How Fintech Can Improve Small Business Lending in Asia

Welcome to Pacific Exchanges, a new podcast from the Federal Reserve Bank of San Francisco. I’m Nick Borst.

And I’m Sean Creehan. We’re analysts in the Country Analysis Unit here at the San Francisco Fed. Our job is to monitor financial sector developments in Asia, and as part of the Fed’s public mission, share information and analysis with listeners like you. We inaugurate the podcast with a series of episodes that look at the state of innovative financial technology, commonly known as fintech, in Asia.

Fintech is a buzzword that gets thrown around a lot, but what exactly is it? One simple definition would be the use of software to provide financial services online or through mobile phones. This could involve banks, but just as often involves startups. Fintech firms operate in a number of sectors ranging from lending to personal finance, digital and mobile payments, and virtual currencies. We’re excited for you to join us in the episodes to come as we explore how fintech is impacting peoples’ lives in Asia.

In today’s episode, we sit down with Anju Patwardhan, a Fulbright Fellow researching fintech at Stanford University, who previously served as the Chief Innovation Officer for Standard Chartered, one of the world’s largest international banks. We invited Anju to speak with us about her experiences managing fintech activities at a bank, the potential for competition between fintech startups and banks, and her research activities at Stanford.

Well, thank you for joining us Anju. To start off maybe you could tell us a little bit about the work you’re doing right now as a Fulbright Scholar at Stanford.

Thank you. It’s a pleasure to be here. I will start at Stanford beginning September 1 as a Fulbright Visiting Scholar and my research will be focused on the use of technology and innovation to support financial inclusion, especially in the area of small business lending. The second aspect of my research actually is to understand what makes Silicon Valley work. What are some of the best practices and other mechanisms which can then be deployed in Asia or in Singapore?

What do you think are the most important technologies over the next five to 10 years that will shape banking and finance?

When we look at financial services these days, there are several interesting trends that stand out. I think these are in the area of payments and mobile wallets, whether it’s doing, you know, M-Pesa in Africa or using mobile wallets in collaboration with telcos or other forms of online and mobile payments. That’s a big space. The other one that you hear a lot about these days is the use of blockchain and distributed ledger technologies in different parts of banking. Another one, which I think is very important, is the use of data science and machine learning. I often say data is the new natural resource to be mined, and banks have a lot of data. Most banks use less than 10 to 20 percent of the data that they already have, so that’s a huge opportunity, to use that data for actionable insights. Another one is around the area of biometrics and digital identity, which is starting to transform the account opening process and other processes in many countries around the world. Peer-to-peer lending, or marketplace lending is very big in the U.S., U.K., China; less so in other countries but starting to pick up. I think the other focus area is on cyber security and related alliances, not just for banks but across different industries. I may have missed a few, but that’s pretty much what a lot of banks are working on. The other one is around robotics process automation.

You previously served as the Chief Innovation Officer at a large bank. Can you tell us about this experience? What does it mean to be a Chief Innovation Officer, and how do you approach collaboration with startups or are they a source of competition?

At the bank we had innovation labs in Singapore and in San Francisco. There were different focus areas for the two labs. The lab in San Francisco was more to source emerging technologies and help for the thought leadership piece to keep an eye on what are the new emerging trends and technologies and what could be applicable for the banks. The lab in Singapore focused a lot more on actually doing prototypes and proofs of concept and also adopting the agile approach to development.

In our bank, and in most other banks, I’ve spoken to innovation heads of many banks.Typically the focus areas tend to be around identifying new technologies for business solutions. It also tends to be around thought leadership to keep an eye on what’s going on and how it could impact banking and, therefore, what should you do about it? Then there’s a piece around industry engagement and regulatory engagement. The last one, which I think is the most important, is around building a culture of innovation in the organizations. That’s what most organizations, or most banks, are trying to focus on.

Would you say in general your colleagues in banking felt like the trends happening in fintech, were those a source of potential innovations that could be adopted? Or was it more of a competitive threat to the industry as a whole? Or a mixture?

It depends. In the area of payments and transfers, if you see a lot of startups focused on the B-to-C space, and that was an area where many startups were a source of competition and they were taking over the revenue streams from the banks. But then there are many other fintech firms, many other solutions that are coming up now, which are in the B-to-B space or in the B-to-B-to-C space. They’re all targeted at making processes within the banks easier or providing a better customer experience to customers of the bank or a better middle office or back office within the bank. When I talk about robotics process automation, essentially it’s nothing but using OCR with business tools to make some of the processes automated.

That’s a typical example of using technology to improve processes within the bank. I would not call it competition. I would say it’s probably more of collaboration and I think the way it’s evolving is that ultimately, the winners will be the consumers. They will benefit from the enhancements on both sides. It’s a symbiotic relationship where each keeps the other one on their toes and it’s a win-win for the customer.

To a certain extent, you might view the current phase of fintech development as kind of a follow up to what started in maybe the 1990s tech boom, where you had the rise of payment companies, for example, like PayPal. I’m wondering, you look back on that phase and maybe there are only a few startups that really survived to mature into really dominant companies. Do you see a lot of these startups potentially being acquired by banks, potentially the banks adopting their technology internally and not necessarily requiring that fintech firm maybe five to 10 years down the line, that the banks will adapt? Or is this something where you see in this phase there will be a lot of startups that survive into more mature financial companies?

It’s hard to predict how it will shape up going forward, but I think what’s very obvious this time around is that the new technologies are coming up and providing solutions which are very different from what we had seen before. If you look at most of Asia and Africa, the solutions have built on the mobile platform. The mobile phones have become like the dashboards to our lives and most organizations are building solutions on that. It’s giving access to a much larger number of people now to banking facilities than it did before.

How it pans out, who knows? But you know, the banks do have huge budgets on technology. When you talk about the fintech spend … I don’t remember the exact numbers, but I think last year or the year before, the fintech spend for the whole year … fintech companies … was around $19 or $20 billion. When you compare that to how much banks spend on technology, I think it’s in the range of $250 to $300 billion. It’s a big number. Now granted, that a lot of that money within the banks goes towards the legacy platforms and supporting the existing systems, but a large part of it does go into new system development and new technologies. That number, I bet it’s somewhere closer to $50 billion, so it’s still two-and-a-half to three times of the total fintech investments spend for the year.

It’s a significant number, and that’s probably why a lot of companies are now starting to pivot more towards B-to-B solutions or B-to-B-to-C solutions, so that they can partner with the banks. Banks do have the customer base. They have the local market knowledge. They have the regulatory licenses. They understand the legal environment. Partnership is probably a better option, especially in the emerging markets.

For some of these new technologies to actually be adopted, you need to some extent collaboration amongst banks, and you also need space from the regulators to experiment with these things where maybe all the risks aren’t quite known. Can you talk about experiences you’ve had trying to work with other banks who are, in some respects, competitors, to adopt new technologies, and then also the relationship with regulators to push these things through?

When you look at the markets internationally, which is what I’m more familiar with, typically, unless you’re looking at a market like U.S. or China, which is big enough in itself and maybe in debt to some extent, which is big enough for a company to try and go on its own rather than collaborate with anybody else, with the exception of these markets I think in most other countries it makes sense to collaborate because the local landscape is different. The local regulatory requirements are different. The bureaus are different. How you approach the regulators for licenses, it’s very different. Therefore, trying to enter any of these markets for a fintech company, like I said, the better route is to go the collaboration way. That we’re already starting to see a lot. We are also starting to see collaboration between banks though to a lesser extent.

Historically, the banks have collaborated with each other, right? If you look at the concept of credit bureaus or the concept of payments through SWIFT, these are essentially collaborations across banks. It’s now just being done slightly differently using the imaging technologies as well. In my previous organization, we did a proof of concept with another bank in Singapore where we used the distributed ledger technology for a trade finance proof of concept. It was very interesting because we were trying to solve an unsolved problem and that required us to partner with other banks. We collaborated with another bank. The project was co-funded by the regulator, and we had somebody from the regulatory authority sitting on the starting committee because they were also trying to understand the new technology and the way it worked. I thought it was a great way of working. It was quite brilliant.

The other new thing that’s emerging these days is also the partnership between banks and non-banks. If you look at the mobile wallets, those are typically partnerships between banks and telcos. We didn’t see too much of that before. Or, you know, some of the organizations are doing POCs in the collateral monitoring space for commodities. That requires using internet of things. Again, it’s a partnership between banks and the innovation labs of non-banks to build some possible solutions in that area. That’s also a new emerging trend. I wish there was more than just a handful of examples, and hopefully we will see a lot more going forward.

You talked about the need in smaller markets for fintech startups to collaborate, perhaps, internationally to get the sort of market size that they need to scale up. I’m curious, you know, from a technical perspective, if a user, say in Indonesia, wanted to borrow from a fintech firm in Singapore or conduct some other sort of fintech service, technically it’s probably not that complicated if they have a smart phone that has software that works with the fintech company’s platform. But it’s often more complicated from a regulatory perspective. I’m wondering, when you’re thinking about these sorts of international cooperation between fintech firms, what is the role of regulators there? How can they collaborate to both kind of mitigate risks of that sort of activity, but also to encourage that sort of collaboration?

There’s been a significant shift in the regulatory mindset in the last 18 months or so. Fintech innovation has become a dominant theme at financial centers around the world. The regulators are very mindful of new risks that are being introduced by digital banking. I think they’re being challenged by the fintech trends as much as the banks are. At the same time, the regulators have a need to balance consumer protection with financial stability. Managing financial crime, but not hampering innovation or competition. It’s a difficult balancing act. Regulators in many of the jurisdictions are very progressive. If you look at what’s happening right now in Singapore or U.K. or Australia, the regulators are working very proactively with the banks to try and understand the landscape, to try and understand the barriers to adoption of these technologies by the bank, the opportunities these provide, and how they can work together. The regulatory sandboxes in Singapore and U.K. are very good examples of that change in regulatory mindset.

The same can also be extended to how they look at the fintech firms. Most regulators understand that certain things the banks cannot do. They are willing to let the non-banking entities or the fintech companies do it with a light touch regulation. They are introducing different types of licenses to support this. I think that most regulators are not yet at a place where they’re willing to let this move forward without any regulation, but they’re all very mindful of light touch regulation. Examples of those would be, say, equity crowdfunding requirements in Singapore or the new regulations or the new types of licenses that are now being issued in Thailand and in India for payment banks, for SME banking, or the challenge of bank licenses in U.K.

There is also a school of thought which is towards regulating activities rather than regulating entities. U.K., for example, now has a payment services regulator that regulates all things related to payment no matter who offers it. I think we’re probably going to see more and more of that going forward.

You have the unique experience of having been familiar both with the fintech world in Asia and now in the United States. I was wondering if you could talk about what you see as the similarities, the differences, how do the cultures compare, and what are the major takeaways from that?

I think what’s amazing about Silicon Valley, and I wouldn’t put all of the U.S. in that category, but I would say Silicon Valley is the culture of openness and collaboration. Every time I came here and spent time meeting venture capitalists or fintech companies or people from other banks it just fascinated me. It was also very energizing. We don’t see so much of that culture of openness and collaboration in other parts of the world. I think that’s one big difference. The second is, again, very cultural. Silicon Valley has this culture of fail fast, learn the lesson, move on. Failure is not seen as a stigma, whereas in most Asian countries or perhaps even in Europe or Africa, culturally fear of failure is a problem. It’s a cultural challenge. People do not want to fail. If somebody fails at something, there is a stigma attached to it. It’s not a badge of honor like it is in this part of the world. I would say those are the two huge differences in terms of culture.

Then of course, there are all these other things about the market size, about the multiple languages, multiple regulations, different market infrastructure, et cetera, et cetera.

Being a little self-centered sitting here as a regulator, how do you reconcile the positive side of a culture that embraces failure to a certain extent with a need as a regulator to monitor systemic risks or institution level risks, and how can you best encourage this sort of fintech innovation given that sort of mandate? I’m just wondering, given what you’ve seen around the world from different jurisdictions, what you see as the developing best practices? Clearly, we’re still at initial stages figuring this all out.

I’m not an expert in this area, but I think what we are seeing is that there is a general recognition that making the banks safer is not necessarily to making the economy safer, right? If you just make the financial system more stable and make the banks more safer, there is a risk of those risks shifting into the shadow banking sector and, therefore, impacting the broader economy in any case. How do you reconcile two, and how do you get them to converge and work in a manner that you can still have financial stability, but also support the broader economy is an interesting one. It’s a difficult and interesting challenge.

Now, one of the big areas, for example, it’s around the SME lending, small business lending and SME lending in general, right? If you look at the contribution of micro, small, and medium enterprises in emerging markets, these businesses are typically … They would be about half the GDP in these markets and about two-thirds the employment. But despite that, 70 to 80 percent of the SMEs struggle to get access to credit from formal financial institutions. They’re not able to borrow and, therefore, for their business needs, working capital needs, they end up relying on family, friends, money lenders, or informal sources.

I think one of the reasons why peer-to-peer lending, or now marketplace lending, took off in such a big way in the U.S. and in China was perhaps because it was filling a need that supported the broader economy, and the banks were not willing or able to step in and support the SMEs. I know that the regulators in U.K. and in Europe did a lot to encourage the banks to lend to the SMEs, but despite that, if you looked at the data since the global financial crisis, year on year, the overall credit to SMEs was declining. Partly because of the way the credit RWA is computed for SME lending in the Basel III, which was a little bit of a barrier. But partly, also, because the way the banks were doing this kind of lending, it wasn’t commercially viable from a risk return perspective. Therefore, I think when the marketplace lenders starting lending to small and medium enterprises or micro enterprises, in many countries the regulators took a very light approach and it continued to grow and supported the economy.

It’s only now that this area is starting to get a lot more scrutiny. I do hope that even with the additional scrutiny, the answer is not to regulate them like the banks are regulated. I think the answer should be to bring in some light touch appropriate regulation for the space and still continue to let them support the mainstream economy. That brings me to the other point, which is around the use of technology and innovation for SME lending. In the past, why did the banks not lend to this sector? Even before the global financial crisis, most banks did not lend too much to the SMEs. The reason was because the way most of them did not have bureau history, and at that time there was no way to use the alternate data sources to establish some form of credit for them. The way the underwriting was done for these small entities was typically in a very, very manual way. You asked for their bank statements. You did phone calls, site visits, reference checks, and did manual credit underwriting, which made the whole process very expensive. Then you gave them a very small loan to start with and build their history, but that meant that revenue was small. And also because there was no history the default rate was high and overall, it wasn’t commercially viable for the banks to keep doing this.

Whereas now, with the use of new technologies, with the use of new, alternate data sources like telco data or social media data, and also by using data science and machine learning, the companies can build models which can help you assess credit in a different way, right? I read somewhere that there are about 1.7 billion people in the world who are now digitally discoverable, as in they have a digital footprint but not a bureau history, right? That information can be used to give them credit.

Can you elaborate on one of those points? I mean, I’ve heard this before, but how does the telecommunications company data inform a credit decision? Could you walk us through that process?

There are lots of companies which are using alternate data sources. I have to say, I’m a little bit cynical about the alternate data sources, especially social media data. I have not yet seen it work. You know, I’ve been trying to get evidence that it works and I haven’t yet seen evidence that it works in terms of the long term default history or how it performs in a period of stress, but I think the telco data is interesting, because the way you use your phone, it’s a little bit like how you use your credit card. It’s giving you behavior data on how much do you use and a lot of telco data can also be a good proxy for fraud checks. In the past, the fraud checks were done through alternate means like phone calls and site visits, whereas now it can be done using the geolocation data. That data has been used by some of these startups to build a credit score, and I think it works. It works better than the social media data, though still not as good as the credit bureau data. The two combined can be powerful.

For example, if you constantly go over your limit for data for the month or your number of messages, that would be kind of an informative data point, or is it kind of just paying your bill on time? I’m just curious.

I think it’s not just paying your bill on time. It’s also a question of how much you spend, which could be a proxy for how much you earn. The geolocation data could be used to understand whether you’re giving accurate information about where you live and where you work, whether you have a regular job or not. It can be used to inform the lenders in different ways.

Is there any danger from using these new data sources that we sort of subject people to the tyranny of the algorithm where certain people are going to be excluded from the financial system now based on nontransparent algorithms that they have little recourse if the numbers shift against them?

I think there is a risk of data being misused, right? I think when the banks are subject to a lot of rules and regulations … and banks and telcos are subject to rules and regulations around the amount of data they capture, how they store the data, how they safeguard it, the privacy guidelines, the consent … it’s all good from a customer privacy point of view. Whereas with some of the fintech companies, because they don’t have to adhere to the same standards, sometimes they may not and the data could be lost or misused or their privacy comprised. I do worry about it at times, but you know on the other hand, I was talking about this with somebody from a media group and they told me that they had done research in Africa where they asked people how comfortable they felt about sharing their personal information with others. Apparently, the research indicated that if, by giving this personal information, it helps them get credit faster and cheaper, then they are willing to share. I think maybe the consumers think differently. Having said that, there should still be some guidelines around how the data is stored and used and safeguarded.

A question about your research, getting back to the small business lending and financial inclusion … It’s interesting to me that that’s your focus within financial inclusion. A lot of times we talk about financial inclusion and we say number of unbanked in a country, but from the perspective of maybe a small business, maybe they do have a bank account but they can’t get a loan as you mentioned. How do you define success or financial inclusion from the perspective of a small business?

When you talk about financial inclusion in general and the number that’s typically quoted as the World Bank Findex number, which says 2 billion unbanked in the world, and when they say that there has been a huge improvement in the prior two years because the number of unbanked adults is now down from 2.5 billion to two billion, yes, that is a big improvement. But I think the end game is not just to open accounts for them, right? The end game is to help them save, to help them get insurance for whatever they need, and to help them invest and grow their business. Therefore, when we talk about the number of people with bank accounts, that is just the starting point. What is much more important and relevant is what you do with it afterwards.

A very good example is what has been done in India, right? India started with this program called Aadhaar, which gave everybody a biometric identity. Using that identity, there was a government scheme which then encouraged the banks to open accounts for these people using the biometric information. In a short period of, I think, one or one-and-a-half years over 200 million new accounts were opened, which is, again, good, but that’s not the end game. What has since been done is that those accounts are now being used to transfer a lot of government subsidies into those accounts, into the accounts of those individuals, right? A lot of the funds that they were supposed to get from the government, which were often siphoned off by the middle men, are now being put directly into those accounts and people who are supposed to get the money are actually getting the money.

Or, on the other hand, some of the subsidy schemes that the government was running, one of them was around providing subsidized gas cylinders or subsidized gas for home use, and using this data and by matching it to people’s national ID information, the government was able to do a lot of de-duplication. It was also to make sure that people who were not supposed to get these subsidies were actually not getting it. A whole lot of actions have been taken, but the net result is that in just one year the government has been able to save $700 million in subsidies, right? That’s a winner. It’s a winner for the consumer, because whoever was supposed to get the money is actually getting the full amount, and it’s a winner for the government, because they are now being able to reduce corruption and siphoning and actually save the national subsidy bill.

Typically a bank account would be a starting point, right? In Kenya, I believe the whole genesis of M-Pesa was around people who were … you know, it was like one family member would be working in Kenya and they needed to send money to somebody back home. The way it was being sent was sending physical cash through someone and it would take two or three weeks to reach the family and then they had to pay for it and it was very late. Somebody with an innovative mind found this solution saying, “Okay, why don’t I just top up on my phone in Nairobi, and the family back in the village can then use the money immediately.” It’s about making payments faster and cheaper in that case.

The same thing goes around access to credit. The reason access to credit for these businesses is important is because then it helps with the overall economic growth of the country. It creates more jobs. It improves the GDP of the nation and of course the insurance part is very important. In a lot of emerging countries we hear about farmer suicides. Two or three consecutive years of too much rain or too little and they don’t have crop insurance and they just end up taking their own lives. One of the areas that a lot of insurance companies or fintech companies are now looking at is how do you provide insurance to these small farmers in various countries? I do hope somebody solves for it quickly.

Thank you so much for joining us today.

Thank you.

We hope you enjoyed today’s conversation with Anju. For more episodes like this you can find us on iTunes, Google Play, and Stitcher. For even more content, look up our Pacific Exchange blog, available at FRBSF.org. Thanks for joining us.