Regulating and Investing for Financial Inclusion

How should regulators and investors determine whether a lender is “inclusive” or “predatory”? Should regulators limit the interest rate lenders can charge? What should investors look for when making socially conscious decisions?

Digital credit options for the underbanked around the world are now more accessible than ever, but for a price. The rise of FinTechs delivering financial services to the masses has left regulators and investors scrambling to distinguish responsible lenders from predatory ones. Having built financial products and researched trends in many countries, I wanted to share a framework for how to invest in and regulate FinTech players in order to further financial inclusion around the world.

TL, DR:

1. Let market set the interest rate
2. Regulate what consumers can’t
3. Invest in financially inclusive players

Consumers want credit, whatever the cost

Consumers with limited or damaged credit history typically don’t have access to loans from large financial institutions and resort to expensive alternatives. The inability and aversion of banks to lend to such risky borrowers paved the way for more informal players to flourish: payday loans are used by more than 2.5 million US households a year. These loans can charge more than 700% APR, a rate so high many consider them “loan sharks”. Yet their popularity highlights consumer’s frequent need for short-term cash to overcome income volatility, sometimes to pay for critical bills to keep their car or home.

FinTechs are helping, but not solving

Realizing the market opportunity, FinTech startups focusing on improving the financial health of underbanked consumers have multiplied. In the US alone, the share of consumer loans originated by FinTechs increased from 5% to 38% of the total $138bn market. Countries such as Mexico, China, India, Kenya and Indonesia have also experienced a similar rise. Leveraging technology, alternative data, and innovative machine learning techniques, digital lenders offer more transparent, convenient and affordable loan options.

Still, most FinTechs need to charge higher interest rates than banks because they lend to risky borrowers that banks typically decline. Since a high percentage of risky borrowers don’t pay back their loans, lenders need to increase rates on everyone to compensate. FinTechs also do not benefit from low cost of capital available to banks that enable them to borrow cheaply in order to lend.

Regulators resort to heavy handed rules with potentially negative consequences

Many regulators focus purely on interest rate when determining whether a player is financially inclusive. Interest rate caps, which restrict the maximum interest rate lenders can charge, are used in over 76 countries around the world. In the US for instance, many states have a 36% interest rate cap and a recently proposed bill would decrease this to 15%. Alexandria Ocasio-Cortez and Bernie Sanders, supporters of the bill, argue that banks make too much money and consumers are crippled by the exorbitant cost of debt. While they are right about the existing imbalance, the proposal to regulate interest rates likely won’t have the intended impact.

The reality is that interest rate caps seem to have opposite effects, based on a recent paper by the IMF. By restricting free market forces, such policies introduce market inefficiencies that create the following unintended consequences:

1. Less credit supply. Competitive markets ensure that interest rates are as low as possible, based on a borrower’s perceived risk and a lender’s break-even point. If players can’t charge that rate, they simply will not lend. This leaves consumers who need cash for emergencies in difficult situations without any options.
2. Less transparency. Lenders will find other ways to charge the same amount on aggregate, such as charging fees for online access or leveraging complex schemes that confuse users. This will make it harder for consumers to understand the true cost of borrowing and may incentivize them to take on more debt.
3. More predatory lending. Consumers who can no longer get loans from regulated players rely on more dangerous credit options. The informal lenders are not regulated and can therefore employ harmful tactics such as aggressive collection practices.

Not only are interest caps potentially harmful, they are also arbitrary. The famous 36% cap used in several states and set as a limit by Google’s advertising disclosures dates back more than 100 years and is based on an arbitrary 3% per month limit. Who’s to say 36% is sustainable? If we have learned anything about risk based pricing it’s that there is no “one price fits all”.

The line between being financially inclusive and predatory is not 36% —it‘s not about cost, it’s about impact.

Let the rules of supply and demand play its course

Competition and transparency are likely more effective than interest rate caps in lowering the rate of borrowing: more competition means lower prices and therefore lower profit margins for payday loan shops and more money back in the pockets of consumers.

Assuming a competitive and transparent market, the best rate offered for a given customer is one at which companies break even, truly representative of the perceived risk of the consumer. If there were ways for companies to charge lower rates in such a market, one certainly would in order to gain market share.

So let the market set the price. Instead, regulators should define rules for lenders to follow that enable consumers to succeed.

The goal of regulation should be to ensure transparency and fairness for consumers, without damaging fair competition. In the US, the CFPB has done incredible work in this space such as the passing Final Rule in 2019 to protect consumers from predatory lending practices. Many emerging markets are still far behind the US in terms of consumer protection and should follow suit.

There are several areas where the free market fails and regulation is necessary to protect consumers:

• Accurate Marketing and Accounting: Ensure product terms and customer experience are clear, accurate, and intuitive during the entire customer journey. For example, SOFI was sued recently for marketing a benefit that the majority of customers do not receive. Some lenders rely on hidden fees, complex schemes, or confusing screens during the application process to hide the true cost of borrowing. In the US, such action are regulated under UDAAP (Unfair, Deceptive, or Abusive Acts or Practices). Also ensure the lender’s terms and conditions accurately match what actually happens during loan servicing (e.g. does the interest charged match the interest disclosed?).
• Privacy & Info Security: Force lenders to disclose to consumers how their data is being used and to maintain adequate security measures such as data encryption. For example, some lenders monetize consumer data illegally by selling it to 3rd parties.
• Equal Treatment: Prohibit unfair and discriminatory practices such as disparate treatment (e.g. asking people of lower income zip codes for additional information) and disparate impact (e.g. declining more frequently people of color). In the US, this is governed under the Fair Housing Act (FHA) and the Equal Credit Opportunity Act (ECOA).
• Fair Assessment of Ability to Afford Debt: Ensure that lenders adequately consider the borrower’s ability to take on debt when evaluating them for credit (e.g. can the borrower’s income minus existing obligations cover the cost of the loan?). Some lenders ignore this and compensate for the higher rate of default with additional fees and aggressive collection practices which leave borrowers significantly worse off.
• Formal Complaints Processes: Force every lender to implement a formal process to review, respond to, and address any customer complaints in a timely and accurate manner. This ensures that customers have a voice, provides visibility into predatory practices, and holds lenders accountable to fixing any problems.

There are many more aspects of FinTech lending that are or should be regulated. This list aims to illustrate areas where consumers cannot protect themselves.

Investors play a critical role in strengthening financial inclusion through their investment decisions. Capital makes or breaks the growth of a startup, and often times determines who will win. Many investors state they only want to invest in financially inclusive players who are mission driven, but struggle to define what this means, often deferring back to laws and regulation.

To be financially inclusive, FinTech players should exceed regulatory expectations which set a low bar when it comes to customer experience. Here are 6 guiding principles any socially minded investor should use to ensure a FinTech lender is inclusive:

1. Are customers satisfied with the product? Investors should invest in products with exceptional customer satisfaction. Simply put, FinTechs are not inclusive if the majority of customers are not satisfied with their product. Players should regularly measure, assess, and report on customer satisfaction at the board level. Such a metric (e.g. NPS or CSAT) should cover the full breath of consumers to accurately depict how a company is treating its customers.
2. Is the company regulated by a formal entity? Invest in FinTech companies that are formally regulated. Regulation is required to ensure companies adhere to fair lending practices they otherwise would not be incentivized to follow. Review the companies’ previous regulatory exam outcomes and ensure there is an adequate monitoring and testing programs. When investing in regions that have less robust regulation, ensure that companies have internal compliance programs that cover all concepts outlined in the previous section.
3. Is the product competitive compared to alternatives? Investing in companies that offer worse products compared to the market does not only hurt consumers, but is most likely a poor investment decision in the long run. Ensure the product is competitive compared to other products for the same customer segment. This means that the total cost of borrowing for the average customer (including fees and interest on the average loan amount and duration) is in the top tier of what is offered on the market.
4. Does the lender share creditworthiness data with regulated third party agencies? Invest in companies that report repayment behavior to a third party bureau so that consumers can build their credit profile. This helps consumers build their credit score and get access to a full breath of financial services from other providers over time. Keeping such data proprietary is a short-term competitive advantage but in the long term consumers and the ecosystem as a whole are worse off.
5. Does the product incentivize financially healthy behavior? Invest in companies that reward borrowers who show positive repayment behavior with better products. Such incentives include more available credit, lower rates or fees, more rewards, free advising, etc. Ensure these incentives do not push consumers to take on more debt than necessary. Such practices can be more impactful than financial education in helping customers change their behavior to be more financially responsible. They also increase customer retention and lifetime value.
6. Does the product help improve customer’s financial health? Ultimately, a financially responsible lender improves the borrower’s financial health. Customers may be satisfied with the product but if they are worse off, the product is not helping. In Kenya for example, over 60% of online borrowers default on their digital loans indicating that lenders may be negatively impacting customers. Leverage expert frameworks such as the Financial Health Network to survey customers against control groups and measure the company’s impact.

Regulators and investors are critical forces in the startup ecosystem to ensure that successful FinTech companies are financially inclusive. The wrong regulation could leave consumers worse off. The right investment could even the odds for the underbanked. Hopefully this framework provides a launch point for how to think about this important topic from the regulator and investor perspective.

Many thanks to Jared from Accial Capital for the inspiration and Accion’s Center for Financial Inclusion for their guidance on Responsible Digital Credit. Are you working in the Financial Health space? Reach out!