Africa Finance Forum Blog
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In the industrialized countries of North America and Western Europe, financial innovation has acquired a bad connotation after the recent crisis, being associated with CDO, CDS and other three-letter abbreviations, which few understand. However, innovation is more than that and comprises numerous new products, new processes and new organizational forms. As I will argue in the following, innovation can be an enormously positive force, even in the financial system and especially in Africa. However, in order to reap the benefits of more innovation, a different regulatory approach is needed than currently present in most African countries.
Financial innovation comprises a variety of new products, new processes and new organizational forms that can help reduce transaction costs, provide better risk management tools and overcome information frictions. Recent examples in Africa include (i) mobile banking, i.e. access to basic payment services through mobile phones, even without having to have a bank account, (ii) the use of psychometric assessments as a viable low-cost, automated screening tool to identify high-potential entrepreneur, (iii) agricultural insurance based on objective rainfall data, and (iv) new players in the financial systems, such as micro-deposit taking institutions, and cooperation between formal and informal financial institutions. Examples from other regions include agency agreements between banks and non-financial corporations (supermarkets, post offices etc.) to deliver financial services to remote and low-income areas, joint platforms for banks to provide factoring services to small enterprises, and private-public partnerships for infrastructure, often supported by international risk mitigation mechanisms.
Financial innovation can be critical in overcoming the two main challenges that financial intermediation faces in Africa: the high costs and the high risks. Take the example of mobile banking. First, it relies to a greater extent on variable rather than fixed costs, which implies that even customers who undertake small and few transactions are viable or bankable relative to banking through conventional channels. Second, trust can be built much more easily by reducing the risk from the customer’s and the provider’s viewpoint. Financial innovation can thus be critical in helping reduce the large share of population that is currently unbanked in Africa. Similarly, new institutions and new products can help overcome the challenge of long-term financing in Africa.
How does financial innovation come about? First of all, incumbent financial institutions are rarely interested in innovating unless forced to do so by competitive pressure. Africa’s banking systems, however, are mostly small and of limited competitiveness. Second, financial innovation cannot be introduced per regulation. It is introduced by market players – mostly private, though not always profit-oriented. Such innovation often comes from unexpected quarters. In Kenya, Equity Bank transformed itself from an underperforming building society into an innovative bank and is now the largest bank in the country in terms of clientele. It did this by offering new delivery channels, such as mobile branches, by targeting a new clientele, and by focusing on the quality of service delivery. These experiences suggest that an open, contestable banking system is needed and that new providers might come from outside the established market.
There are different approaches towards innovation. The traditional regulatory approach is that of “proper sequencing” - legislation-regulation-innovation. This process can take years, however. An alternative approach is one of try-and-see or test-and-see, as applied by regulators in Kenya with respect to M-Pesa. Such an approach is not be confused with a laissez-faire approach. It requires an open and flexible regulatory and supervisory approach that balances the need for financial innovation with the need to watch for fragility emerging in new forms. Such an approach can take into account the unexpectedness of innovation, in terms of needs, technical possibilities and origin.
In the forthcoming Financing Africa: Through the Crisis and Beyond flagship report, my co-authors and I advocate for the second approach, one of a more open regulatory mindset. This does not mean that there should be an open-door regulatory environment to permit all and sundry to offer deposit-taking services and that regulatory authorities stand by silently as the financial system is changed through innovation. On the contrary, the success of M-Pesa and the possible dominance of the mobile payment market by Safaricom show the need for an active regulatory approach to prevent the potential entrenchment of a monopolist. Similarly, excesses in payroll lending – an innovation initially welcomed for extending credit services to previously unbanked - show the need for an active approach to consumer protection to avoid overindebtedness on the household side and financial fragility on the supplier side.
Such a more open regulatory mindset towards innovation also implies looking beyond the banking system and incumbent financial institutions towards new potential providers. Ultimately, we care about the users of financial services – enterprises, households and governments. If current providers cannot provide the necessary services, look beyond them to new institutions, even if outside the financial system. This imposes higher strains on regulators as they have to supervise more according to services rather than institutional categories, but can come at a great benefit.
When evaluating new products and new delivery channels, regulators often cite concerns related to Know-Your-Customer (KYC) requirements, put in place for Anti-Money Laundering (AML) and Combating the Financing of Terrorism (CFT) purposes. More recently, regulators around the world, however, have moved towards a risk-based approach. Thus, for example, South Africa lowered the documentation barriers on basic financial products subject to monetary limits and certain other conditions, including that clients be natural persons, South African nationals, or residents and that the transactions be domestic.
In summary, Africa can benefit from financial innovation, both in extending access to financial services and in extending the maturity of financial contracts. To reap such benefits, however, a different regulatory mindset is needed.
Thorsten Beck is Professor of Economics and Chairman of the European Banking Center. Before joining Tilburg University and the CentER, he worked at the Development Research Group of the World Bank.
His research and policy work has focused on two main questions: What is the effect of financial sector development on economic growth and poverty alleviation? What are the determinants of a sound and effective financial sector? Recently, his research has focused on access to financial services by small and medium-sized enterprises and households. He is co-author of "Making Finance Work for Africa" and "Finance for All? Policies and Pitfalls in Expanding Access" and lead author of the forthcoming joint AfDB-GIZ-World Bank report “Financing Africa: Through the Crisis and Beyond.” His country experience in both research and policy work includes Bangladesh, Bolivia, Brazil, China, Colombia, Egypt, Mexico, Peru, Russia and several sub-Saharan African countries.