Consumer Protection for Financial Technology in Emerging Markets

CONSUMER PROTECTION FOR FINANCIAL TECHNOLOGY IN EMERGING MARKETS

Risks faced by unbanked and underbanked consumers in digital credit and the technological and regulatory approaches to mitigate risk.

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Abstract

Digital credit is an evolving industry, particularly in emerging markets with tremendous income and business potential. The growth of this industry leaves low income and financially inexperienced consumers vulnerable to a range of risks. Our project aims to identify the existing and anticipated risks consumers face in accessing digital credit; analyze the intricacies of causes that drive risk; and assess risk alleviation approaches to determine their effectiveness in stemming risk, ability to propel financial inclusion and welfare contributions. Our research is comprehensive in mapping this digital credit ecosystem.

Understanding the landscape of digital credit will allow stakeholders to more effectively intervene and provide solutions to protect unbanked and underbanked consumers in emerging markets. For the Center for Effective Global Action, our project will contribute analysis to their work on digital credit, from the consumer protection and welfare perspective. We provide recommendations for future research based on identified gaps and assess the effectiveness of tested practices to allay consumer risk. This will help CEGA design their financial inclusion programming. For implementers and CEGA affiliates including digital credit providers, governments, NGOs, and researchers, our report will provide a big picture of consumer protection in this space to inform their activities.

Context, Goal and Project Objective

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Context

The rapid expansion of digital credit, defined as small loans provided instantly and remotely over digital channels, has created new, unique risks for consumers that do not exist in traditional credit markets. Three features of digital credit make these risks unique: Digital credit platforms are designed to reach households and merchants with little experience in formal finance; Digital credit is delivered online; Digital credit is largely deployed in emerging economies.

The central issue today is that actions to allay consumer risk have not kept up with this new technology. Risk mitigation approaches have either not been implemented by providers and/or regulators or remain untested. There is a dearth of evidence based analysis on the short- and/or long-run impacts of digital credit, specifically consumer vulnerabilities. While there exists a body of research and evaluations on the effectiveness of approaches that have been implemented, their reach and scope have been  limited. As a result, stakeholders including lenders, consumers, and policy-makers are making important decisions without full knowledge and critical assessment of consumers’ interaction with digital credit.

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Goal and Project Objective
Protecting consumers in the digital credit marketplace is the ultimate goal. Risk mitigation means that digital credit providers and regulators understand potential consumer risks and needs and implement proven practices to stem these risks without diminishing access to credit.

The project objective is to assess, in a comprehensive manner, the risks that consumers face in digital credit. The assessment is meant to fill the gaps in stakeholder knowledge, providing a whole picture of threats and means to address these threats. The objective facilitates the ultimate goal of protecting consumers because with complete information resource deployment in the forms of intervention and further research will be deployed more effectively.

Methodology

Methods

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Our methods of aggregating research and assessing consumer risk were conducted through:

• Literature review and background research to synthesize trends in digital credit pertaining to consumer protection. Relevant research included reports, studies, and academic articles which provided perspectives from consumers, digital credit providers, NGOs and government regulators.
• Interviews with relevant stakeholders and experts to codify results and analysis.
• Systems mapping to synthesize the digital credit ecosystem relevant to consumer risk.
• Analysis of relevant quantitative and qualitative data and research to identify the most salient features of risk mitigation for potential interventions and needed research. The analysis will inform decisions to invest in study, action, and innovation.

Landscape Map of Consumer Protection in Digital Credit
Mapping the consumer risk landscape includes the following topics that together provide an overview of consumer risk and risk mitigation strategies:

• Primary risks consumers face in the fintech space
• Causes that drive consumer risks
• Mitigation approaches that allay consumer risks and causes
• Examples of mitigation strategies that have been implemented

Ecosystem of Consumer Risk, Causes, and Approaches to Mitigate Risk

Consumer Risk 1:  Credit traps and Overindebtedness

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Predatory lenders and lending practices take advantage of consumers. Predatory lenders target people that have trouble borrowing from legitimate, formal lenders. These borrowers are often low-literacy and low-income, have bad credit and are unfamiliar with the credit apparatus. While people with a good credit scores and stable incomes have more options when borrowing money, targets of predatory lending tend to have fewer choices. As a result, they are susceptible predatory lenders who intentionally set high interest rates, additional fees, and rigid repayment terms. Borrowers are trapped in vicious credit cycles, with increasing debt and inability to make payments in line with the aggressive lending terms.

Cause 1.1: Lenders set higher interest rates than traditional banking.^[1]

Low income borrowers often take loans to pay off immediate expenses and to fulfill short term financial needs. Banks almost always turn down low-income applicants, leaving them with few options. Borrowers turn to private or informal money lenders. Lenders prey on borrowers’ low income status and lack of security to exploit borrowers through offering loans at high rates and quick and rigid repayment terms.  The instant influx of cash from informal lenders solves the borrower’s immediate problem but triggers a cycle of inability to repay and contributes to mounting debt. Poor financial capacity and the burden of high interest rates accumulating over time, trap borrowers and drives overindebtedness. Borrowers are tethered to the expensive financial product which diminishes their economic prospects.

Mitigation Approach 1.1.1: Setting interest rate caps through regulation (Implementor: Regulator)

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Interest rate caps have are a key component of many countries’ credit policies. Governments use interest rate ceilings to address consequences of high costs of borrowing and predatory lending. Governments also use interest rate caps as a form of subsidy to economically vulnerable groups.