Fintech in perspective

Fintech is perhaps the most fashionable thing in the impact investment world today. There is a widespread belief that it can be transformative in addressing not just financial inclusion but poverty itself in a significant manner. 

Like with all fads, we need to be cautious about separating the hype from the reality. Evangelists cannot, by their very nature, entertain doubts and have to ride the bubble. And the converts are, again by their very nature, likely to be blind-spotted to the limitations of fintech.

As to evidence itself, the story is mixed and inconclusive. 

So here is an attempt to put the promise of fintech in its perspective. And I will not dwell on its undoubted benefits on the financial inclusion side which is already well-documented and part of the fintech folklore. I am therefore referring to those fintech companies offering lending and savings products, and not to digital and mobile money intermediaries.

A diagnostic of credit markets in developing countries reveals two important constraints. One, on the demand-side, the credit-worthiness assessment of borrowers is too expensive or unavailable, thereby either making credit too expensive or inaccessible to the vast majority of borrowers. Second, on the supply-side, the cost of capital (for lenders) is too high to facilitate affordable enough median loans and the volume of aggregate credit available (to such lenders) is too limited to meet the demand, thereby necessitating credit rationing that favours the more credit-worthy of borrowers. Regulatory restrictions and financial repression (arising out of fiscal dominance) amplify these challenges. 

Taken together, these two costs mean that the effective lending rate faced by the BoP market is at least 10-12 percentage points higher than the base lending rate in most low-income countries. 

Further, these are unlikely to disappear or even meaningfully lower in the foreseeable future, and even technology may have limits to significant lowering of these costs.

The presumption behind fintech is that it can lower the transaction costs (by enhancing credit-worthiness assessments, and reducing the general intermediation costs) and crowd-in capital (increase volumes). Let's examine each assumption.

For sure, fintech lowers the intermediation costs - after all digital transactions are cheaper than brick and mortar cash-in-cash-out transactions. While in theory digital trails make credit worthiness assessments easier, and that is indeed practically the case, the costs to bridge this information asymmetry are significant and the relative gains are less and trickier to realise. Also, as we are finding out now, in practice such digital trails with good enough quality are neither easy to accumulate nor disentangle. However, this, with time and technology could be significantly addressed. But it will take a good time, perhaps very long, before its impact is felt by those at the bottom of the pyramid. For those excited about big data, here is a cautionary note from no less a source that Ant Financial - big data ain't strong data!

The bigger challenge is with the assumption on the supply-side. For a start, given the local currency nature of the loans, in order to avoid asset-liability mismatches, it is only prudent that the refinancing credit come from domestic sources. 

Second, unlocking a large supply of domestic credit is very difficult. Domestic sources are of two kinds - deposits and capital markets. Deposit taking banks access credit through the former and capital markets, while a non-banking financial institution (NBFC) like a fintech credit provider accesses credit from either the banks or the capital markets or from the shadow financial sector. But each of these sources of finances are inherently limited in developing countries due to constraints that are not meaningfully impacted by the beneficial effects of fintech intermediation. Banks balk at lending to all but the most reputed NBFCs, whose clients are likely predominantly the non-poor. Capital markets are very narrow in every developing country, despite a very long and rich history of efforts to create both the supply and demand-sides of the market (Latin America is the best example). Shadow financial institutions, while thankfully small as on date, are unregulated and pose so many systemic risks that encouraging it is hazardous for countries where even the regular regulatory systems are so weak. One only needs to look at China where shadow financing has engendered so many excesses and distortions across the economy. 

Even thinking in terms of the value of fintech in boosting savings, thereby increasing the supply, runs into its set of challenges. At the aggregate level, the household savings rates in low-income countries are so low, and of this the financial (compared to property, jewellery, and other physical assets) savings rate is even less. And the adoption of fintech savings products by the low-income segments creates a set of very intractable behavioural challenges. 

In simple terms, there is a very rich body of research work that points to the multiple market failures that are responsible for the limited formal credit availability in these countries and none of them are likely to be addressed in any reasonable enough time and in any significant manner by fintech innovations. 

It is one thing for a fintech company to reach $50 m in assets, an altogether different thing to be doing $500 m, much less in the billions (or a market having 50 fintech lenders with $10 m in assets, compared to having just 3-4). No wonder that outside of China, fintech lending has remained still-born.

Other fintech innovations aimed at enhancing the efficiency of financial markets, too pose challenges. For example, some fintech providers have sought to position themselves as loan originators for banks. Now this, in turn poses a big challenge. An outsourced loan origination coupled with the ability of banks to securitise and sell their loan books poses a massive incentive distortion challenge for banks with systemic consequences - banks will have no incentive to ensure that the loans are of good quality. And we know what happened with just the latter in the US (from the housing market) during the financial crisis.

This is not to at all say that fintech innovation is a dead-end or not interesting, but merely to highlight the very formidable challenges, especially on factors outside the remit of fintech, that need to be overcome to realise significant sustainable gains from the entrepreneurship that abounds in the fintech sector.