This weekend, my wife and our maid a small argument. Our maid wanted a salary advance of INR 1,000 (about $15). Wife had paid her salary last week only, so she was curious about why maid needed the money. Apparently, maid had some emergency. Wife paid her advance amount. This would be deducted from her monthly salary when she is paid. This is not the first time she needed an advanced payment. And I am reasonably certain this won’t be the last time as well. In reality INR 1000 is relatively small amount. She would be repaying that on next pay day which is about 3 weeks away. In traditional banking terms the 1,000 rupees she took is really loan which she would pay off that within 30 days.
This is not one-off case. Lot of people who are working on daily wages or small jobs need a small loan to meet their expenses. In terms of traditional banking, these are loans which have small amount and have short tenure. People who are operating on an extremely tight budget and essentially living life paycheck to paycheck need some sort of credit line to take care of their emergencies. This becomes a daunting task if they’re not part of formal banking systems. So, taking care of their emergencies can become a challenge. With limited options available, they try to address the need by either going to pay day lenders or like in our maid’s case, collect part of paycheck in advance. These loans / credit requirements are so small that they don’t qualify under “Micro Finance”. Due to amount involved these can be categorized under “Nano Finance”.
This phenomenon or challenge is not that different from what you and I face when unexpected expenses pop up and throw off budget. In our case we either dive into our savings or borrow to take of these expenses. When it comes to borrowing, there are again 2 potential options. One is use credit card to take care of the need or other option is to go for “personal loan”. In either case, because we’re part of formal banking system these options are relatively easier. From Bank / Lender’s perspective, both Credit Card and Personal Loan are unsecure credit. However due to prior relationship with them the risk involved with these loans is reduced a bit. As a customer, Bank has already done your KYC (Know Your Customer) checks. Also, Bank / Lender has access to your credit score or CIBIL score to determine your loan / credit eligibility.
But for unbanked population things are not so easy. These are not part of formal banking system either by compulsion or design. One of the biggest challenges this customer base faces is they can’t afford to maintain minimum account balance requirements to avoid monthly maintenance fees that banks charge. So, opening a bank account is not the highest priority. After subprime mortgage crisis, most banks in US have tightened their lending norms to reduce charge offs. As part of this process, they have set certain credit score requirements. These customers have low or very little credit history. As a result, these customers are high risk when it comes to lending. This results in customers getting excluded from formal banking system. As a result, most of these customers are turning to Non-Banking Financial Institutions. Interest rates charged by these companies is really high. Typical rate structure for $100 loan for period of 14 days, the lenders charge $15 interest / fee. The Pay Day loan business has its share of criticism. In fact, the practice is illegal in 14 states and Washington DC. Post 2008 financial crisis, Dodd Frank regulations also called for tighter regulations of this sector.
In the field of Nano Finance, Indian Government has done some good innovations and has tried to address this problem. India’s drive to have all its citizens to be part of Formal Banking system using JAM trinity has solved this problem a bit. JAM essentially is combination of 3 different schemes or areas when merged together provide a very powerful tool / weapon. J is for Jan Dhan account. These can be opened with any Bank. These accounts come with Debit Card and have a Credit Line / Overdraft facility of up to INR 5,000 (this amount varies and there are certain rules). A is Aadhar, unique 12 digit # provided to every Resident of India which is tied to their biometric identity. M in JAM trinity is Mobile. With 1.1 Mobile subscribers, more or less there is a Mobile Phone user in every family. With Jan Dhan accounts linked to Aadhar, the KYC process has got simplified and people have found it easy to be part of formal banking system. Some of the private sector Banks are also getting into the act of Nano Credit. In 2016, Axis and Kotak Bank launched a scheme to offer INR 15,000 Nano Credit facility.
Unfortunately, in case of US, things are not so good. Most big banks are staying away from “Nano Finance” customer base due to risks involved. One of the biggest challenges is these customers are not part of formal banking systems and there is no credit history / credit score. So, this has become a game of egg first or chicken first. This lack of data, has put severe restrictions. There is need for new data model to cater needs of this customer base. McKinsey has published a paper on putting together a new Data Model which can help gathering data for unbanked.
With emergence of new technologies and cell phones, the data can be gathered. However due to risks, investment for data gathering and putting together data model based on it and potential return on that investment, big banks may not just enter this space just yet. However, there are enough signs of encouragement and examples of start-ups trying enter this area…