Digital financial services and their challenges to microfinance institutions – from the microfinance investment funds perspective

Digital financial services and their challenges to microfinance institutions – from the microfinance investment funds perspective

(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 17^th to 31^st 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

1. Introduction

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:

1. Speed: Transactions can be performed quickly and with less or no intermediaries. Travelling large distances, sometimes required in remote places, can be avoided

• Security: Although cybersecurity risks are higher, cashless transactions are overall less risky,  

• Transparency: Documentation, traceability and customer data recording when using DFS improve transparency and with this, reduce transaction risks

• Cost Reduction: More efficient operating model although requirements of economy of scale can limit technology penetration

• Access: With DFS technology accessibility is improve even for customers with volatile and small income.

The before mentioned benefits from DFS can be used to leverage further improvements in both the supply and demand side of financial inclusion services:

1. Demand: Demand of financial services is increased by lowering access barriers, removing limitations due to customer identification, reducing distance barriers, and giving the possibility to service providers to offer a more customized digital product

• Supply: Supply of financial services is increased by reducing intermediary and operating costs (although CAPEX upfront investment costs remain significant, and hence the need of economies of scale), increasing competition and facilitating information flow.

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:

1. Mobile payments
2. Money accounts
3. Digital Lending
4. Alternative credit scoring
5. Micro-insurance and embedded micro insurance products (systems usually leverage other technologies such as satellite imagery, artificial intelligence)
6. Biometrics Identification
7. Pay as you Go asset financing
8. Government to Person payments

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.    

2. Future Opportunities

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:

1. Expansion of digital identification software (include but not necessarily limited to biometric systems). Access to traditional financial services typical requires extensive documentation for authentication, which is not necessarily available or possible in certain remote areas. To increase financial inclusion, technologies that allow simpler identification methods (permitted by law and regulation), for example biometric IDs, can further enhance financial inclusion. One example is India, where the Biometric ID program gave the possibility for a cheap, reliable, and fast ID authentication.

• Openness of application programing interfaces (API) to access data faster and at lower prices. Developing an infrastructure in which different systems can exchange information, based on a set of APIs can serve as a foundation for an inclusive financial sector.

• Flexible Electronic Payment systems that allow users to use their preferable (and less expensive) system irrespective of the nature and location of their bank account.

• Digital currency (blockchain virtual currency or e-fiat national currencies)

3. Future Risks

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:

1. Unequal access to DFS. Currently the access to technology remains uneven across the different social layers and genders, particularly limited access to the women and the poor.

2. Predatory lending and finance illiteracy: reaching large numbers of customers with DFS can lead to predatory lending practices and eventually to high levels of over indebtedness. Therefore appropriate legal and regulatory frameworks will required. This includes the creation of banking licenses and reporting controls, for example.

3. Cybersecurity risks are inherent in any digital solution. For a fully interconnected and integrated financial system, the risks of hacking or the risks of security breaches through an ad-hoc digital service represent a very large risk that needs to be mitigated by technological and structural solutions.

4. Unauthorized access to digital data. For users, data privacy concerns arise from data trails generated by the DFS which can expose to unauthorized access. Proper regulation and solutions should be implemented and facilitated to ensure data remains private and confidential.

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:

1. Recognition that Individual clients are affected differently by the crisis. The results showed that the best MFIs where those which engaged with their clients in a different and customized way. These MFIs identified their client situation and the impact of the crisis. The institutions went beyond from just simply managing a crisis scenario to managing the client relationship. To be able to compete and obtain a similar level of customer loyalty, FinTech organizations offering DFS will need to develop these capabilities. Although artificial intelligence and other algorithms can support the process, FinTech organizations will require years of experience to successfully internalized these capabilities.

2. Preparation to handle different scenarios when a client is in difficulty. FinTech organizations and other DFS providers are capable to prepare and plan for concrete solutions and algorithms to determine the policies and procedures to handle difficult clients. Nevertheless, training and client relationship will remain key to find appropriate restructuring options and eventually achieve a better outcome form these situations. (loan extensions instead of loan impairments, for example.). Therefore, FinTech organizations will have to develop these capabilities that today remain inherent in the traditional Microfinance business model

3. Successful organizations have middle and senior management fully engaged to the cause and mission of the institution. They represent the values and the identity of the institution. In other words, they show the true character of the institution and the level of care they take to their social and financial inclusion mission. Having a strong social mission and an active management will create strong relationship with clients. Clients and stakeholders will recognize that the institution have a social commitment and strive for more than only profitability. Customers will field the institution “have their back”, and therefore they will remain loyal and reduce their delinquency levels. Today, mission statements of FinTech organizations do not necessarily emphasize as priority, their social and financial inclusion objective. To access the population excluded from the traditional financial system, it is then fundamental that FinTech organizations formulate and live their social mission statements.

4. Establish a phases process to crisis management. Most of the MFIs that have proven successful during the COVID crisis had established a crisis management plan, including the following phases:  
   1. Immediate response to crisis
   2. Adjustment to crisis (management adjustments)
   3. Regrowth strategy (start recovery)
   4. Stop and Go – new phase
   5. Rapid recovery

5. Resilience and evolution of Business Model. The pandemic has also shown that digital financial services, and data analysis are and will be essential for MFIs to remain competitive. As mentioned previously, end customers will get tangible benefits if they have access to efficient and inclusive money transfers (digital wallets), access to digital cash and savings accounts. MFIs can also leverage their capabilities for digital lending and alternative credit scoring, optimize their data collection, etc. All these DFS services are offered by FinTech organizations and therefore, MFIs should eventually integrate these services and develop these capabilities.  

Conclusion

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.

Works cited

1. Ceyla Pazarbasioglu, World Bank Group, “Digital Financial services”, April 2020