November 24, 2022
  • November 24, 2022

Digital lending to low-income customers needs careful consideration

By on October 16, 2022 0

The small note lending space has seen a flurry of regulatory activity lately. The Reserve Bank of India (RBI) has issued regulations for microfinance. To address customer protection issues attributed to digital lending practices, RBI has taken several steps in quick succession. It banned the loading of prepaid instruments issued by non-banks via credit lines, notified the recommendations of its digital lending task force and issued guidelines for it. These regulations define digital lending as “a remote and automated lending process primarily through the use of transparent digital technologies.” At the same time, industry reports have highlighted that more than 60% of digital lending via mobile platforms and apps are low New Income Borrowers (NTC). Lending to these customers using a remote and automated process is a powerful mix. In our quest for innovation, we must pause to reflect on the why, what and how of these loans and their impact from the client’s perspective The well-established microfinance (MF) model has embraced digitalization in a calibrated way while maintaining customer orientation.

The MF group lending model was an innovation that catalyzed the provision of microcredit to low-income NTC borrowers in the early 1990s. Lending to these borrowers had been a challenge due to the inability of banks to provide loans of low value without guarantee. Microfinance institutions (MFIs) have overcome the information asymmetry inherent in these loans due to a lack of documentation and data by accessing information embedded in their social networks through the joint liability group loan model. This required innovations in product design, processes, and customer engagement based on consumer behavior. The MF model focused on home-based service delivery, an understanding of client livelihoods and cash flows, and low operational costs. Supported by a favorable regulatory environment, lenders using this model serve approximately 60 million urban and rural customers.

Over the past decade, the MF sector has digitized while keeping financial literacy levels and changing consumer behavior in mind. It now deploys an optimal mix of technology and human contact. A separate credit bureau for MF loans was created in 2011 and now all loans and repayments are reported to the credit bureaus. MFIs and banks of non-banking finance companies have invested in a technological framework to allow data to be uploaded to credit bureaus on a daily or weekly basis. Faster processing of loan applications and customer complaints is achieved through the use of tab-based solutions. A field force of nearly 200,000 people provides an assisted digital interface to borrowers. Know Your Customer documents are read using Optical Character Recognition and verified using API integration with the KYC Central Registry. The underwriting models use data on credit experience with different customer segments and necessarily use credit bureau reports. Nearly 100% of microfinance loans are disbursed digitally. At the same time, efforts to make borrowers comfortable with digital repayments have yielded good results. All of these initiatives are in addition to weekly or bi-weekly group meetings attended by the lender’s field officers to provide the human touch necessary for the provision of last mile financial services.

Lending to low-income borrowers from NTC must operate on a “savvy seller” model, keeping in mind their level of financial literacy. For an NTC borrower, this literacy is acquired over time through experience with financial products, peer-to-peer discussions, and regular interactions with the lender. We should ask ourselves if digital interactions can replace this organic process.

Microfinance regulations require the lender to ensure that annual loan repayment obligations are capped at 50% of the indebted household’s annual income. Lack of documentation, multiple streams of income and the seasonality of cash flows make estimating income and expenses an intensive exercise. The use of proxy indicators is a poor substitute for face-to-face interactions and risks inadvertently pushing borrowers into over-indebtedness. As the use of credit reports becomes a central element of underwriting, delays in repayment by these borrowers could in fact lead to their “financial exclusion”. Coupled with a remote complaints resolution system, these problems could become widespread: a study by FINCA International showed that only 30% of customer complaints are filed through a formal system; the rest are handled by ground staff in regular interactions.

A customer-centric approach to digitizing the lending process has the potential to deliver widespread benefits. The regulations issued by RBI have several positive aspects, such as a mandatory free examination period during which a borrower can cancel a loan, the publication of a statement of key facts with details of interest rates and others conditions, and the requirement of client consent before increasing a loan amount.

At the same time, there are other features of remote and automated lending that would benefit from closer examination. These concern the assessment of income and repayment capacity, protection against over-indebtedness, the promotion of financial literacy and also the redress of grievances.

These are the personal opinions of the authors.

Alok Misra and Vinay Kumar Singh are, respectively, CEO and Director, and head of the self-regulatory organization, Microfinance Institutions Network (MFIN)

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