(An article written by InFiNe.lu scholar Alejandro Vazquez, on his experience attending the Back to Boulder programme 2022).
This note focuses on my personal insights and learning outcomes, particularly as fund manager of LMDF, a Microfinance Investment Fund, from the module 5 “Digital Financial Services” of the Back to Boulder (B2B) training held in English and French between March 17th to 31st 2022.
This note starts by summarizing the literature presented in the course in relation to the digital financial services available, their benefits and the future opportunities and risks identified.
Secondly, this note gives an insight on the challenges that Microfinance Institutions (MFIs) face or will face with the evolution of the DFS and FinTech organizations, more specifically on how quality of MFIs is evaluated from the point of view of a Microfinance Investment fund.
Finally, this note ends with a short conclusion and references for further reading.
Digital Financial Services
The Boulder faculty presented the main conclusion drawn from the World Bank report on Digital Financial services. The report concludes that expanding the use of digital financial services (DFS) will support economic development and poverty reduction, the same way as countries with deeper and more developed financial systems achieve higher economic growth and income equality.
The report identified the following benefits obtained from the DFS technology:
The before mentioned benefits from DFS can be used to leverage further improvements in both the supply and demand side of financial inclusion services:
The report also highlights that the main DFS available are focused on the following services, ranging from those with a larger track record to those with limited used or just emerging:
One of the main setbacks of DFS remains the prerequisites for the deployment of technology, which translate into a significant amount of CAPEX investment needed upfront. For example, remote areas still need investment to develop mobile broadband and agent networks.
In recent years, and boosted by the COVID19 pandemic, FinTech organizations have played a significant role to enlarge the offering of mobile broadbands and consequently of DFS. For example, in Kenya, these FinTech organizations have already leveraged mobile phone penetration to offer money accounts and transfer services, that otherwise were non accessible.
Now, DFS continue to evolve and offer new digital services generating new business models. One example is the use of Virtual currencies, that can be used not only to settle money payment transfers between parties but also used as saving accounts and short-term treasury deposits. Another relevant example is the use of block chain smart contracts to mitigate and transfer risks or the use of the eKYC technology to accelerate, or even automate loan approval documentation.
As per world bank report points out, DFS have further expansion opportunities to improve financial inclusion to the poor but these opportunities remain untapped mainly also because of the complexity involved in preparing the appropriate legal and regulatory frameworks in the industry and foster proper levels of competition.
Some of the main opportunities identified with potential success in the short to medium term are:
While the benefits of digital financial services to the poor are well documented, the literature also covers a list of different risks that are inherently introduced by them. Some of the main risks introduced by DFS include:
Challenges of DFS services to MFIs business models
Today leaders of the Microfinance sector, including asset managers and investment fund managers, are questioning how the FinTech organizations and Big tech companies, relatively new to the industry, can further expand their DFS offering and, in certain cases, directly compete and challenge the traditional Microfinance business models.
One example is the quick access to liquidity. Through DFS, the FinTech organizations can provide almost immediately and at very low costs the required liquidity that sometimes is lacking from traditional financial services and to which traditional MFIs cannot respond immediately.
Although DFS capabilities have large opportunities, as described in previous section, Microfinance Investment Funds are required to select, within their niche, the best institutions that can ensure financial inclusion and alleviate poverty. The role of investment fund managers is to determine the appropriate risk/ return profile acceptable for for each MFI investment
To discern between the different MFI and calculate their risk return profile, Microfinance Investment Funds, such as LMDF (Luxembourg Microfinance and Development Fund) will perform detailed due diligence. The investee will be analyzed in relation to its governance, its financial performance, its portfolio quality, its market positioning, etc. One way to also complement this analysis is to analyze how the MFIs react to crisis situations and how its system and services perform. It is during the crisis situations that critical subtle differences can make the difference to fund’s portfolio performance.
As observed from the COVID19 pandemic results, the best Microfinance organizations were those that focused on the following priorities:
From the perspective of a Microfinance Investment Fund, Digital Financial Services (DFS) offered by FinTech organizations and larger big tech companies will not replace, at least in the short term, the role of Microfinance Institutions. On the other hand, Microfinance Institutions should look how to develop their digital financial services offering as they will become an essential element of success. MFIs can do so by establishing partnerships or alliances with FinTech organizations that have developed these offerings already, or by internalizing this expertise. What is clear, however, is that for the mid to long term future, Digital Financial Services will be an essential added value to the Microfinance industry with significant benefits.
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Picture 1 © Pallab Seth