Enhancing financial inclusion beyond alternative credit scoring: Empowering underserved markets

26/07/202406/08/2024

FSD Uganda

By Joseph Lutwama

Setting the scene

Alternative Credit Scoring (ACS) or use of non-traditional data such as airtime purchases and mobile money transactions to assess bankability, has been touted as one of the solutions that could open the formal credit markets to the underserved market segments.

Already widely used by emerging digital lenders-both fintechs and digital savvy incumbents, ACS has indeed extended the financial inclusion frontier for underserved market segments.

Such alternative data shades light on the risk profiles and untapped business opportunities of market segments that until now were considered untouchable and unreachable. Despite making in-roads into previously untapped credit markets through ACS, the cost of credit remains high and the amounts of credit available to customers in these new markets remains limited and for much shorter loan tenures. Therefore, if the credit markets are going to provide meaningful and lasting impact to these new market segments, we need to think beyond alternative credit scoring mechanisms.

The credit market environment

Despite gains made to date with over 60 percent¹ of Ugandan adults using mobile money financial services, active usage of formal financial services remains low. Less than 10 percent² of Ugandan adults access their credit from regulated commercial banks. Several reasons explain this state of affairs the major one being a lack of collateral.

Collateral is a prerequisite for anyone seeking for a loan from a regulated financial institution. In most cases this is physical collateral in the form of land or real estate property. While 70 percent³ of Ugandan adults own land, less than 10 percent⁴ have formally registered land titles. This renders their properties and land ineligible to act as collateral for any form of financial transaction.

A case has been advanced that there is more to credit risk than the availability of physical collateral. This line of argument presupposes that one can be credit worthy even without physical collateral, if they are running a profitable business or they have verified, consistent and regular income. This is information that previously was not accessible due to the high levels of informality among most Ugandan businesses. With the current prevalent use of mobile money, it is possible to capture and track a vast wealth of customers’ digital activity that financial institutions can leverage to offer financial services to previously underserved market segments. This has resulted in the increased adoption of alternative credit scoring mechanisms away from credit risk frameworks that rely heavily on physical collateral. A new product category of digital loans targeting a previously underserved market segments has emerged offered by both emerging digital credit providers and digital savvy incumbents.

These loans are usually very short term not exceeding 30 days and in rare cases not exceeding 6-12 months. They are tied to the personal and business financial transactions of the customer and they are designed not to exceed the volume and velocity of the money in the customer’s digital wallet. The maximum amounts one can borrow will be based on the money balances in one’s digital wallet and how many times they move money through their digital wallet. The higher the velocity and balances in one’s digital wallet the greater the chances of accessing a digital credit facility. However, this usually comes at a very high cost.

Taking the example of the MSE Recovery Fund, a liquidity facility that advances credit to micro and small businesses most of which do not have physical collateral. The digital lenders accessing the MSE Recovery Fund and using alternative credit scoring mechanisms have the highest costs of credit. One of the lenders charges an annualised interest rate exceeding 140 percent per annum. While this credit is issued in average tenures of not more than a week which has made it affordable, beyond a month the costs become untenable. Likewise on average the loan amounts do not exceed Ushs 500,000 on average. This keeps these customers perpetually small with limited or no capacity to grow and scale into much bigger businesses.

Beyond alternative credit scoring mechanisms

Therefore, much as alternative credit scoring increases the chances of accessing credit for previously underserved market segments, for most of the customers in these market segments it only magnifies their already high-risk profile. The result is limited credit limits at very high interest rates and in some adverse cases further exclusion. Therefore, if alternative credit scoring is going to have meaningful and lasting impact on the underserved market segments, it needs to be combined with business development support and financial capability training for the target customers. This will greatly reduce their risk profile and increase their chances of accessing much higher credit limits for much longer tenures than is currently the case.