solutions” in niche areas.
Fintech companies are increasingly collaborating with banks and creating a variety of business models. Fintech companies are partnering with banks to benefit from their experience and expertise in regulatory compliance and to facilitate scaling up. In turn, fintech companies provide banks with the state-of-the-art platform for reaching out to new customers. In some cases, especially digital microcredit is operated by fintech companies that manage the lending on behalf of the banks.
Big banks are also inviting fintech companies to set up in-house incubator and innovation labs (for example, Barclays and Lloyds). In Korea, which has a very high penetration of credit cards, some fintech companies offer platforms that serve as aggregators and connectors to the services provided by credit card companies. In India ICICI Bank recently ( Feb 2021) said it will buy stakes in two fintech companies — CityCash and Thillais Analytical Solutions. CityCash is a bus transit-focused payments technology company which provides ticketing system technology to state transport corporations ( Table. 1 Depicts the surge in Tech spending in fintech by various global banks).
The above factors depicts that it is limited disruption of traditional providers so far and it is also complementary between fintech and banks. Indeed, digital solutions appear to be “filling the gap” left by traditional financial institutions.
Fintech payment services tend to be supplied more, and used more, where traditional access is limited. Many works on digital payments reveals that the availability of tra- ditional means of financial inclusion (such as access to bank branches and ATMs) is negatively associated with both the supply and usage of digital payments
While this may in part reflect the shift by banks toward digital means of service provision (e.g., mobile and online banking), it suggests that digital financial inclusion tends to be higher where there is a gap in the existing supply of traditional financial services or when the traditional banking sector is inefficient.
Fintech credit also tends to emerge where traditional services are limited, i.e., where bank branches are few, and financial depth is lower.
That said, competition between traditional and nontraditional providers, though nascent, is emerging. For instance, purely digital banks are coming up, directly competing for traditional bank customers and attracting new ones due to their technological advantages and low-cost services. Similarly, fintech lenders now compete directly with informal money lenders, microfinance institutions, and small banks in both payment and credit. Big banks, too, are beginning to feel the competitive pressure and are responding in different ways. Some are buying up small fintech companies or investing heavily in fintech. This trend could be further strengthened as they adopt to lockdowns and social distancing measures to contain the COVID-19 pandemic by accelerating the shift toward digital delivery services.
- What Are the Factors that Enable and Constrain Digital Financial Inclusion?
These include:
- Customer identification,
- Digital infrastructure,
- Financial literacy, and
- A supportive regulatory and legal environment for making progress in digital financial inclusion.
Customer identification is a first step for promoting financial inclusion. Financial services require accurate identification of customers, including to prevent fraudulent activities. Many creative solutions are emerging: in EMDEs(Emerging Market and Developing Economies), telephone numbers are often used as a source of identification for providing basic services such as payments; countries are developing centralized database for customer due diligence identification. In some advanced economies, fintech companies are working with regulatory authorities (such as the Financial Conduct Authority in the United Kingdom.) to set up “digital portable identity” in order to help small businesses expand rapidly. These digital identities can be stored in smart phones and used across institutions and borders. The introduction of the Aadhaar card in India, a national system of biometric identification issued to more than 1 billion people, has been a game changer. Its potential usage is high, ranging from delivering national services (pension, health, insurance, and social welfare payments) to digital financial services to satisfying regulatory requirements on customers’ identity. Biometric identification has also been introduced in developing Pacific countries, such as Papua New Guinea or Samoa, allowing unregistered persons to use fintech-based payments. A key regulatory and legal issue in many countries is to balance between information sharing and privacy protection. Many fintech companies have expressed two major constraints: uncertainty of the regulatory environment and lack of technological expertise the “coders.” Uncertainty or frequent changes in the regulatory environment was, in some sense, more of a constraint than a clear road map with tighter regulation. In some countries, the regulatory support measures, implemented as a response to the COVID-19 shock, are designed to be channeled mainly through the banking sector, which could further exacerbate these constraints. The shortage of technological expertise, the coders, is also increasingly weighing on their minds, particularly in EMDEs. Further, although many fintech firms rely on alternative data to assess creditworthiness, they thought credit bureaus could help augment their assessments. Fintech firms seeking to expand globally also noted the lack of universal credit scores and legal frameworks for loan recovery as impediments.
Funding constraints, especially to scale-up, were also mentioned by many fintech companies, and is even more evident during the COVID-19 crisis. Initial support or funding typically comes through incubators or accelerator programs or from angel investors and crowdfunding. Some are increasingly being funded through private equity, venture capital, and hedge funds, while a few successful ones are already being publicly listed on stock exchanges.
Regulatory authorities are also facing wide range of challenges. These includes catching up with the fast-changing landscape, facing budgetary constraints or lack of expertise, and managing lobbying pressures from traditional financial institutions. Regulators are also responding to the development of fintech by encouraging and adopting RegTech (The use of information technologies (IT) to enhance regulatory processes) and SupTech (the use of IT to enhance supervision). From the financial service providers perspective, the automation and data-driven analysis of internal control systems and reporting are enhancing cost-efficiency. From the supervisors’ perspective, it allows for risk-based supervision of vast amounts of data. According to one RegTech company, the cost of compliance for one of their clients went down from £18 million to £0.5 million per annum by switching to their technology.
Factors that facilitate or impede digital financial inclusion:
- Better access to digital infrastructure (measured by the availability of the internet and mobile phones) is associated with higher usage of digital payments and credit. In fact, we find a monotonic and positive relationship at all levels of digital infrastructure. Similarly, increasing the number of mobile money agents in the same proportion would also lead to improvements in digital financial inclusion (although the magnitude would be smaller).
- The efficiency of traditional providers also matters. More inefficient banking systems (with higher overhead costs to total assets) are associated with more digital financial inclusion.
- The usage of fintech payment services is higher where there is already a high usage of traditional financial services. This could reflect higher financial literacy, as well as trust in the financial system in general.
- Institutions matter, at least for the development of mobile money agents, and the quality of governance is positively associated with the availability of mobile money agents.
- Finally, a more consumer-friendly environment (i.e., higher mobile money regulation index) is, as expected, associated with greater adoption of mobile money.
- On the credit side, the availability of borrower information and higher protection of legal rights tend to support the emergence and development of fintech credit. Perhaps big data would help in a great way as for as credit off take is concerned.
The priorities in promoting digital financial inclusion should depend on country circumstances. For example, for countries where traditional access is low, there is room to improve financial inclusion through fintech, irrespective of the level of usage. Conversely, for countries where traditional usage is low, enhancing financial literacy and, more broadly, familiarity with financial services, is essential to support financial inclusion, irrespective of access.
The experience with the COVID-19 crisis underscores the importance of promoting digital services to the most needy. Fiscal policy should include investment in digital infrastructure such as access to electricity, mobile, and internet coverage, digital ID among others. In some countries where digital access is higher, the crisis could provide the needed push to accelerate initiatives already in the pipeline in areas related to building conducive regulatory and institutional frameworks. These efforts should be complemented by the promotion of consumer and data protection, cybersecurity, interoperability, and financial and digital literacy.
- What Are the Risks of Fintech to Financial Inclusion?
Regulators around the globe have begun to assess the fintech-related risks and formulate policies, and these should be accelerated during and after the COVID-19 crisis. At the international level, the Financial Stability Board (FSB) has concluded that fintech and Big Tech do not yet present systemic risks (FSB 2019). At the same time, it is worth recalling that the push for financial inclusion without proper regulation contributed to the 2008 global financial crisis. The development of digital lending is already raising concerns about predatory lending practices in some countries, which could become even more prevalent in the ongoing COVID-19 crisis (Faux 2020).
For instance, fintech borrowers who are unable to make loan repayments due to sudden loss of income, might be subject to aggressive debt collection practices and high late payment/default fees. In Indonesia, the Financial Services Authority has identified and closed down more than 1,000 illegal peer-to-peer lenders recently that were offering prohibited financial services or operating without a proper license. Therefore, a sound policy approach at both the global and domestic level is crucial. Global cooperation is needed to mitigate risks related to the possible emergence of global monopolies such as the Big Techs, regulatory arbitrage and race to the bottom, cross-border activities, cybersecurity, and money laundering. At the domestic level, the list is also long: it includes protecting data; preventing cyber risk; facilitating digital infrastructure; strengthening regulatory and supervisory frameworks; upgrading payment and securities settlement systems; ensuring standardization and interoperability; and developing effective user protection and contingency planning.
Whether the Fintech Create Direct Risks to Financial Inclusion?
Reaping the benefits of fintech requires a minimum level of investment and those who do not have the means may find themselves financially excluded. Investment here includes “tech capital” (e.g., mobile phones, internet access) as well as the human capital required to use digital financial services. As fintech develops and becomes more sophisticated, uneven access to the needed physical infrastructure, or insufficient human capital, could create a new source of financial exclusion, notably among women, the poor, and the elderly, in both EMDEs and advanced economies (G20).
The COVID-19 shock has induced a strong shift toward digital financial services, a trend that could exacerbate financial exclusion of those groups left behind. Moreover, “easy” digital credit creates risks for people with limited financial literacy.
The use of big data analytics could become a source of financial exclusion if the initial data entry is biased, or if algorithms are imperfectly calibrated. Fintech firms’ use of big data and algorithms to profile consumers can allow them to reach customers who, until then, had been excluded from the traditional financial sector because of no or limited credit history. But there are concerns that it may also entrench biases present in historical data, and this in turn could perpetuate the unfair treatment and exclusion of some categories of consumers. Furthermore, the unprecedented economic impact brought by the COVID-19 shock will likely test the reliability of existing models and indicators in the downturn, potentially requiring adjustments and recalibrations. The Financial Action Task Force (FATF) standard on ML/TF (Money Laundering and Terrorist Financing) promotes a risk-based approach that encourages countries to design measures that meet the national goal of financial inclusion without undermining the measures that exist for fighting ML/TF. However, an improper or disproportionate implementation of the risk-based approach to ML/TF, including through the use of big data analytics, may aggravate financial exclusion (e.g., blanket exclusion of categories of customers associated with higherrisks of terrorist financing).Financial inclusion through fintech could be more procyclical than financial inclusion through traditional means, as is already being observed in some regions following the COVID-19 crisis. The small size of fintech credit limits the potential impact of a fintech credit cycle on the economy. But fintech lending is growing rapidly, in part because the automation of credit decisions makes credit extension more frequent and much faster. Insofar as credit provision based on large and frequently updated datasets allows for a robust evaluation of creditworthiness, such credit could be resilient to the economic cycle. At the same time, automation could also lead to procyclicality to the extent that algorithms do not substitute for long term relationship with clients, more automated credit decisions could also lead to faster contraction during a downturn. The procyclicality could further be exacerbated by the tightening of funding conditions of fintech lenders, as some are starting to experience during the current health crisis. Many of these firms are new and less established, with less liquidity and balance sheet buffers. They could retrench their operations more sharply in downturns, curtailing access to financial services for SMEs and low-income households disproportionately. If this results in consolidation, the fintech industry could become more concentrated with a few large firms emerging as dominant players. Finally, where fintech and big tech companies intermediate small deposits, banks funding structure may become more dependent on wholesale deposits, which could be more volatile. Swings in bank funding could lead to contraction in credit, with could be particularly detrimental to the marginal borrowers. Altogether, these effects could lead to procyclical swings in financial inclusion.
Whether Fintech Create Indirect Risks to Financial Inclusion?
As fintech develops, the microfinance institutions and small banks that have traditionally catered to the financially vulnerable may suffer. Some of those financial institutions including, in many cases, the traditional money lenders in low-income countries embraced the digital transformation early on, collaborating with fintech companies. But the pressure from fintech could put the business models of the laggards at risk: digital credit and saving solutions, fully online banks, or money transfer solutions are making inroads into some of their business lines. These institutions have less resources to respond to competitive pressures they face from nimble fintech companies. If they were to scale back their operations before fintech companies have sufficiently scaled up, the risk of financial exclusion could increase. The COVID-19 crisis could increase this risk: in addition to their clients being likely to be hit harder by the economic fallout of the pandemic, many microfinance institutions lack the expertise and resources to expand digital operations at least in the near term.
A loss of trust in digital technologies could setback progress in financial inclusion. The progress in digital financial inclusion rests on the delicate balance of convenience provided by the technology and trust placed by customers in fintech. For instance, the increased availability of personal data can play an important role in facilitating identification of the people most adversely impacted by the COVID-19 crisis, such as by mobile wallet providers in China and Kenya. However, loopholes or fraud in the handling of private data can erode trust. Data privacy or cyber security concerns might prompt consumers to look for ways to reduce fintech companies’ access to their data, thereby reducing the ability of fintech to support financial inclusion. Recognizing these risks, some regulators noted that a code-of-conduct directive for fintech firms was in order, especially those dealing with retail customers. Inadequate user protection could also undermine digital financial inclusion. Households must trust that mobile money or e-wallets are a reliable means of payment. However, risks exist. The mobile money operator could go bankrupt. Alternatively, the bank holding its funds as deposits (which are the aggregation of mobile money users’ funds) could fail. In these scenarios, mobile money users may not fully recover their balances. However, some of these risks can be mitigated. Legal structures ensuring the segregation of customer funds from other creditors of the mobile money operator should be explored. Also, customer funds should be invested in highly safe and liquid assets and should be diversified across the safest banks to the extent they are held as deposits of the mobile money operator. Another option is for central banks to require that mobile money operators hold customer funds as central bank reserves.
Conclusion and way forward:
As fintech develops, policymakers are facing questions relevant for inclusive growth, financial stability, and regulation. The G20 has identified the need to “provide an enabling and proportionate legal and regulatory framework for digital financial inclusion” as one if its High-Level Principles for Digital Financial Inclusion, and there is an active effort by all stakeholders, including think tanks, to think through the contribution of regulation to the safe development of fintech which preserves financial integrity . This is an important point, as fintech is often allowing the development of unregulated substitutes to highly regulated activities, such as currency issuance or consumer finance. Currently, there are no internationally agreed regulatory standards, but country authorities around the globe are responding, with China, India, Mexico, Singapore, and the United Kingdom, among the countries that are taking a more proactive role. The United Nations Secretary-General’s Special Advocate for Inclusive Finance for Development (UNSGSA 2019) identifies several preconditions for raising digital financial inclusion safely and competitively. These include data privacy, cybersecurity, digital identification, fair competition, physical infrastructure (agents network, connectivity, interoperability), and financial and digital literacy.
Though a tall order, it provides a clear set of goals for policymakers to pursue. In this context, ensuring high-quality supervision and regulation, particularly of nonbank financial institutions is important. Supervisors have recognized the need to adapt regulatory approaches that strike the right balance between enabling financial innovation and addressing challenges and risks to financial integrity, consumer protection, and financial stability. Examples include the adoption of mechanisms such as innovation hubs and, where appropriate, regulatory sandboxes. Importantly, regulation should remain proportionate to the risks and should support the safe use of innovative technologies. It is becoming imperative that international agreements are needed to address data privacy, cybersecurity, cross-border digital currencies, and digital identification. A valuable benefit of fintech: it offers the ability to conduct transactions securely and cheaply. Big Tech firms such as Alibaba, Amazon, Apple, Facebook, Google, and Tencent bring value in terms of speed, efficiency, and economies of scale. At the same time, with their global footprint and funding advantages, they could easily put smaller companies out of business and be formidable competitors to established financial institutions. With an abundance of cash and business lines that fit well with the COVID-19 demands, Big Techs are doubling down on acquisitions and research and development. With smaller companies being hard hit by the tighter funding conditions, it is important to ensure that the fintech landscape remains sufficiently competitive after the COVID-19 crisis. Furthermore, the entry of Big Tech companies is raising questions from a number of perspectives (loss of sovereignty, cost of global monopolies, and others). On the policy side, there is a concern that small countries and their regulatory policies could ultimately be captured by these giants. Financial and digital literacy is as much of a scarcity in advanced economies as in EMDEs. Emerging markets with younger populations seem to be adapting to fintech much better than aging advanced economies. But common across regions is the fact that few countries mandate courses in financial literacy in high school or college. One country official in an emerging market reported introducing such a course as a high school graduation requirement, but then pointed out that they quickly ran out of teachers who had the qualifications or experience to teach high school students. Challenges for countries with larger populations, remote regions, or cultural resistance to the use of digital communication means, remain immense. Authorities should undertake measures to increase financial and digital literacy, including through creating incentives for private digital service providers to educate customers. There are also several macrofinancial risks related to fintech that need to be addressed. Fintech adds to the interconnectedness of the financial system and brings banks and unregulated nonbanks even closer, posing risks for both. Even when fintech companies are unleveraged, they could be affected by spillovers from turbulences in the banking or capital markets. And that, in turn, could put financial inclusion at risk. Finally, fintech could lead to “excessive” financial inclusion (such as the US subprime lending crisis or the more recent rise in default rate to nearly 20 percent on mobile bank loans in Kenya) when access to credit grows under insufficient regulation and supervision. In crafting new laws, it would be important to ensure proportionality in regulation of small fintech firms, while being mindful that unsecured digital credit combined with the light regulation of some digital financial service providers may raise complex issues of crisis management. These issues are even more relevant as fintech companies go through the economic downturn triggered by the pandemic. For instance, individuals may seek fast access to credit, including digital credit, to meet immediate living expenses. This practice may expose consumers to less scrupulous credit providers, unfavorable terms and conditions, and increase over-indebtedness.
Fintech’s potential to help counter the impact of the COVID-19 pandemic and support the eventual economic recovery is large but cannot be taken for granted. Fintech is proving to be a useful tool in ensuring access to financial services and helping deliver governments’ support measures. Its role in the recovery phase, however, will depend on the industry’s resilience to the shock and how the fintech landscape evolves post-COVID-19. Hence it is concluded that with careful regulation and supervision, as well as addressing the several constraints that the expansion of financial inclusion facing can attain the promise of fintech to serve greater proportions of the population in realizing their dreams of upward mobility.
