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Task Force on Regulatory Standards for Financial Inclusion
Increased financial inclusion—greater access by the poor to the use of payments, deposits, credits, insurance and risk-management services—can improve the opportunities and welfare of people living in poverty. This CGD Task Force seeks to identify needed regulatory changes to increase financial inclusion by encouraging innovation and the use of new technologies, especially those related to digital finance, while protecting consumers and financial stability.
An enabling regulatory and supervisory environment can drive innovation to more effectively bring financial services to the bottom of the pyramid. The experience of Kenya, the Philippines, and other countries has shown remarkable progress, particularly on digital financial inclusion. However, that has not been the case for many other countries where inadequate regulations continue to affect the business and value proposition to promote financial inclusion. For example, excessively tight regulators’ entry and licensing requirements could prevent mobile network operators from using their extensive business networks to extend access to payments services to millions of cell-phone subscribers. Likewise, inadequate competition rules might result in oligopolistic behavior by financial or nonfinancial service providers, which would in turn keep the cost of financial products above what they would be in a competitive environment.
In light of our previous work and recognizing the crucial role that an effective regulatory framework can play in improving financial inclusion, a new CGD Task Force seeks to identify and address the concerns and challenges of regulators, with the goal of encouraging the adoption of needed reforms for financial inclusion. The key questions that the Task Force aims to address include the following:
What are the most common regulatory deficiencies that constrain both financial and non-financial institutions in serving large segments of the population?
How can central banks advance financial inclusion while preserving the traditional mandates of financial stability and integrity?
What is the right regulatory framework that levels the playing field between regulated financial institutions and non-financial firms (such as mobile network operators) offering payment products? What should the global standard be?
What type of national and international regulations are needed to ensure that KYC rules are consistent with the objectives of financial inclusion?
How can regulators ensure the development and secure operation of an electronic retail-payment system that all financial services providers can use at fair prices?
The Task Force is led by CGD senior fellow Liliana Rojas-Suarez with Stijn Claessens, Senior Advisor at the Federal Reserve Board, as co-chair. The Task Force comprises leading experts from around the world with deep knowledge of the challenges for designing and implementing regulations for improving financial inclusion. The Task Force has met three times: in February and November, 2014 and in June 2015. A report with their conclusions and recommendations was launched in March 2016. The accompanying brief can be accessed here.
In the following map, you can learn about events across the globe where the report has been featured, and gain access to recorded conferences, presentation slides, and more.
Some of the background papers for the report are as follows:
Thorsten Beck Professor, Cass Business School and Tilburg University.
Massimo Cirasino Manager of the Financial Infrastructure Service Line and Head of the Payment Systems Development Group of the Financial Inclusion Practice of the Financial and Private Sector Development Vice Presidency (FPD).
Addressing concerns related to financial exclusion continues to be a high priority for the international financial community. This was made clear at the G-20 Summit in Hangzhou, China in September, at which the Financial Stability Board (FSB) provided an update of its work on the issue, and at the IMF/World Bank annual meetings, where the World Bank hosted a flagship event on the topic of “Financial Inclusion not Exclusion: Managing De-Risking.”
In November 2015, CGD published a report on the unintended consequences of anti-money laundering policies for poor countries, focusing on three groups: migrant workers who send remittances to their families, vulnerable people who are displaced by conflict or natural disasters and are in need of foreign assistance, and businesses that rely on cross-border trade. Since then, the international community has made several efforts to address the problem of financial exclusion created in part by these policies. Specifically, FSB has worked closely with G-20 members, as well as the IMF, World Bank, and the Financial Action Task Force (FATF)—the global standard setter for AML/CFT regulations—to implement a four-pronged approach aimed at supporting financial access through the correspondent banking system. The work plan consists of (1) improving data collection, (2) clarifying regulatory expectations, (3) supporting capacity building in vulnerable countries, and (4) leveraging technology to facilitate compliance with anti-money laundering and countering the financing of terrorism (AML/CFT) regulations.
Improving Data Collection
Two World Bank surveys (“Withdrawal From Correspondent Banking – Where, Why, and What To Do About It” and “Report On The G20 Survey On De-risking Activities In The Remittance Market”) published in November 2015 shed light on the causes and scale of account closures and more recent data gathered by the IMF have largely supported those findings. The data suggest that the withdrawal of correspondent relationships is a global phenomenon but one whose effect has varied greatly by country and region. Small countries have been the hardest hit, particularly those with offshore financial centers, and those where there are perceptions of high AML/CFT risk. Several larger countries have also reported a large number of account closures, including Mexico and the Philippines. On a regional basis, the Caribbean and Pacific Islands appear to be the most affected.
Using data from SWIFT, the global provider of secure financial messaging services, more recent analysis by the Committee on Payments and Market Infrastructures (CPMI) indicates that the volume of transactions processed through correspondent bank relationships has increased since 2011, while the number of correspondent relationships has declined over the same period in most regions (see Figures 1 and 2). This suggests that interbank flows have become more concentrated, which may have implications for financial stability and market competition. The FSB is now conducting a follow-up survey that will examine the extent of this concentration in specific markets, as well as how account closures have affected specific categories of customers.
The World Bank data also provide insight on the causes of account closures. Banks continue to cite AML/CFT concerns as the predominant reason for terminating accounts. Specifically, they note the increasing cost of complying with AML/CFT regulations and uncertainty about both supervisors’ expectations for appropriate due diligence and the nature of enforcement actions if they get it wrong. There are other drivers of account closures as well, that have received less attention, including the low interest rate environment and the more rigorous prudential standards put in place following the global financial crisis. Low interest rates compress banks’ profit margins, while higher prudential standards have raised the cost to banks of holding risk on their balance sheets. All these factors have combined to make correspondent banking less profitable and less attractive.
We still do not know to what degree account closures have affected financial access and real economic activity. To determine this will require carrying out in-depth qualitative studies in affected countries, as well as developing a framework for systematic data collection that produces time-series data that is comparable across countries.
Clarifying Regulatory Expectations
Since 2012, when the FATF completed its shift away from endorsing a rules-based approach to AML/CFT, the risk-based approach has been the foundation of national AML/CFT frameworks. This approach provides flexibility by allowing banks to allocate their resources more effectively and take preventive actions commensurate to the nature of risks that they face. However, it also puts the onus on banks to fully understand the nature of those risks and how to respond appropriately. Given this heightened responsibility, and the relative newness of the approach, it is unsurprising that banks have asked for greater clarity regarding how they should apply it to their client (i.e., “respondent”) banks and money transfer operators (MTOs), since these relationships often require enhanced due diligence.
The FATF responded to this request in 2016 by updating its guidance on MTOs and publishing new guidance on correspondent banking services, both of which sought to clarify the responsibility banks have applying the risk based approach in each area. The guidance also tried to disabuse banks of the belief that they are required to conduct CDD on the customers of their respondent banks (a practice often referred to as “know your customer’s customer” or KYCC).
The US Treasury Department and US bank supervisors—including the Federal Reserve Board, Federal Deposit Insurance Corporation (FDIC), National Credit Union Administration (NCUA), and Office of the Comptroller of the Currency (OCC)—have also attempted to clarify expectations, while refuting the notion that U.S. enforcement of AML/CFT has been disproportionate and unfair. In their “Joint Fact Sheet on Foreign Correspondent Banking” published in August, US supervisors pushed back against the concern often raised by banks that they are apprehensive of receiving large fines for minor AML/CFT violations. The Fact Sheet emphasized that large fines had been levied only in cases involving “a sustained pattern of reckless or willful violations over a period of multiple years and a failure by the institutions’ senior management to respond to warning signs that their actions were illegal.” It also highlighted that “about 95 percent of AML/CFT and sanctions deficiencies identified by US authorities are corrected through cautionary letters or other guidance by the regulators to the institution’s management without the need for an enforcement action or penalty.”
The OCC recently provided more proactive guidance, publishing a set of “best practices” that banks can consider following when conducting periodic risk reassessments of their correspondent relationships.
Supporting capacity-building in vulnerable countries
If banks lack confidence in a country’s ability to supervise for AML/CFT risks, the hurdle for doing business with financial institutions in that country is significantly higher. For that reason, improving compliance with global AML/CFT in countries vulnerable to financial exclusion is crucial. The challenge for the international community is two-fold: to ensure that sufficient resources are available to meet this demand and to take care that resources are directed to those countries that are truly committed to reform. At the Hangzhou Summit in September 2016, G-20 Leaders called on member countries along with the IMF and World Bank to intensify their support for these efforts.
The IMF and World Bank play an important role in this area due to their intimate understanding of global standards, neutrality, and global footprint. While the modalities of their approach to TA differ, both organizations provide a wide variety of services, including helping governments draft AML/CFT legislation, supporting national risk assessments, and training supervisory staff.
In the past decade, the IMF has provided TA for AML/CFT to 118 countries, and today has 37 ongoing projects in 29 countries. The World Bank has assisted 54 countries in developing national risk assessments in recent years, with 15 more engagements in the pipeline. Both organizations can do more, including by allocating more of their own administrative resources towards this effort. Currently, both rely heavily on donor-supported trust funds to finance their AML/CFT TA efforts but these trust funds are often limited to supporting work in low-income countries—while financial exclusion also affects middle and upper-middle income countries such as those in the Caribbean.
Treasury’s Office of Technical Assistance (OTA) is another important provider of TA. OTA currently oversees 30 projects focused on AML/CFT and prudential bank supervision, and is proactively assessing requests for assistance from a number of affected countries. Over the last several months, OTA agreed to new projects in Belize and Somalia.
Leveraging technology to facilitate compliance with AML/CFT regulations
Technological innovation has helped expand the scope of financial inclusion by allowing the financial sector to reach more people at lower cost. Over time, it will also help banks reduce the cost of complying with AML/CFT requirements. To date, however, the work of the international community—including the FSB—on the role of technology in addressing financial exclusion has focused more on relatively narrow technical measures—like promoting greater use of the legal entity identifier (LEI) and improving the information included in banks’ payment messages—than it has on potentially disruptive and “game-changing” technologies like blockchain and cryptocurrencies.
This reflects, in part, the natural lag between technological innovation and regulation. While international regulatory bodies, including CPMI and the FATF, have already published initial analysis and guidance regarding the role of virtual currencies, policymakers are still coming to terms with the benefits and risks associated with these new technologies and, until they do, they are unlikely to endorse specific approaches.
As we’ve noted before, the distributed ledger technology that underlies many cryptocurrencies has the potential to make cross-border transactions faster, more secure, and more transparent. But it can also make it harder to detect money laundering or terrorist financing, depending on how a distributed ledger platform is designed. The challenge for regulators is to create a regulatory environment that protects the integrity of the financial system without stifling potentially transformative innovation.
One private sector-led initiative that holds great promise is the development of know-your-customer (KYC) utilities. Such utilities could reduce paperwork and improve the accuracy and consistency of KYC information by storing customer due diligence information in a single repository that can be accessed by client banks. Several private entities, including SWIFT, have already developed, or are developing, KYC utilities. At a recent IMF event on solutions to the withdrawal of correspondent banking relationships, a private sector participant estimated that broad use of the SWIFT KYC utility could reduce banks’ compliance costs by as much as 30 percent.
In spite of recent progress in the usage of alternative financial services by adult populations, Latin America’s financial inclusion gaps have not reduced, relatively to comparable countries, and, in some cases, have even increased during the period 2011-2014. Institutional weaknesses play the most salient role through direct and indirect effects. Lack of enforcement of the rule of law directly reduces depositors’ incentives to entrust their funds to formal financial institutions. Indirectly, low institutional quality reinforces the adverse effects of insufficient bank competition on financial inclusion.
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.
This article was originally published as a guest post for IFMR Trust.
Only about half of Indian adults have access to an account of any kind. The number is even lower for the poorest 40 percent (World Bank, Global Findex 2014). Furthermore, there are only 13 commercial bank branches per 100,000 adults (IMF, Financial Access Survey 2014). Keeping in mind the low levels of financial inclusion in the country, the Indian authorities have developed a broad strategy to improve access to financial services, as outlined in the report by the Committee on Comprehensive Financial Services for Small Business and Low Income Households, led by Nachiket Mor. Among the committee’s recommendations, payments banks are one innovative tool to further India’s goal of greater financial inclusion.
Payments banks are different from regular banks. They can only accept deposits up to Rs. 1 lakh per person, roughly $1500, and cannot grant loans. Furthermore, payments banks can only invest their money in safe government securities and other highly liquid assets. Their primary objective is to further financial inclusion by providing access to small savings, payments and remittance services to low-income customers without compromising financial stability. By leveraging technology and tapping into their large networks, these banks might potentially allow millions more people, many in remote corners of India, to operate bank accounts, with often very small sums of money. In August 2015, the Reserve Bank of India (RBI) granted “in-principle” licenses to eleven entities to launch payments banks.
While it is too early to assess results, as these banks are not operational yet, a valid question is whether the regulations governing these payments banks are consistent with fundamental regulatory principles for improving financial inclusion while protecting financial stability and integrity. To answer this question, I compare key characteristics of the payments banks against major recommendations in the recently released report, Financial Regulations for Improving Financial Inclusion, by the CGD Task Force on Regulatory Standards for Financial Inclusion. The report advances three major recommendations (among others) for expanding financial inclusion in a safe and sound manner:
Encourage competition by allowing new and qualified providers to enter the market
Create a level playing field between different providers by making the regulatory burden proportional to the risk posed by providers to individual customers and the overall stability of the financial system
Apply risk-proportionate Know-Your-Customer (KYC) rules to balance financial integrity and financial inclusion
How do India’s payments banks measure against these recommendations?
Enhancing Competition among Providers of Financial Services
Payments banks certainly encourage the entry of new, qualified and innovative players. The entities licensed to become payments banks encompass a broad range of sectors, including telecommunications, finance and banking, IT, and postal services. The first payments bank is expected to be operational by the end of this financial year.
The licensing of payments banks is contingent upon various players meeting the appropriate entry criteria. The approved entities need to have a solid track record and ability to conform to the highest standards of service. More details about the licensing process can be found here. A thorough regulatory and licensing regime is crucial for financial stability. After all, India’s experience with expanding rural banks in 1976 without a proper regulatory framework ended in huge losses in 1991. India’s clear licensing requirements for payments banks are consistent with the CGD report’s recommendation to encourage entry of a wide variety of qualified providers of financial services. Of course, given the restrictions on payment banks’ activities, the implications of “fit and proper” are quite different for these banks compared to traditional banks.
Leveling the Playing Field between Providers of Financial Services
Since payments banks do not undertake credit risk, the RBI has stipulated a minimum capital requirement of Rs. 100 crore ($15 Mn) for payments banks (among other requirements), unlike traditional banks that must meet a capital requirement of Rs. 500 crore ($75 Mn). As these payments banks assume lower risk, it only makes sense that they have to carry a lower regulatory burden.
However, if the entities licensed to become payments banks wish to expand their activities beyond those allowed for payments banks, they would need to be licensed to become full-service banks. Similarly, if the payments bank reaches a net worth of Rs. 500 crore and becomes critical to the stability of the financial system, diversified ownership will be mandatory within three years. Such a risk-based approach is essential to ensure a balance between fostering innovative financial services and ensuring the safety and soundness of the financial system, as recommended in the CGD report.
Applying Know-Your-Customer (KYC) Rules
India has already encouraged improvement in financial access as well as up-take of national ID (Aadhaar) by allowing people to open restricted bank accounts subject to later showing proof of identity. These restricted bank accounts have limits on balances and activities. Similarly, simplified KYC requirements would be applied to “small accounts” transactions through payments banks. Payments banks are expected to encourage the expansion of these types of “small accounts” through their extensive networks. Furthermore, Aadhaar will play a key role in facilitating the take-up of “small accounts” with simplified risk-based KYC processes, as recommended in the CGD report.
While there is no one-size-fits-all solution to improve financial inclusion, there are important lessons to be learned from India’s step to approve payments banks. After India’s previous experiments with different efforts to improve financial inclusion, payments banks offer one promising way towards better financial access. India’s forward-looking vision to leverage digital finance combined with innovation-friendly regulations could pave way for a bright and safe future for payments banks.
The rise of digital technology has nurtured a growing industry around the world in financial services that benefit the poor, from mobile payments and money transfers to micro-savings and mobile-based crop insurance. But as the financial landscape evolves to include these disruptive innovations, new players and new business models could bring fresh risks to individual users and to financial systems. So how should policymakers respond?
Does broadening financial access to large segments of the population pose risks to financial stability? Not necessarily, according to recent remarks by IMF managing director Christine Lagarde. Increasing access to basic financial transactions such as payments does not threaten financial stability, especially when appropriate supervisory and regulatory frameworks are in place. In fact, with the right regulatory supervision, increased access to financial services can result in both micro and macro benefits. Recognizing the macroeconomic and regulatory dimensions of financial inclusion, CGD and the IMF joined forces for a seminar to kick off the IMF Spring Meetings 2016.
Both CGD and the IMF have been actively engaged in rigorous research centered on financial inclusion. CGD recently published a report on how regulation can improve financial inclusion. The IMF has produced a study investigating the linkages between financial inclusion and macroeconomic benefits. The seminar provided a unique opportunity for the merger of these two areas of expertise.
While there is clear micro-level evidence for the benefits of financial inclusion in improving the daily lives of large segments of the population, the evidence for macro benefits of financial inclusion has been less clear. Lagarde’s opening remarks highlighted the main question motivating the first panel: is the concept of financial inclusion even macro-relevant? In other words, does increasing access to financial services make a difference at the national or global level? In short, yes. Previous evidence by the IMF has shown that inclusive growth could lead to tangible macroeconomic benefits, such as higher GDP and lower income inequality.
Watch Christine Lagarde’s comments on the macroeconomic benefits of financial inclusion from 6:30-8:17 in this video.
What is less clear is the link between financial inclusion and financial stability with respect to credit access. Credit can play a crucial role in helping the poor cope with poverty. However, unchecked credit access could also harm financial stability. The 2010 microfinance crisis in Andhra Pradesh, India is often cited as the prime example of such an instance. However, appropriate regulations and checks are critical to ensure that financial stability is preserved as credit access is broadened. In fact, Lagarde noted in her opening remarks: “Using information on supervisory quality in about 100 countries from the Financial Sector Assessment Program, we find that when supervision is of high quality, broadening credit access actually leads to an increase in financial stability.”
Watch Subir Gokarn and Aslı Demirgüç-Kunt discuss the risks of broadening credit access from 43:19-46:00 in this video.
The first panel also tackled ways to lower barriers to financial inclusion for traditionally marginalized groups, particularly women. Despite broad advances in improving access to basic financial services, the male-female financial inclusion gap has remained persistent. IMF’s Subir Gokarn and Gates Foundation’s Gargee Ghosh highlighted the role of attitudes and trust as key barriers to the uptake of financial services by marginalized customers. Product design is crucial to overcome such behavioral biases and to ensure that financial products are catered to the particular needs of consumers (also discussed in this CGD blog post). While the panel talked about the role of financial literacy and branchless banking in addressing some of the barriers faced by women, IMF’s Ratna Sahay went a step further, emphasizing a bolder approach to address the gender gap and recommended greater involvement of women in the supply side as financial services providers.
Watch Ratna Sahay discuss ways to reduce the gender gap in financial inclusion from 56:32-58:13 in this video.
Photo by IMF
The second panel kicked off with an opening presentation by CGD senior fellow Liliana Rojas-Suarez on the recently published CGD report on regulations for improving financial inclusion. Her presentation laid down the key principles and areas of focus for regulatory improvement to further financial inclusion without compromising financial regulators’ traditional mandates of stability, integrity, and consumer protection. The discussion of financial inclusion as a key policy objective alongside the traditional mandates of regulators is a big step forward in itself.
Watch Liliana Rojas-Suarez present CGD’s recent report on how regulations can improve financial inclusion from 7:05-9:54 in this video.
Any conversation about financial inclusion is incomplete without discussing the role of technology. Digital advances have played a major role in expanding financial services to previously underserved sections of the population. However, they have also introduced new risks through new products, players, and models. One important challenge for regulators is to not fall behind the technological curve, as noted by Nicola Véron, senior fellow at Bruegel. However, at the same time, regulators have to be cautious about not regulating prematurely, which could stifle innovation. The CGD report recommends striking a balance between ex ante and ex post regulations, where clear rules are specified ex ante but with the option for ex post intervention as services and providers evolve.
Watch Stijn Claessens talk about how to strike a balance between ex post and ex ante regulation from 27:13-29:00 in this video.
In line with another recommendation from CGD’s report, the panelists emphasized the need for greater coordination between different regulatory and supervisory agencies, both financial and non-financial ones. Tim Adams, president of the Institute of International Finance, pointed out that there is enormous fragmentation in the regulatory and supervisory space. Echoing these concerns, Tilman Ehrbeck, partner at Omidyar Network, took note that we are unlikely to see movement in the Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) space until the regulatory and supervisory jurisdictions are in alignment.
Watch Tim Adams and Tilman Ehrbeck discuss the need for greater coordination between regulatory and supervisory agencies from 1:08:40-1:10:15 in this video.
The event concluded with closing remarks by CGD’s Nancy Birdsall, who drew attention to how financial inclusion has come a long way. The attention towards financial inclusion in both domestic and international agendas shows the increasing recognition of financial inclusion, especially digital financial services, as a key development tool. She also underscored the importance of data, particularly real-time data to bring financial services to underserved populations. By the end of the event, it was clear that advances in financial inclusion are fast-moving due to technology and will continue to require attention in times to come. The future of financial inclusion depends on how regulators and policymakers interact with these rapid technological advances driving financial products.
Watch Nancy Birdsall’s closing remarks on the future of financial inclusion from 1:26:19-1:28:06 in this video.
Poor regulation is a key obstacle to financial inclusion. An enabling regulatory environment is critical for creating incentives for businesses to offer innovative financial services to the poor, and for underserved customers to take up formal financial services.
While new technologies have broadened access to financial services among the poor, they have also introduced new risks. The primary challenge for regulators is to broaden financial access while ensuring financial stability, integrity and consumer protection. How can regulators balance these multiple objectives?
The topic was the center of discussion at a recent event at CGD to launch Financial Regulations for Improving Financial Inclusion, a report by the high-level CGD Task Force. The event kicked off with opening remarks from Marisa Lago, Assistant Secretary for International Markets and Development, U.S. Department of Treasury, who stressed that regulatory structures must keep pace with evolving technologies in the digital finance space to protect consumers and the financial system without suppressing innovation. “As the report rightfully indicates,” she commented, “regulations should be appropriately tailored according to risk, and in particular the risks associated with services being provided but also the scale at which they are provided.”
The keynote address was followed by a presentation by co-chair of the CGD Task Force, senior fellow Liliana Rojas-Suarez, who gave a brief overview of the framework and stressed three key principles for regulations for financial inclusion: similar regulations for providers carrying out similar activities regardless of institutional form, regulation proportional to risk imposed by the particular activity, and a balance between ex ante and ex post regulations to allow for experimentation and innovation.
How can regulators level the playing field between different forms of service providers?
Stijn Claessens, Senior Adviser to the Federal Reserve Board and the other co-chair of the Task Force, stressed the importance of a level playing field between different providers of similar services, such as banks, mobile network operators and other digital financial services providers. That essentially means the creation of a regulatory environment where similar services are treated equally, regardless of the institutional form of the provider. Basically, regulations should be tied to the risk that the provider’s activities pose to the consumers and the financial system. For example, the regulatory standard applied to a digital financial institution that only engages in small payments should be lower than the standard applied to a full-service bank. However, when the same institution starts offering bank-like services such as store-of-value and credit, the applicable regulatory standard would be higher. In a nutshell, if you act like a bank, you should be regulated like a bank.
How important is national identification for Know-Your-Customer (KYC) rules?
A unified national identification system, although an expensive goal, is important to create a financially inclusive system. In order to implement risk-based KYC procedures that expand access to financial services among the underserved while minimizing the risks of illicit fund activities, it is crucial that financial institutions have access to accurate information about consumers. CGD's Alan Gelb leads the field in research on biometric identification for development, and at the event he noted how many countries have unfortunately seen the development of multiple identification systems, which is not only costly for individual institutions but also makes "knowing your customer" harder. Njuguna Ndung'u, the former Governor of the Central Bank of Kenya, who oversaw the rollout of the hugely successful digital payment system M-Pesa, further stressed that it is not important to just have an ID, but to have a legitimate ID. Alan Gelb recommended that ID systems need to transition from identifying cards to identifying people with the help of biometric technology.
Here at CGD we will be continuing the conversation about regulatory principles to broaden financial inclusion. While there is no “one-size-fits-all” solution, as each country’s opportunities and challenges are likely to differ, we hope that the broad principles put forward in this report can serve as a guiding tool for countries seeking to expand financial services to traditionally excluded segments of the population.
Enabling millions more people around the world to control their financial futures is good for development and will be high on the agenda when G20 leaders meet in China later this year.
But while exciting new technologies for mobile money transfer deservedly make the headlines, there's a drier aspect of financial inclusion that doesn’t get as much attention: regulation. And it's no less important.
“There is no innovation that actually comes to life without the rules that determine how it’s going to operate,” CGD Senior Fellow Liliana Rojas-Suarez tells me in this week’s podcast.
Rojas-Suarez, along with Federal Reserve Board Senior Adviser Stijn Claessens, together chair CGD’s High Level Task Force on Regulatory Standards for Financial Inclusion. Their new report makes clear that the traditional priorities of financial regulation – safeguarding the stability and integrity of financial systems and protecting consumers from fraud – can be compatible with the goal of financial inclusion.
In fact, the two are complementary. “There is no way that you are going to get financial inclusion if you have an unstable financial system,” Rojas-Suarez says in the clip below.
"The more financial inclusion you have, that also contributes to stability, because you’re moving the funds that people are dealing with from the informal to the formal system.”
As recently as 2011, only 42 percent of adult Kenyans had a financial account of any kind; by 2014, according to the Global Findex, database that number had risen to 75 percent. In sub-Saharan Africa, the share of adults with financial accounts rose by nearly half over the same period. Many other developing countries have also recorded gains in access to basic financial services. Much of this progress is being facilitated by the digital revolution of recent decades, which has led to the emergence of new financial services and new delivery channels.