1 FOCUS NOTE | May 2019 FINTECHS AND FINANCIAL INCLUSION Gayatri Murthy, Maria Fernandez-Vidal, Xavier Faz, and Ruben Barreto Looking past the hype and exploring their potential May 2019ACKNOWLEDGMENTS The authors thank the 18 fintechs and their staff referenced in this paper. The insights presented in this paper are gleaned from their experiences of bringing their innovative services to market. We also thank their customers who shared their time and their views with us. Lauren Braniff, Jayshree Venkatesan, and Fernando Barbon, all financial sector specialists and CGAP consultants, contributed to the insights presented in this paper. We are also thankful to the Busara Center for Behavioral Economics for its intellectual partnership and contributions to this paper. Wed like to thank the Department for International Development (DFID), United Kingdom, and the Mastercard Foundation for funding for the fintech pilots and associated work discussed in this report. Consultative Group to Assist the Poor 1818 H Street NW, MSN IS7-700 Washington DC 20433 Internet: cgap Email: cgapworldbank Telephone: +1 202 473 9594 Cover photo by Hung Dao Tran, CGAP Photo Contest. RIGHTS AND PERMISSIONS This work is available under the Creative Commons Attribution 4.0 International Public License (creativecommons/licenses/by/4.0/). Under the Creative Commons Attribution license, you are free to copy, distribute, transmit, and adapt this work, including for commercial purposes, under the following conditions: AttributionCite the work as follows: Murthy, Gayatri, Maria Fernandez-Vidal, Xavier Faz, and Ruben Barreto. 2019. “Fintechs and Financial Inclusion.” Washington, D.C.: CGAP. TranslationsIf you create a translation of this work, add the following disclaimer along with the attribution: This translation was not created by CGAP/World Bank and should not be considered an official translation. 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All queries on rights and licenses should be addressed to CGAP Publications, 1818 H Street, NW, MSN IS7-700, Washington, DC 20433 USA; e-mail: cgapworldbankFOCUS NOTE | May 2019 CONTENTS Introduction 5 Section 1: Emerging innovation areas 11Innovation 1: Interactive Customer Engagement 11Innovation 2: Smartphone-Based Payments 15Innovation 3: Connections-Based Finance 19Innovation 4: Location-Based Smallholder Finance 21Innovation 5: De-Risking Unproductive Expenses 24 Section 2: Fintechs as catalysts for financial inclusion 28Internal challenges 28External challenges 37 Conclusion 40 References 411 FOCUS NOT E | May 2019 EXECUTIVE SUMMARY F INTECH COMPANIES COMBINE TECHNOLOGY WITH ACCESS TO data to deliver new financial services and experiences to customers. They have been proliferating in emerging markets and developing economies (EMDEs), and some are creating solutions specifically for underserved, low-income, or remote customers. Yet for all the general excitement that fintechs have generated in the global development community, there is little information available about how specific fintech innovations solve pain points in financial inclusion. In 2016, CGAP launched a program to understand fintech innovations and draw clear links to financial inclusion, where they existed. We supported pilots with 18 fintechs in Africa and South Asia that targeted financial services to low-income or underserved customers. Our goal was to explain innovations in a detailed way and generate insight on whether the services (i) work as stated, (ii) create value for underserved customers, and (iii) ease age-old pain points in delivering financial services to underserved customers. This paper is written for funderswhether donors, investors, development finance institutions, or philanthropic organizationswho engage with fintechs to advance financial inclusion. Based on CGAPs work, it identifies five types of fintech innovation that offer potential for financial inclusion. We also highlight challenges that these fintechs, particularly those in early stages, face that inhibit their ability to impact financial inclusion. Key Findings FINTECHS ARE BRINGING INNOVATION TO EVERY PART OF THE FINANCIAL SERVICES SECTOR The excitement around fintech is not without merit. Fintechs are innovating at every step of the financial services value chain, often through new value propositions, including flexible products and better ways to address the financial challenges faced by low-income customers. They are making financial services more affordable and accessible. They are improving the customer experience of financial services and accelerating use and engagement. They are also building the groundworkincluding easier digital identity verification, collaborative customer due diligence, data sharing, and payment schemes that can catalyze a host of financial services. 2 FINTECHS AND FINANCIAL INCLUSION | Executive Summary FIVE INNOVATION AREAS DISPLAY THE POTENTIAL FOR FINTECHS TO IMPACT FINANCIAL INCLUSION The following list is not an exhaustive set of innovations in the fintech space, but each represents a powerful idea for financial inclusion. While most focus on payments and credit today, we expect there will be a diverse array of products in the future, as providers capture more data about their customers and are able to provide other services at marginal cost: Interactive customer engagement. Fintechs are using SMS and other communication tools to reduce the cost and effort of engaging with customers. These tools ease complaint resolution, feedback gathering, and information dissemination. The result is greater use, trust, and loyalty. See Table ES1. TABLE ES1. Interactive customer engagement pilots Fintech Service Juntos Mobile messaging and customer service Arifu Mobile advice and information Peoples Pension Trust Mobile nudges and incentives to encourage long-term savings Smartphone-based payments. Fintechs are delivering intuitive, engaging smartphone- based payments applications with low data costs and low storage requirements. These solutions are reducing account dormancy and expanding use cases for payments. See Table ES2. TABLE ES2. Smartphone-based payments pilots Fintech Service Wave Money Payments app NALA and Hover Payments app with no data requirements Fundu P2P ATM app Connections-based finance. Fintechs are creating or leveraging social connections to build customer creditworthiness and offer connections-based finance for low-income people who cannot easily access cheap, timely credit to bridge cash-flow gaps. See Table ES3. TABLE ES3. Connections-based finance pilots Fintech Service M-Changa Digital crowd-funding site MaTontine Digital savings groups and credit advance Pezesha Digital P2P lending Patasente Digital lending marketplace for MSMEs Social Lender Social-score-based lending 3 FOCUS NOTE | May 2019 Location-based finance. Fintechs are using satellite data and machine-learning techniques to analyze physical location and offer insurance or credit at reduced cost to smallholders, who are some of the worlds most excluded groups. See Table ES4. TABLE ES4. Location-based finance pilots Fintech Service Farmdrive Digital loans for farmers Apollo Digital loans for farmers Pula Satellite data-based digital insurance De-risked nonproductive finance. Fintechs are helping low-income people pay sizable or unexpected expenses while using unique features to reduce risk for the financier. See Table ES5. TABLE ES5. De-risked nonproductive finance pilots Fintech Service Microensure Digital health insurance bundled with microcredit Tulaa Digital credit for farm inputs Biolite Energy products on credit F UND ERS H AV E A RO L E T O PL AY IN S UPP OR T IN G E A R LY-S TA G E F IN T ECHS The funding that reaches EMDEs primarily goes to more established fintechs that have proven their business models. Without support from “angel” investors, many early-stage fintechs struggle even though they may have potentially game-changing ideas. Supporting these fintechs could unlock innovation and produce relevant lessons for the entire financial services market. However, because their business models are unproven, they may be too risky for private capital. Global development and impact investing communities can invest patient capital, but they may need to take the following steps: Bring clarity to a crowded marketplace of ideas. Fintech innovation is varied, and because much of it is new, there is a lack of universal understanding of new business models and their potential to scale. Link solutions to financial inclusion. There are too few metrics for success and impact on financial inclusion goals. Extract lessons from successes and failures. Global lessons about how fintechs attempt to resolve pain points in financial inclusion would provide a realistic sense of fintechs effects on financial inclusion.4 FINTECHS AND FINANCIAL INCLUSION | Executive Summary FINTECHS FACE A UNIVERSAL SET OF INTERNAL CHALLENGES Funders should be aware that all fintechs must overcome one or more of these four internal challenges, particularly during early-stage innovation: Develop a clear value proposition. Since financial services for the poor are scarce in emerging markets and competition is low, fintechs often fail to invest enough time to test and articulate their value before launching services. Assemble the right human and technological resources. Having all three core skills and resourcestechnology, market insight, and leadershipcan be rare for start- ups in emerging markets. Balance digital and in-person customer interaction. Ensure underserved customers are comfortable using unfamiliar services or technologies that may require in-person interactions. However, a business model that relies heavily on physical interactions through stores and agents may limit the ability to scale. Form strategic partnerships. Many early-stage fintechs depend on partnerships to get their ideas off the ground, either because they lack scale, capabilities, or adequate licensing. However, their newness and size may make it difficult for them to forge equitable partnerships with established institutions. Conclusion After two years of experimentation, we see preliminary evidence that fintechs have the potential to affect financial inclusion, but more granular research is needed. Going forward, CGAP will support the global development sector, policy makers, and the impact investing industry by facilitating a common understanding of emerging business models in fintech that have the potential to advance financial inclusion. We will also extract granular lessons from fintech innovations that can shed light on what creates value for the poor and on the limitations of new approaches. 5 FOCUS NOTE | May 2019 INTRODUCTION A NEW SET OF TECHNOLOGY-BASED COMPANIES ARE disrupting the financial services market globally. Fintechs, as they are called, have developed a market presence in the decade since the 2008 financial crisis. They have garnered attention because they combine technology with access to alternative data and innovative approaches to deliver new kinds of financial products, services, and experiences to their customers. They have challenged business-as-usual by being nimbler, serving underserved segments, or improving unit economics. Their success is reflected in the number of customers that adopt their services and how they influence established financial institutions to compete with more innovation and more customer-centric features and services (PWC 2017). Fintechs often begin as start-ups, but many have scaled dramatically. SoFi, a credit marketplace founded in 2011 to offer digital, unsecured loans had issued more than US$9 billion in loans by 2016 and expanded to offer personal finance, billing, payments, insurance, and even pensions (CNBC 2016). Robo-adviser Betterment uses big data to reduce the cost of investing for a large base of U.S. customers. 1It charges customers just 0.25 percent of their assets every year and does not require a minimum balanceall offered through a user-friendly, interactive interface. After 10 years, Betterment manages US$13 billion in investments. Until recently, the fintech phenomenon was largely limited to developed markets. Now, fintechs are beginning to disrupt the financial ecosystem in emerging markets and developing economies (EMDEs) as well. While most solutions globally still focus on affluent customers who are well served by financial services, some fintechs are creating solutions specifically designed for underserved low-income customers. The rise of fintechs such as PayTM, Zoona, Jumo, and Cellulant in EMDE markets inspired CGAP to study them to understand their potential effects on financial inclusion. Fintech innovation and the role of fintech firms Fintechs are not alone in using technology to innovate. The term “fintech innovation” refers to activities by a broad range of actors, including incumbent financial institutions, and others. In fact, established financial institutions (e.g., banks, credit card companies) around the world are using innovative technologies for improving everything from customer complaint 1 Robo-advisers provide financial advice or Investment management online with moderate to minimal human intervention. They provide digital financial advice based on mathematical rules or algorithms Some fintechs are creating solutions specifically designed for underserved low-income customers. 6 FINTECHS AND FINANCIAL INCLUSION | Introduction resolutions to fraud control. When innovation is combined with an established institutions scale, brand recognition, and trust, the potential for impact can be high. In practice, however, adopting innovation has proven to be challenging for established organizations. Legacy IT systems, heavy operational processes that are difficult to change, and a business model that relies on physical infrastructure make the cost of transformation high and limits the potential for reaching underserved segments. Nevertheless, Equity Bank in Kenya, Capitec in South Africa, and DigiBank in South East Asia are examples of established financial institutions that use innovative technologies to grow and expand their offering in emerging markets. 2 On the other hand, fintechs typically begin as small firms with an innovation culture. Their size and newness give them the agility to change and develop infras