In the last few years, the development of mobile banking and other digital services has drastically changed the financial landscape and extended the reach of financial institutions to people in poor and remote regions of the world. Between 2011 and 2014, 700 million adults across the world obtained an account for the first time, reducing the world’s unbanked population to 2 billion, underscoring the value of new technology. While the advances are encouraging, they also present new challenges and complexities and introduce new risks to be properly managed and regulated. The international community has recognized this. Starting in 2010 with the launch of the G20 Principles for Innovative Financial Inclusion, the G20 once again, in its communique following the recent Leaders’ Summit in Hangzhou, highlighted financial inclusion. Specifically, the G20 leaders endorsed the High-Level Principles for Digital Financial Inclusion, designed to “drive the adoption of digital approaches to achieve financial inclusion goals,” while addressing the challenges.
Along a similar vein, the Center for Global Development (CGD) continued its commitment to the subject of financial inclusion with the release this March of Financial Regulations for Improving Financial Inclusion. As co-chairs of the Task Force that produced this report, we are enthused to see much alignment between the High-Level Principles of the G20 and the CGD Task Force report. Three of the High-Level Principles in particular are directly comparable to our report:
Principle 2, “Balance innovation and risk to achieve financial inclusion,” encapsulates the analytical backdrop which frames Financial Regulations.
Principle 3, “Provide an enabling and proportionate legal and regulatory framework,” describes the core aims of the Task Force report and underlines the necessity of proper financial regulation.
Principle 7, “Facilitate customer identification for digital financial services,” emphasizes how strong national identification ID systems can improve Know-Your-Costumer (KYC) compliance, one of the three key focuses of the CGD Report.
Understanding digital services and managing risks
Principle 2 of the G20 involves balancing innovation and risk of digital financial services, including better understanding digital services offered via third party agents and mobile networks. For some time now, the G20 has stressed the need to better understand the level of risk posed by new products and services and to design rules that regulate financial service providers commensurate to those risks. The concept of a risk-based approach is one that has long been embraced by the financial inclusion community as well and is integral to Financial Regulations for Improving Financial Inclusion.
One of the fundamental challenges is how to balance greater financial inclusion with the traditional three mandates of financial system regulators and supervisors; financial stability (identifying and reducing financial system vulnerabilities), integrity (preventing financial crime and money laundering), and consumer protection (protecting consumers from fraud, abuse, and discrimination). Like the G20, the CGD Task Force report sees these mandates as not mutually exclusive, but, in fact, as mutually reinforcing: It is much more likely that a system will embrace financial inclusion if it is stable. Conversely, greater financial inclusion contributes to stability as it broadens and diversifies participation, and moves funds from the informal system to the formal system. Adopting the risk-based approach can thus allow those in charge of regulation to balance the innovation needed for inclusion with the appropriate rules needed to maintain stability and integrity.
As part of the risk-based approach, our report also advocates to balance ex-post and ex-ante regulation. Regulation should be well specified ex ante to give providers a clear understanding of the rules of the game. But regulators should also have the authority to intervene ex post as financial markets evolve and issues emerge. This approach is not unfamiliar to regulators, but relatively new to the financial industry. It can clarify as to how to handle new market practices, such as bundling (a strategy that involves selling multiple products and services as a single unit). This practice may raise competition concerns if, for example, a firm controlling a large share of the mobile market tries to leverage power over mobile payments. Though this concern should not be dismissed, it is not so prevalent as to warrant ex ante intervention. Rather than impose potentially innovation-damping regulation early on, such risks should rather be managed through ex post interventions on a case-by-case basis. Related, as our Task Force report also points out, a greater understanding of digital technologies and the potential risk they introduce can also require more coordination among financial supervisory agencies and industry officials (Principle 1 of the G20 High-Level Principles).
G20 High–Level Principles for Digital Financial Inclusion:
Promote a Digital Approach to Financial Inclusion
Balance Innovation and Risk to Achieve Digital Financial Inclusion
Provide an Enabling and Proportionate Legal and Regulatory Framework
Expand the Digital Financial Services Infrastructure Ecosystem
Establish Responsible Digital Financial Practices to Protect Consumers
Strengthen Digital and Financial Literacy and Awareness
Facilitate Customer Identification for Digital Financial Services
Track Digital Financial Inclusion Progress
The necessity of an enabling regulatory framework
Many of the challenges facing financial inclusion can be addressed through an enabling and proportionate regulatory framework. This concept is at the heart of our Task Force report and one consistent with the G20’s third High-Level Principle on the promotion of “competition and a fair, open and balanced level playing field for digital financial inclusion.” Proper regulation allows for new service providers to enter the market; is proportionate to the level of risk presented by a given financial institution (as emphasized in the 3rd G20 Principle); and imposes only such compliance costs that services to the poor remain viable. In this sense, a supportive regulatory framework not only complements financial inclusion efforts, but makes the emergence of efficient and inclusive digital service providers possible.
Whereas the G20 Principle 3 emphasizing competition remains at a high level, the Global Partnership for Financial Inclusion (GPFI)’s recent whitepaper Global Standard Setting Bodies and Financial Inclusion: The Evolving Landscape, repeatedly cited in the Principles, offer more specifics. These very much complement the discussions in Financial Regulations for Improving Financial Inclusion as it provides the type of proportionate regulation needed to translate this Principle into concrete steps for financial regulators and supervisors. For example, whereas the Principles broadly call for a regulatory framework that “allows for new entrants” and “[reflects] a proportionate and enabling regulatory approach,” the CGD report offers specific entrance criteria. To promote competition while considering risks, the CGD report makes the important distinction between digital service providers that limit their services to small payments and those that offer additional store-of-value products which may or may not be leveraged. It then recommends that “entry of digital providers that restrict their retail activities to (small) payments and transfers, or that offer stores of value fully backed by safe assets, should be relatively liberal” whereas, “higher entry standards, including ‘fit and proper’ entry rules and tests, should apply to digital providers that, in providing their services, pose risks to consumers and to financial system stability, such as those providing stores of value not fully backed by safe assets, credit, or insurance.” Of course, some policies remain generic: licenses for example should only be awarded to providers that demonstrate the sufficient technical and financial capabilities.
Proper regulation is key in ensuring any competitive market. In the context of digital financial service providers, this means ensuring that the market does not deny providers necessary inputs or prevent provider networks from communicating with each other (part of Principle 4 in the High-Level Principles). Just as telephone companies require access to common telecommunications lines, electricity providers to the power grid, and water providers to pipelines, the CGD report recognizes that digital financial services require, among others, access to network services for payment and settlement, credit bureaus, and functioning telecommunications systems. Assuring the contestability of infrastructure services can be done in different ways: by articulating codes of conduct and promoting the convergence of standards to reduce barriers; by putting pressures on traditional financial services providers to open their systems and by directly limiting collusive practices; and by encouraging greater scope for consumer mobility through lowering the costs of switching between providers. Efforts like this should be expanded to incorporate those new digital financial services providers that also require access to these crucial inputs. Conversely, traditional financial services providers must have access to important network inputs such as telecommunications services.
One important step: strong national ID systems to improve Know Your Costumer compliance
Besides competition policy and level playing field issues, the Task Force report focuses on Know Your Costumer (KYC) rules. Adherence to Know Your Costumer (KYC) regulations can represent a considerable obstacle to banking for the poor and less documented persons. Indeed, the G20’s 7th Principle, “Facilitate Customer Identification for Digital Financial Services" recognizes the importance of facilitating compliance with KYC rules to allow for greater financial inclusion. As this Principle rightfully recognizes, and as discussed in Recommendation 17 of the CGD Task Force report, legal identification is “critical” to meeting financial inclusion goals. To properly assess the risk of a growing customer base and to comply with KYC regulations, it is paramount that all financial services providers have access to a reliable database through which they can identify known criminals and terrorists. More generally, robust national ID systems are frequently mentioned by development economists as instrumental to social protection and economic empowerment.
The promotion of biometric data, listed by the G20 as a key action, can especially facilitate customer identification. The CGD Task Force report cites the case of India’s Aadhaar system as a promising example of a system capable of supporting the dual goal of promoting financial inclusion and satisfying a risk-based KYC approach. The program, though still in its early stages, has established a low-cost authentication process to easily and instantly verify identities online. It consists of a 12-digit number that is stored in a centralized database and linked to the individual’s basic biographic information, a photograph, a full set of fingerprints, iris scans, and a digital faceprint. Despite participation being voluntary, the Aadhaar program has enrolled more than 900 million people, and offers them the chance to gain access to financial services.
It is very encouraging to see that CGD and the G20 are working along the same lines. Many of the themes expressed in the G20 High-Level Principles have their counterpart and detail in the CGD Task Force report. We hope that together the High-Level Principles and the Report catalyze further actions toward achieving more accessible and digitally supportive financial systems, and that countries, standard setters and others involved in financial inclusion can benefit from these efforts.